People’s Bank of China (PBOC) Plays with Fire

Friday: The Chinese central bank lowered short term interest rates and bank reserve requirements – at the same time – in another move (part of a pattern) to help push the nations growth along in the second largest economy in the world. Only once before as the PBOC moved on both policies at the same time.  

The central bank is stuck between a rock and a hard place. It is stuck between freedom and control. On the one hand it wants to free up, just a little more, the animal spirits that will drive growth. You read a lot about the current transition of the Chinese economy, from a manufacturing/export based economy to the services/import based scenario.  

At the same time the Chinese authorities want to free up the yuan and allow it float a little more freely, in order to obtain eventual IMF approval to be included in the global basket of reserve currencies (in recognition of its economic might). These are the levers the hand of freedom seek. However, the other hand is pushing a very different set of objectives.

The other hand is the more comfortable and historic power that represents a centralized bureaucracy that cannot yet reconcile to the freedom and dynamism needed in a free market. This hand is about control – not of the economy as in the past, but of the rules and the boundaries by which that economy operates in order to preserve the political system itself. Thus China is playing the most interesting game of all: The West  has ditched (in principle, even if not quite in practice) large scale centralized government control and bureaucracy; China is the last of the Eastern countries of any size, with a controlling core, that finally made a difference in the world economic order.  What is interesting is that China is succeeding where Russia and all other such scenarios have failed.

But the operator of these two hands – the Chinese authorities and financially the PBOC – are not used to the game they are playing. China’s position in the world is changing fast and few nations have such experience. In recent times only Britain has played a similar game between 1880’s and 1940’s. In that period America replaced Britain and the dollar replaced sterling as the global reserve currency. America is now in the unenviable position of being the current incumbent for whom the bells now toll, and China is the new hegemon-in-waiting. This is what makes the recent state visit of the Chinese premier to Britain so interesting – Britain is getting closer to China.

The move this week by the PBOC to change rates and bank reserve requirements was not predicted at the time, and caught the markets flat footed – in response global markets rose positively. However, don’t forget that at the same time the ECB is signaling more easing too, and the Fed may yet be forced to respond in kind – rather than risk itis own economy with a raise in rates. So just as China tries to play a new game it has little experience with, so too Europe and the US.

I am reminded of another period in history where the US took a monetary decision, at odds withglobal sentiment and in deference to domestic needs over global stability. It was at the London Economic Summit in 1933 where the US, Britain, France and other nations were going to re-establish a gold standard of sorts. The backdrop was of a Europe in tatters, struggling terribly to cope with reconstruction after the Great War, and trying to reinvigorate global trade. The US had signaled its willingness to cooperate with Britain and France in the run up to the Conference and everyone assumed some monetary stability was finally going to be achieved in the markets.  

With scant regard for the international monetary dimension, and through ineffective coordination and communication between US state officials and the US team at the conference, the newly elected President Roosevelt effectively changed course and took the US off gold. This “torpedoed” the Conference and it collapsed. Roosevelt was ‘annoyed that the conference, supposedly called to deal with world economic problems, was focusing so much on what he regarded as the domestic economic policy of the United States. The United States, he insisted, must be “fully free to maintain stable domestic price level as our first consideration.”‘ (1)

We can assume the PBOC will do what it wants to do to achieve its own ends. At this point there is a possibility the Chinese would collaborate and coordinate global monetary policy, though we can’t assume it would lead that effort. The US needs to lead that effort, yet it is not doing so. When next the Fed reviews its interest rate policies, I wonder if domestic expediency will overtake global responsibility? Either way, we are all playing with fire. We are just passing around the fire starter.

(1) The Reconstruction of the International Monetary System: The Attempt of 1922 and 1933, Stephen V. O. Clarke, Princeton University, 1973.

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