China’s money supply should not be misinterpreted

Statistics show that China accounts for half of the world’s new money supply since the global financial crisis. Certain people thus accused China of over-issuing currency, and attributed the country’s rapid gross domestic product (GDP) growth to over-issuance of the yuan.

The alarmists completely ignored objective conditions, and failed to uncover the reasons behind China’s massive money supply. As a result, a supposedly rigorous discussion of a major economic problem was filled with meaningless uproar.

Market-oriented reforms are the first important reason behind China’s ever-expanding money supply. For example, a company bought 20 mu of land from the local government for only 100,000 yuan at the time of its founding more than 10 years ago, and the investment was included in the GDP that year. After the company goes public, the market value of the land rises to 200 million yuan, which demands 50 million yuan in new money supply.

What does it mean? The example shows that in the process of market-oriented reforms, the 100,000-yuan investment more than 10 years ago is equivalent to today’s 200 million yuan in market value and 50 million yuan in money demand. If the central bank does not issue the 50 million yuan, the 200 million yuan in market value will be just a bubble. This explains why China’s money supply has grown faster than GDP, and been on a steady rise.

By the same token, price reforms can also lead to a substantial increase in the demand for money. For example, if resource prices rise, companies will have to pay more for the same amount of raw materials, and consumers will have to pay more for the same product. It should be noted that this problem is unique to China. Developed countries have followed market rules from the very beginning, and do not face the problem of ever-expanding money supply.

China has had to issue much more money than developed countries in order to recover from the global financial crisis because its economic structure is different from that of developed countries.

After the global financial crisis erupted, the United State gave top priority to rescuing its financial institutions, while China attached great importance to stimulating its manufacturing sector. U.S. financial institutions adopted an average leverage ratio of 60-1, meaning that they could use every one dollar to create 60 dollars in market liquidity. By contrast, manufacturing enterprises would be in a very dangerous situation if their debt-to-asset ratio reaches 80 percent or debt-to-net-asset ratio reaches 400 percent. In other words, China as a manufacturing-based country must issue 15 times more money than the United States in order to provide as strong support to its economy as the United States does.

This is the crux of the problem. The U.S. economy is based on finance and services, while the Chinese economy is based on manufacturing. The services sector can adopt a much higher debt-to-asset ratio than the manufacturing sector.

China has greatly increased its money supply to tackle the sharp economic slowdown, which is reasonable but has indeed created considerable risk of debt expansion. In fact, equity financing rather than debt capital expansion should be given top priority in the face of grave international and domestic economic risk. Unfortunately, China seems to be scared by the sharp increase in its money supply, and has thus tightened its monetary policy.

Facts prove that the tight monetary policy has led to a slump in domestic stock markets, a surge in loan demand, persistently high interest rates, and such financial risks as usurious loans, shadow banking, and trust loan expansion. However, the greater risk lies in an increasingly weak real economy.

Read the Chinese version at: 不要误读中国货币发行量 , Source: Economic Information Daily, Author: Niu Wenxin