Tight credit, loose monetary and fiscal policies may become norm

Updated: Mar 15, 2021 By Peng Wensheng China Daily Print
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A clerk counts cash at a bank in Nantong, Jiangsu province. [Photo/Sipa]

The prices of crude oil and other commodities have risen sharply since February. Meanwhile, United States bond yields have also risen rapidly. The Biden administration is ready to launch a $1.9 trillion fiscal stimulus, and the Federal Reserve has repeatedly stressed that it will not exit monetary easing anytime soon.

In this context, the market's concerns about global inflation have increased significantly. There are some worries that inflation may exceed the levels seen already.

First, we need to understand the nature of the recent economic fluctuations, the stage of economic cycle we are in and the factors driving them.

The traditional business cycle is generally demand-driven and has an endogenous mechanism. From recession to recovery, demand often rebounds first under the stimulus of policies, thus stimulating production.

Therefore, demand recovers faster than supply, resulting in a contracted output gap. Deflationary pressure is thus mitigated, increasing inflationary pressure. Typically, this can lead to a decline in monetary policy easing and even marginal tightening.

But this time round, the impact of the COVID-19 is exogenous and is mainly driven by supply. The impact of the pandemic is mainly exemplified by suspension of work and production as well as social isolation. Although demand is also affected, the major impact starts from the supply side.

When the pandemic ends, social isolation will be lifted. The market will witness recovery in supply amid recovery of demand. The economy will return to its normal trajectory.

The mechanism of the epidemic's impact is more in line with the logic of the real business cycle theory, which downplays the role of currency demand in business cycle fluctuations. The theory maintains that economic fluctuations are mainly driven by factors on the supply side of the real economy, such as technological progress and natural disasters.

The large-scale supportive monetary and fiscal policies adopted across economies in 2020 were unable to stop the economic downturn, as economic activities have been constrained by physical restrictions brought about by the public health crisis.

This year, as the epidemic eases and physical restrictions will be reduced or even eliminated, global economic activity is sure to rebound. This is a driving factor that is irrelevant to fiscal currency. This is the key to our understanding of the current economic cycle mechanism.

The epidemic is also different regarding its strong synchronization. All economies were shaken by the epidemic last year, going downward simultaneously. With this, monetary easing and fiscal easing were implemented worldwide at the same time, at different levels but in the same direction.

This year, such synchronization will be seen in the simultaneous upward movement of the global economy, which is a true concurrent recovery.

Therefore, a synchronized recovery worldwide this year means the multiplier effect of demand between countries will increase, supporting economic growth more powerfully. The recent rise in commodity prices and the continued upward trend in US bond yield have, to some extent, reflected the market's expectations of a concurrent recovery of the world economy.

To better understand inflation, one should distinguish between endogenous currency and exogenous currency. Exogenous currency is not the result of the economic system itself, nor is it a currency produced by financial activities.

A typical example of exogenous currency is gold, as people cannot freely control the production of gold. Another exogenous currency is the currency issued by fiscal policy.

The typical endogenous currency is credit, which reflects the internal energy of economic activities, including economic growth and the property market's demand for credit.

In 2020, China mainly supplied money through credit, which is basically endogenous currency. Although currency expanded more rapidly in the US last year, most of it is exogenous currency from fiscal supply. Calculations show that the US M2 growth rate topped 25 percent in the second half of 2020, 10 percent of which came from fiscal supply.

One of the risks that the capital market shall face this year is the higher-than-expected US inflation. Both the inflation expectation implied in the US Treasury bond and the inflation expectation based on consumer surveys over the past two months have both exceeded expectations.

Although the actual inflation data have not been released, consumer demand will further rise and inflation will also rise with the advancement of vaccination and the implementation of US fiscal stimulus.

The probability of persistent hyperinflation in the US is not high, for some of the deep-seated problems that lead to low inflation are not likely to change at present. For example, the polarization between the rich and the poor leads to excess savings and insufficient consumer demand, which curbs inflation.

Judging from the Fed's statements, it is more likely that the US monetary policy will respond less efficiently, which will likely increase the volatility in the world's financial markets.

Unlike the US, the endogenous nature of currency points to debt problems. After the substantial expansion of credit in 2020, China's private sector debt-to-GDP, or macro leverage, ratio increased by about 18 percentage points, the largest annual increase since the response to the 2008-09 Global Financial Crisis.

It can be said that the rate of monetary and credit expansion this year will be slower than that of last year. One implication of this could be the ratio of the debt service burden of the private sector's stock debt to new loans will bottom out.

Historical experience shows that rising debt service burden will increase the pressure of debt default and reduce investors' risk appetite.

Based on the above findings, the US may have a loose fiscal policy and a tight monetary policy. Monetary environment will inevitably be tightened marginally. It may not be achieved by the Fed raising interest rates, because the Fed adopts an average inflation target system, and increasing tolerance for inflation. It may be realized by rising long-term interest rates.

In the medium term, fiscal stimulus will help the US economy achieve full employment ahead of schedule, which will eventually result in a contraction of the Fed's currency policy and an increase in short-term interest rates. Overseas capital markets have started to discuss when the Fed will start raising interest rates, which can be seen as a response to the potential impact of large-scale fiscal stimulus.

Given the limited scope of China's fiscal expansion, the balance of macroeconomic policies will mainly be reflected in the interaction between monetary policy and supervision. The rise in China's short-term interest rates since January may be related to the rapid expansion of credit and the pressure of rising asset prices.

This means that China's monetary policy this year may be tight first and then loosened. The logic behind it is the debt problem discussed earlier. Looking ahead, under the general trend of deleveraging, the "seesaw" relationship between currency and credit will be an important dimension for us to understand China's monetary policy for a long time to come.

Chinese financial regulators have tightened their grip on credit supervision since 2017. Credit was expanded in 2020 to combat the epidemic. When the economy recovers after the epidemic, deleveraging and dealing with financial risks may be emphasized again. Looking at the developments over the next few years, tight credit, loose monetary and fiscal policies may also be the general direction of macro finance.

China has made world-renowned achievement in poverty alleviation on the back of the efforts of the whole society, guided by public policies, which can be said to be the role of finance in a broad sense. The common prosperity required by high-quality economic development means that direct and indirect policy measures with fiscal attributes will play a greater role.

The writer is chief economist with China International Capital Corp.

The views don't necessarily reflect those of China Daily.

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