After writing an article on world inflationary pressures on Friday it was nice of the Chinese regime to agree with me and raise reserve requirements for their banks! I wrote last week about the inflationary pressure she is under with rising commodity prices and a broad measure of money supply which are both rising strongly. Just as a reminder her last consumer price inflation measure was at 5.1% and her M2 measure of money supply is growing at 19.7% around 9% above the last recorded rate of economic growth. This morning there has been another sign of inflationary pressure with according to the China Information News data released that house prices in 70 cities rose 6.4 percent in December from a year earlier. This new data combined with the follow-on implications of the reserve requirements rise has meant that the Chinese Shanghai Composite index equity has fallen by 3.03% this morning which continues her underperformance of the world’s other main equity markets. As an aside it gives me a slight wry smile as the Sunday newspaper I read yesterday was recommending investments in China. There was also a more grim confirmation of rising food prices in Tunisia where there were food riots over the past few days and the President has been forced out of the country.
What does raising reserve requirements for banks actually do?
If we look at what China actually did on Friday we see that she raised reserve requirements for her biggest banks from 18.5% to 19%. This increase of 0.5% should mean that going forwards Chinese banks who receive deposits can lend out less of them via the so-called banking multiplier. In theory this works as follows. If you have a reserve requirement of 5% then for each Yuan received the bank has to hold 5% as reserves meaning that this one Yuan can be lent up to 20 times. However raising the reserve requirement to 10% would mean that for each Yuan deposited then 10% of it will have to be kept as a reserve and so it can only be lent out ten times.
The formula for this is that the money multiplier is the inverse of the reserve requirement or M=1/R where M is the money multiplier and R is the reserve requirement.
This type of theory is the bedrock behind discussions about fractional reserve banking and when you read discussions about it (for example a UK MP Douglas Carswell has a bill in parliament trying to stop it) this is what is meant. If we move back to China then we can see now that her increase in reserve requirements of 0.5% is an effort to reduce the money multiplier and hence to reduce broad money growth and bank lending.
Will it work?
Unfortunately the real world is full of examples where economic theories have been shattered by being exposed to reality, and the credit crunch period has been hard on many theories. If we look at examples of this sort of policy from the past we can see that results have been quite patchy. It is not true to say that it is a complete failure but results tend to be both slow to arrive and minor in their effect. This usually leads to the policy being used more aggressively which then often puts the country in the reverse situation to where it started.So a boom responded to by reserve requirements if we look at history often turns to bust. In a nutshell it is a very blunt instrument.
Furthermore modern financial economies and banking systems are advanced and have all sorts of ways of slipping to the side of official definitions. I do not wish right now to debate what is money? But simply to make the point that these days a definition can be more elusive than you might originally think. This is one of the reasons that many countries have abandoned this system as a policy tool. For example it has been estimated that in the run-up to the credit crunch the “shadow banking system” in the United States may have actually been larger than the traditional one! Also for most banks around the world the real constraint on them is their capital position and regardless of what the money multiplier might say they lend according to their capital position and perhaps more importantly their prospective capital position.
So whilst as a policy it may help the Chinese over time it is not a solution in itself and I expect more interest-rate rises will be necessary to support it and if I was in charge I would have put more emphasis on them as they have time lags in their operation so it is best to concentrate them at the beginning of your policy response. I can see from the Chinese government’s point of view as rulers of a command economy how the theory of the money multiplier might seem an obvious policy tool but suspect that just like everyone else they will learn that practice is not theory.
One country that certainly does not suffer from an excess of bank lending is Greece! In fact with a banking system that is being propped up by the European Central Bank Greece (and Ireland) is the polar opposite of China in many ways. Ironically however Greece has virtually exactly the same consumer price inflation rate as China at 5.2%. This is mostly because of the increase in consumer taxes which have been imposed by her government as it tries to get a grip on Greece’s fiscal deficit and national debt.
Just to add to Greece’s problems Fitch which was the last ratings agency where she had an investment grade rating reduced it on Friday to what polite people call sub-investment grade or the less polite call junk. In the arcane world of rating levels she is now BB+ with a negative outlook. If we pause briefly to point out that yet again a ratings agency is acting with 20/20 hindsight we can then move on to something relevant which Fitch points out in its statement.
