The NRCC fixed exchange rate mechanism affords the private sector the opportunity to conduct open market operation. The private sector can affect a change in the domestic money supply as well as a corresponding change in the international reserve holdings of the central bank. An increase in international reserves is registered as a balance of payment (BOP) surplus and a reduction in the international reserves is registered as a BOP deficit.

The private sector is not the only source of money creation. The central bank can also create or print money. However, the money creation ability of the central bank is not unlimited. If the central bank prints too much money, the private sector can reverse it, by simply bringing the yuan to the central bank and demanding dollars. This will be registered as a BOPs deficit, a reduction in the bank international reserves, and a corresponding reduction in the monetary base. Again, in the extreme case that the central bank prints too much money, it is possible that the bank will have zero or little international reserves. In that extreme case, the monetary base will consist solely of domestically printed yuan or what we will term “domestic credit creation.”

As the monetary base is endogenously determined, the Chinese central bank has no control over the magnitude of the monetary base. All they have control over is the composition of the monetary base. If it prints too many yuans, the BOPs deficit will reduce the international reserve holdings of the central bank. If it prints too little, there will be capital inflows and an increase in the international reserve holdings that will force the central bank to print additional yuans. Hence, by looking at the proportion of the money backed by international reserves, we can get a sense as to whether the Chinese central bank has been too loose or too tight.

Fig. 49.1 shows the ratio of international reserves held by China’s central bank to the Chinese M1. One can see that while it has slowed down and even declined in recent years, the ratio of reserves to the monetary base has steadily increased during the first decade of the millennium. The NRCC fixed exchange rate mechanism, combined with the rising international reserves, means that over the time the reserves were rising, the Chinese monetary policy became increasingly tighter. The tight monetary policy has had several effects. One was the decline in the ratio of domestic, high-powered money creation. This is an important point because under a floating exchange rate system, a tight monetary policy would lead to a currency appreciation and lower domestic prices and/or inflation rate. If anything, this data suggests that the Chinese central bankers were quite hawkish on inflation during the fixed exchange rate period.

In previous paragraphs, we have shown that the RCC sets the global inflation rate. It determines the purchasing power of its currency. Hence, that component of money demand is exogenous to the NRCC. We also know that the RCC determines the global amount of dollars in circulation. So, the question is how are the incremental dollars allocated across regions? The answer is simple. If everyone grew at an average rate, the dollars would be distributed proportionately to their size. Therefore those who grow above average will tend to accumulate international reserves, while those who grow at a below average rate will experience a loss of international reserves. Furthermore, those with an improving growth rate will experience an improvement in their BOPs. This is a testable implication. Fig. 49.2 shows that as the adoption of the fixed exchange rate mechanism, the change in international reserves, that is, the BOPs, have behaved as expected. When China’s relative growth rate improved, so did the change in international reserves or BOP. When China’s relative growth rate deteriorated, so did the changes in international reserves or BOP.

We do not believe the central banks are without tools to combat the credit expansion induced by capital inflows or asset bubbles. While we do not distinguish between hot or normal capital flows (we do not know how), we all can agree that both types of flows result in changes in a NRCC’s BOPs, and thus the stock of international reserves held by the central bank. We have already mentioned that the Chinese central bank was quite timid, if not tight, on the issuance of domestic high-powered money not backed up by international reserves during the fixed exchange rate period. In fact, Fig. 49.1 shows that, over time, the ratio of international reserves to the M1 base steadily increased. The increased ratio meant that a larger component is due to the action of private agents who bring their dollars to the central bank and convert them into yuan.

The inflow of international reserves allowed the banks to expand the quantity of money through its creation of domestic deposits under a fractional reserve banking system. The logic is simple. Under a 10% reserve requirement, 1 yuan would create a maximum of 10 yuans worth deposits. As the deposits denote a liability to the banking system, under a double-entry bookkeeping, the asset side must also match. The bank’s assets consist of 1 yuan worth of bank reserves and 9 yuans worth of loans. The credit creation is equivalent to the amounts of deposits less the reserves held by the banks.

