A thin sliver of “ultimate liquidity” is supporting a vast edifice of private-sector debt obligations in China. That structure is unstable.
The UL indicator, which figured in a recent paper by International Monetary Fund economist Manmohan Singh, includes bank reserves held at the monetary authority combined with depository institutions’ inventory of government bonds and bills. The name refers to the ability of these assets to retain nominal value under extreme circumstances, when no private IOU is deemed trustworthy.
Too little UL is dangerous because private debt can only be settled with official liquidity. When enough liquidity is not available, a credit meltdown can become hard to reverse: central banks in advanced nations are struggling to revive loans even after pushing down interest rates all the way to zero because financial intermediaries are hoarding reserves. But too much UL is also risky; it is potentially inflationary.
So what is the right amount of UL? It depends on the economic conditions. In the United States in 2006, the ratio of UL to overall credit fell to less than one-sixth of 1 percent, according to Singh’s research. That was far too low – when investors started to take fright at private credit, banks were caught out. In 2008, they had to run to the government for additional UL.
The share of ultimate liquidity in China’s total credit was as high as 37 percent in 2002. It may have declined to about 26 percent in the last quarter, matching the record low reached in September 2010 (see graphic). That estimate is based on official data on social financing – the broadest available measure of credit flow in the economy – combined with economists’ estimates for wealth management products sold to yield-hungry savers by an increasingly important shadow banking industry.
There are good reason to believe the 26 percent ratio is too low in China, even though the United States did just fine with a similar ratio during the 1950s and 1960s. For one, institutional arrangements that govern the relationship between debtors and creditors – and give the latter comfort – differ significantly. The United States has had a solid bankruptcy law since 1898; the Chinese insolvency code is just five years old, and untested. Besides, it was only in the 1980s that credit in the United States breached the level in today’s China – 172 percent of GDP – after remaining stable for decades, according to research by Peter Stella, a former head of IMF’s central banking division. By contrast, total credit in China, including financing by shadow banks, has more than doubled in just the past four years to an estimated 89 trillion yuan ($14 trillion).
The current quantity of UL may be too low to keep deflation away. An index of local producer prices has fallen this year. In an excessively leveraged economy, even small price decreases can cause large increases in bad loans and financial stress.
The shortfall of UL is in part a by-product of the decline in China’s trade surplus. The People’s Bank of China issues newly created bank reserves to scoop up exporters’ foreign currency, expanding its balance sheet and supplying UL at the same time. Before the collapse of Lehman Brothers, the central bank’s balance sheet was expanding at a 30 percent annual pace; now it isn’t growing at all.
One way to compensate would be for the government to issue more debt. Gross public debt last year was just 26 percent of GDP – there is definitely scope for Beijing to do more. However, the sudden appearance of unexpected UL might just encourage banks to lend more recklessly. That would be dangerous in a country that had a 6.5 percent retail inflation rate only a year ago. House prices grew modestly in September from the previous month. Fears of quicker price gains are understandable.
Indeed, for now the central bank is acting as if it’s worrying more about too much than too little UL. The 1 trillion yuan in net liquidity that it has injected into the banking system since July is small change for a financial edifice almost 90 times as big. If nothing else, a little bit more generosity will be sensible insurance against nasty deleveraging.