Nonetheless, general government debt/GDP is currently projected by Fitch to peak at close to 160%, while interest payments/revenue are expected to rise to 20% by 2014, even under a favourable base-case scenario of effective implementation of the EU-IMF programme and modest economic recovery beginning in the latter half of 2011.
For Greece this is the real problem, how can she finance herself once the rescue ends? To which there comes no answer as a solvency problem cannot be fixed by liquidity and accordingly she finds herself abandoned by international investors who are afraid that sooner of later Greece will have to restructure her government debt and possibly by a substantial amount. This is why her ten-year government bond yield is over 11% which leaves her looking profoundly insolvent in spite of an improvement last week of around 1%.
Ireland: Is her central bank printing money?
Regular readers will be aware that I avoid politics on here so I will merely note that the situation in Ireland currently is at best confused and somewhat in disarray. I can advance that as a fan of democracy I think that a new election and soon would be a good idea. However there has been a development in the monetary situation in Ireland which follows on from an article I wrote back on the 16th of November 2010. Back then I pointed out that the other assets section of the Central Bank of Ireland balance sheet had risen to over 40 billion Euros which is around a quarter of her economic output.
On Friday came news that this section has now expanded to 51 billion Euros and if we add this to the 132 billion Euros lent to Ireland by the European Central Bank we see that there is an enormous amount of liquidity support being supplied to the Irish banking system in addition to the official rescue package. It also makes me wonder about the relationship between the ECB and its constituent central banks as after all it is supposed to be the central bank now and the constituents to my mind were not really supposed to be doing this sort of thing.You either have a joint central bank or you do not.
So the situation in Ireland’s banking system looks ever more grim and unfortunately unless there is a change in the strategy employed or rather perhaps the non-strategy employed it is hard to see much of an improvement taking place. It looks as though depositors are continuing to leave Ireland’s banks and accordingly as I wrote at the time the scale of the rescue package for Ireland is likely to prove to be insufficient.
Should the European Financial Stability Facility buy peripheral Euro Zone government bonds?
This proposal has gathered some momentum over the past few days and I feel that it needs a sober analysis. If we look where we stand right now we have the European Central Bank supporting various government bond markets via its Securities Markets Programme. This has announced some 74 billion Euros of purchases and I believe it was fairly active last week particularly in Portugal in addition to this.
The problem is that this is a tactic and not a strategy. It is something that should have lasted for a month or two not the nine it has. It should have held the line whilst a strategy was constructed. If you like that is part of a central banks role to respond to a crisis in the shorter-term whilst a full plan is developed.
The consequence of it is that it has allowed Europe’s politicians to dither and we still have no strategy in place. Another is that it questions the position of the ECB itself. If you analyse the ECB’s purchases it must have losses greater than its capital so its own position can now be questioned. Also if you look at Greece and Ireland their bond markets have not improved if anything they have got worse.Also we have the issue of at times the ECB in effect being the market which if it was done by anyone else would be called a false market.
So if we look at this flawed plan and replace it with the EFSF we have essentially the same problems. Many of the problems highlighted above would be made worse not better by expanding the EFSF. Also the EFSF has a flaw in that to deploy funds it has to borrow it and so it would be entering into the same debt markets that individual countries borrow in. What if the crisis grew and the EFSF struggled to borrow?
So my contention is that unless you intend to create an entirely false market any bond buying plan is a tactic and not a strategy…
Regular readers will be aware that I have questioned the solvency position of the European Central Bank as it has relatively low capital levels combined with a lot of,ahem, under-performing assets on its books. There have been two official responses to this. The first was a low-profile announcement about plans to increase the capital of the ECB. The second took place last week when the President of the ECB Mr.Trichet called suggestions that the ECB might be insolvent “absurd”.
Those who like me are fans of the Yes Minister series of books may well remember the statement by Sir Humphrey Appleby that nothing should be believed until it is officially denied!