The previous calculations illustrate an important point. The banking system creates the credit, but the supply of the credit is determined by the amount of reserves and the effective reserve requirement imposed on the deposits. Absent government regulations, one would expect the quantity of money and credit to grow at the same rate. One would not expect to find any changes to the money multiplier. However, to the extent that the ratio of the credit creation to the money creation changes, it reflects either a government regulation (i.e., tinkering with the reserve requirements) or differential growth in the demand for credit and money. The latter is the domain of the private sector and depends on a multitude of factors that we are not going to discuss at this time. The important point is that by paying attention to the credit to deposit ratio, we may identify any differential impact on the two markets and with a little luck, we may be able to discern the source of the differential performance.

Looking at Fig. 49.3, it is evident that the ratio of credit-to-deposits steadily decreased during the fixed exchange rate period. This result is quite interesting, especially for those who worry that capital flows could result in an excessive credit creation. First, if the reduction in credit-to-deposits is part of the private sector equilibrating process, this is a reassuring outcome. The market automatically adjusts to deliver the results desired by the private sector. This makes a lot of sense. If, as we have assumed, under a fixed exchange rate system the private sector initiates open market operations, it will increase or reduce the quantity of international reserves held by the central bank and all else the same, that expands the monetary base and quantity of money. The second explanation is that the Chinese monetary authorities marginally increased the reserve requirements of the banks, thereby reducing the credit creation ability relative to the deposit creation ability of the banks.

Other interesting details are also evident in Fig. 49.4. Notice a divergence between the two series around 2008. The data suggest that during that time the credit created by the banking system increased relative to the deposits created. Hence, from 2008 going forward, the money multiplier has risen in China. Put another way, China’s domestic credit per yuan worth of reserves increased during this time. To the extent, that the ratio of international reserves to the monetary base also rose, it allows us to rule out hot capital flows as a source of the credit easing. Looking at Fig. 49.4, it is apparent that during the 2008–14 time period that the rate of increase in international reserves declined, it still remained positive even though the credit creation per yuan was declining. This means that the international reserves were growing throughout this time and thus we can rule out the hot capital outflows theory. However, this leads us to another question: if not hot capital flows, then what?

Our answer is simple and we have already hinted at it: central banks can also affect the domestic credit creation of the banks through moral suasion and reserve requirement increases. And we know that China’s authorities have a great deal of moral suasion. Increases in the credit creation have to be allowed by the Chinese monetary authorities. During the bubble years, the Chinese monetary authorities reduced the credit creation ability of the financial institutions in China. The credit multiplier declined steadily throughout the period. This does not mean that credit declined. During that time, the monetary base was expanding. All it means is that the amount of credit produced by each yuan’s worth of reserves was reduced as the central bank raised its reserve requirements.

It is evident to us that China’s monetary authority has the tools to regulate the domestic credit creation ability of the banks and it does with gusto when it deems appropriate. Viewed this way, it is not the hot capital flows that caused China to change its banks credit creation ability. The surge in the credit multiplier may be attributable to Chinese concerns about the slowdown in the global economy and their desires to keep their economy expanding at a rapid pace. However, the possibility remains that China may overdo it. If it does, its inflation rate will begin to increase, the exchange rate will depreciate, and the international reserves may decline as a result of a capital outflow. The next few years will tell us if we were correct in believing that China made a mistake in abandoning its fixed exchange rate system.

Given the imported inflation rate, determined by the RCC’s central bank, China had the amount of money needed by the economy to function properly. More importantly, the money was created by the private sector through the BOPs. As we deem inflation to be too much money chasing too few goods, it follows that absent the international reserves inflow and under a floating exchange rate, the noninternational component of the monetary base would not have been enough to satisfy the economy’s money demand. Under a floating exchange rate, the shortage of money would have, all else the same, resulted in a decline in the underlying inflation rate and an appreciation of the exchange rate. For those who equate the nominal exchange rate with the terms of trade, these would be the opposite of what a currency manipulator would do.

