China drowning in money: what it means for the rest

At the high levels of liquidity that have now been reached, further leveraging has and will continue to become increasingly ineffective. More and more money must be employed to get the same results. Barring a major policy misstep, there is no true crisis imminent. However, a crisis must loom as a possibility at some point.

This leaves Beijing with unpleasant choices. More monetary stimulus will have only a limited impact now at the cost of digging deeper into a hole that China must eventually climb out of. Whether or not further short-term stimulus is chosen, the PRC must eventually de-leverage to some extent. This will exert downward pressure on growth for some time. After years where growth has been inflated by a flood of new money, this signifies instability, and the Communist Party does not like instability.

How liquidity is drained, however, could matter a great deal. Broad money should at least stabilize relative to GDP, and total credit should slow relative to GDP. It would be greatly preferable if, at the same time, bank lending were to become less important. This could occur with financial reform. The PRC should have more commercialized banks that are more circumspect about lending under the wrong conditions. It should have more financial options so that banking is less important relative to bonds, stocks, futures, and other financial outlets.

Financial reform is not only painful; it takes time. Interest rate liberalization, de-control of financial markets (with attendant risk), and partial privatization in banking cannot be done overnight. Beijing has a bit of time, since there is no impending crisis, but genuine reform should start as soon as possible. If it begins quickly, the payoff from reform can more than offset the discomfort from the inevitable deleveraging. The PRC's financial system can shift from a source of instability to a source of efficiency.

American Involvement

Like it or not, the U.S. is already involved in the Chinese liquidity problem. Some portion of excess Chinese liquidity inevitably spills into the U.S.-and more than anywhere else, because the yuan is tied to the dollar. Most famously, this was part of the feedback loop that contributed to the recent financial crisis. It has continued since, with Chinese money entering the U.S. in various ways.

But, as it was before the financial crisis, Chinese liquidity overflow into the U.S. remains only part of the loop. Though American money supply is now smaller, the U.S. economy is still much bigger, and the dollar is the world's reserve currency. Extra American liquidity, whether due to low interest rates in the middle of the last decade or quantitative easing more recently, spills over onto the rest of the globe.

When it finally becomes willing to deal with its own monetary problems, Beijing will therefore cast a nervous eye to the Federal Reserve. To a lesser extent, the Fed should do the same with regard to the People's Bank. The U.S. should:

• Continue and enhance information exchange with China on monetary policy. Countries make their own monetary choices, but transparent and timely communication helps make for better policy.
• Plan for notable economic change in the PRC in the medium term. Beijing could adopt financial reform and become much more efficient, or it might refuse and see true growth slow considerably.
• Intensify bilateral and Asian regional trade and investment liberalization, such as the Trans-Pacific Partnership, to help protect friends and allies against a possible Chinese slump.

Tightening the Taps Together?

China and the U.S. face the same long-term challenge to unwind money growth. The two challenges are connected, though the PRC's is clearly more daunting. China must act or lose monetary policy as a tool, and American policymakers should be aware of the stakes.