Columbia University professor Xiao Geng says China’s only way out of the current boom/bust cycle is to raise interest rates, even though this means overcoming many vested interests and fears of a hard landing for the economy.
Xiao, who is based in Beijing in a partnership with Tsinghua University, spoke at last week’s AsianInvestor 6th annual investment summit in Hong Kong (pictures of which can be found in this gallery).
Almost as an aside, he argues that Hong Kongers are wrong to assume they should look to the internationalisation of the renminbi as a future currency peg for the Hong Kong dollar. Hong Kong is competitive because it is different, and not just another Chinese city.
Xiao recognises that the US dollar peg is past its prime, however, because of the aggressively loose Federal Reserve monetary policies that are creating distortions in the Hong Kong economy. But he says Hong Kong’s currency, which is printed by private banks, should become as international as the city itself.
The solution is to peg it to the IMF’s Special Drawing Rights accounting unit, which is a mix of dollars, euro, yen and also renminbi.
“Make the Hong Kong dollar an international currency and let market forces define it,” Xiao says. “In turn, the Hong Kong dollar can be used globally for commodity trading. Hong Kong is politically neutral. Develop Hong Kong dollar products and make Hong Kong a true international financial centre.”
He adds that Hong Kong is famous for its legal and regulatory system, and not much else. “What is Hong Kong good at making anymore? Nothing except the Hong Kong dollar,” Xiao says. “If Hong Kong bases its future on just being ahead of Shanghai, its path is not sustainable.
"The development of the offshore RMB market is fine, but it is fragile and it can collapse. Instead, it would benefit both Hong Kong and China to let Hong Kong dollar financial products enter the mainland market, and then the world.”
In the meantime, however, Xiao’s main preoccupation is China’s economy. For example, today 49% of the population is urbanised, and he expects that to rise to 80% over time. This is a source of growth, but it’s leading to a shortage of capital at a time when the industrialised West is printing money. Moreover, in China, SOEs have come to dominate industries, and most of China’s savings are either derived from government or SOEs, not individuals or private companies.
Even as China must grapple with huge hidden unemployment, in the form of surplus labour still stuck in villages, it is exporting capital. Rising domestic inflation is challenging the status quo, pushing local prices very quickly towards convergence with prices in the United States.
Xiao says such price rises are structural, that is, they come with the growth in demand and urbanisation. The government has been slow to raise interest rates, which means today’s depositors are suffering real negative rates of interest. (This explains why the appetite for property goes unabated – it’s a hedge against inflation and the erosion of personal savings.)
Instead of raising rates, China is imposing price controls, but Xiao argues all this does is ultimately keep export prices low and subsidise American consumers.
He notes that black-market lending in Chinese cities is done at much higher rates than official bank loans. The government’s preference for administrative measures such as hiking reserve rates is not curbing credit expansion; in fact it is just adding fuel to the fire.
The People’s Bank of China has been reluctant to jack up interest rates because it knows from past experience that boom quickly turns to bust. It also fears hot money, although Xiao argues inflows are not about punting on the currency but for real investment, and IRRs in China remain much higher than in Japan or the US.
Property owners, SOEs and local government cadres are opposed to raising interest rates. But as long as monetary policy remains loose, it will feed more imports, more overcapacity of fixed investments, and misallocation of capital, including in second-tier cities.
The challenge for China over the next five years is how to encourage more efficient investment and reduce capital misallocation, which should help to promote more consumption and better investment. The best tool is the price mechanism, but as long as costs for infrastructure projects and new buildings are not priced according to reality, people will keep throwing money at wasteful projects.
The true cost for such projects is much higher. “Raising the cost of capital will benefit investors, especially Chinese depositors, and force capital to go after quality investments instead of the real-estate bubble,” Xiao says.
If the PBoC doesn’t raise interest rates, however, Xiao predicts its foreign exchange reserves will build to as much as $5 trillion, a dangerous bubble in loss-making US Treasuries. Furthermore, if inflation rises to 7% or more it will undermine the renminbi’s strength, and possibly cause the currency to depreciate – which would damage the CNH market in Hong Kong.