If one believes that the nominal exchange rate affects the terms of trade, China’s action would have produced a rising currency and therefore a deterioration of its trade balance. The one point where the critics of China’s exchange rate policy were correct was that if China allowed its currency to float, all else the same, it will appreciate. So far, that was the case under the early days of the managed float. What these critics missed was that the appreciation is due to the tight-monetary policy that the Chinese monetary authorities have pursued as fixing the exchange rate. The tight policy has resulted in a monumental accumulation of international reserves. That is precisely the mechanism by which the private sector forces the central bank to print more domestic currency. And the central bank is assured that any money creation is precisely what the private sector wants. If the central bank did not have the right money creation under a fixed exchange rate system, the private sector would take care of it. It had the power to reduce or increase the quantity of money through a BOP deficit. In turn, under a floating exchange rate system, all the private sector can do is alter the purchasing power of the money to achieve the desired level of real balances, that is, the inflation rate. In the process, as the purchasing power of the money adjusts, so will the exchange rate. Under a managed float, an excessive monetary policy would lead to a combination of the two. Higher inflation and a capital outflow translates into a loss of reserves. This is precisely what has been happening during the last couple of years. The yuan has depreciated and it now takes more yuans to get a dollar (Fig. 49.5). Additionally, China has lost some of its international reserves (Fig. 49.1).

During the fixed exchange rate period, the Chinese monetary authorities were also mindful of the credit market conditions. They were quite active in raising reserve requirements of financial institutions and, in so doing, they reduced the deposit and credit creation abilities of these institutions. China’s monetary authorities have been quite active. Deciding whether or not allowing the recent expansion of credit was a wise policy decision is hard to argue against, given the central bank’s track record. We feel the central bank made a mistake, but time will tell if they were right or wrong.

Looking back in time, it seems to us that the Chinese monetary authorities have been very shrewd and quite active when they had to be. They have also been fairly conservatives and smart. They outsourced their monetary policy and gained instant credibility and transparency. That was the right move at the right time. They have also been quite active at regulating the financial institutions’ credit creation ability. At a time when the Maestro was talking about irrational exuberance and did nothing, China’s monetary authorities raised the reserve requirements of the banks and restricted banks’ domestic credit creation as a percent of GDP. Greenspan could have learned a thing or two about monetary policy from the Chinese.

Contrary to the perception in the press, China ran a very conservative monetary policy. Its domestic credit creation was been minimal. That, in turn, forced to the private sector to import money to increase the domestic monetary base. As a result of these policies, China experienced consistent BOP surpluses and accumulated a huge amount of international reserves over time.

Under a floating exchange rate system, the “tight” domestic creation would have resulted in a decline in the inflation rate and, quite possibly, deflation, as well as an appreciation of its exchange rate. The fixed exchange rate appreciation provoked the ire of protectionists in the United States who confuse the nominal exchange rate with the terms of trade. These people correctly believed that if allowed to, the Chinese yuan would appreciate, as it did during the early stages of the managed float. Where they went wrong was that they also believe that the rising currency would lead to a decrease in the price of imports and an increase in the price of exports. Put another way, a change in the terms of trade. It is apparent to us that these people either do not subscribe to the Economist or if they do, they have forgotten about the Economist’s Big Mac calculation where the price of a Big Mac in local currency is converted to dollars and compared to that of a Big Mac in the United States.

The Economist’s calculation illustrates a simple point. If the dollar price is the same across borders, purchasing power parity holds. In that case, the domestic price changed to offset any change in the exchange rate. That is the point the protectionists are missing in the case of China. While it is true that the Chinese monetary policies under a floating exchange rate system would have resulted in a 26% currency appreciation, as the critics argue, the fact that the exchange rate remained fixed eliminated the exchange rate as a price adjustment mechanism. If no other price changed, then the terms of trade would be affected as the protectionists argue. However, if other prices change, then the Big Mac standard may still hold. Since the beginning of 1994, around the time China fixed its exchange rate to 2005, China’s domestic prices relative to the US’s prices rose about 25%. The exchange rate adjustment that the protectionists were expecting had already been effected. Domestic prices, nontraded goods in China in particular, increased enough to result in an approximated cumulative excess inflation rate of approximately 25%. The floating of the exchange rate would have only changed which variable would have been affected—the exchange rate instead of domestic prices—yet the outcome would have been the same. While the Chinese may be unfair competitors, the fixing of the exchange rate does not prove that they are currency manipulators. In fact, the data presented here suggests that they behaved like a textbook NRCC. And if we had to give them a grade, it would have to be an A+.

Being a successful NRCC does not mean that they will be a successful RCC. However, the fact that they have mastered their domestic and international monetary aspects gives China a chance to become a successful reserve currency country if they do in fact become one.