Chinese Monetary Policy under Pressure
as Asset Bubble Balloons– Japan's experience and lessons offer useful reference –Kwan Chi Hung
Senior Fellow,
Nomura Institute of Capital Markets ResearchI.

Introduction

The Japanese economy experienced years of subpar growth following the collapseof its economic bubble in 1990, and indeed has yet to recover completely from theaftermath. The inception of the bubble can be traced back to the Plaza Accord inSeptember 1985. The Bank of Japan lowered the discount rate five times from 5.0%
to 2.5% between January 1986 and February 1987 to help weaker exporters and boost
domestic demand as the yen appreciated sharply in the wake of the accord. Interest
rates stayed at these record low levels until May 1989. This process encouraged
financial excess and money began to flow into the stock and real estate markets
creating an asset bubble. As the bubble collapsed, the Japanese economy entered a 20year period referred to as the lost decades.
In China, too, prices of assets such as real estate are surging on the back of an easy
monetary policy, and are taking on the features of a bubble. What should China learn
from Japan's experience so that it can avoid making the same mistakes?

II. Asset prices are one of the important variables in monetarypolicy
The primary objective of a central bank is to maintain the stability of the currency(prices) and the financial system. However, changes in asset prices could become adestabilizing factor for the financial system in the form of an increase in bad bankloans, so when determining monetary policy the central bank should monitor not only
the consumer price index (CPI), but also the movements of stock and real estate prices.
On this point, the Bank for International Settlements (BIS) and the U.S. FederalReserve Board (FRB) have differing opinions: The former says that "a central bankshould tighten monetary policy to avoid financial system destabilization attributable
to excessive rises in asset prices, even if prices are stable." In contrast, the latterclaims that "a central bank should focus entirely on price stability when carrying out
financial reform." Although Fed Chairman Ben Bernanke is known as a theorist

1Nomura Journal of Capital Markets Autumn 2010 Vol.2 No.2

representing the latter view, he has attenuated his stance somewhat following therecent financial crisis.
In Japan, although asset prices moved sharply higher following the easy monetary
policy of the second half of the 1980s, the monetary authorities then had very little
sense of the need to tighten quickly, because overheating of the economy and rising
prices were not pronounced. The Bank of Japan began to tighten monetary policy in1989 as it faced rising inflation pressure, but the economic bubble was by that time
already huge. Given a fairly significant time lag between the movements of assetprices and changes in prices as demonstrated above, authorities could find that they
are too late to prevent a bubble if monetary policy focuses only on the price behaviorof the moment.
Following the collapse of Lehman Brothers and the associated shock, China
adopted radical monetary easing. In response, real estate prices soared, with housing
prices in 70 large and medium-sized cities rising 12.8% (year on year) in April 2010.
As observed this time round, China has been seeing a trend in which prices of assets
such as stocks and real estate rise ahead of CPI (figure 1). Therefore, adding asset
prices to the target variables of monetary policy is useful not only for preventing abubble but for stabilizing prices as well.

Figure 1: Stock and Real Estate Prices Move Ahead of Consumer Prices- Situation after Lehman Brothers Bankruptcy (Year-on-year, %)

3530
25
20
15
105(Year-on-year, %)Shanghai Composite Index(right axis)→M2↓
Housing prices
in 70 large andmedium-sized cities
↓CPI↓

80
60
40
200-20-40-60-5-80
Sep-2008
Oct-2008
Nov-2008
Dec-2008
Jan-2009
Feb-2009Mar-2009
Apr-2009
May-2009
Jun-2009
Jul-2009
Aug-2009
Sep-2009
Oct-2009
Nov-2009
Dec-2009
Jan-2010
Feb-2010
Mar-2010
Apr-2010
May-2010
Jun-2010
Jul-2010
Aug-2010

0Source:National Bureau of Statistics of China and Shanghai Stock Exchange

Some Possible Lessons for Japan from China's Economic Reforms

2III. Noteworthy movements of property-related loans
Second, to prevent the expansion of an asset bubble, a central bank needs to pay
attention not only to the rate of quantitative growth of credit but also to changes in thestructure of loans, particularly the share of loans to the real estate sector.
In Japan, the total of loans to three property-related industries, namely nonbanks,
real estate, and construction, accounted for 25% of total bank loans during the bubble
era. In particular, loans to the real estate industry were extended through nonbanks
known as housing loan companies, which were outside the control of regulatory
authorities, and this spurred the expansion of the property bubble and aggravated thebad loan problem after the bubble burst.
Property-related loans in China are still around 20% of overall bank loans, evenincluding housing loans, and this is still lower than the ratio in Japan during thebubble era. However, the size of new housing loans surged in 2009 to a level fivetimes that in 2008 ("China Monetary Policy Report, Fourth Quarter, 2009" of thePeople's Bank of China, February 11, 2010). This is an alarming phenomenon. Also
needing close monitoring is the extent to which bank loans flow out to the real estatemarket through investment companies established by local governments.

IV. Significance of a forward-looking monetary policy
In addition, the more time that passes after a bubble emerges, the greater will be
the damage when it finally bursts and the more difficult the policy response.
Consequently, the regulatory authorities should adopt a forward-looking monetary
policy by determining the risks inherent in the economy as much as possible when
they are still at the potential phase. In this regard, the Bank of Japan "reflects" inretrospect on what it has done, saying that "the most significant lesson that central
banks have learned from the emergence of bubble economies (in the second half ofthe 1980s) is the importance of conducting monetary policy in such a forward-lookingmanner." (Kunio Okina, Masaaki Shirakawa, and Shigenori Shiratsuka, "The AssetPrice Bubble and Monetary Policy: Japan's Experience in the Late 1980s and theLessons," Monetary and Economic Studies (Special Edition) February 2001, Institutefor Monetary and Economic Studies, Bank of Japan).
In Japan at that time, there were domestic concerns about the stronger yen anddemand from the United States to reduce the current account surplus and expand
domestic demand. Also, given that public opposition to monetary tightening was
deep-seated as inflation eased, the response to the asset bubble was slow. It was not
until May 1989, more than three years after the sharp rise in asset prices began, thatthe Bank of Japan began tightening credit. The Nikkei Stock Average rose by a factorof approximately 2.7 from the end of September 1985 when the Plaza Accord wasconcluded to the end of April 1989. Commercial land prices in the Tokyo area weremeanwhile up by a factor of 2.5 in 1988, compared with 1985 levels. Even after

3Nomura Journal of Capital Markets Autumn 2010 Vol.2 No.2

monetary policy was tightened, share prices continued to climb for more than sixmonths, while land prices rose for more than two years.
In China, property prices have been surging, and inflation has been acceleratingfrom -0.7% in 2009 to 3.5% (year on year) in August 2010 in terms of CPI. China has
shown a trend in which inflation lags GDP growth by about three quarters.
Inflationary pressure is expected to rise going forward following the sharp economic
recovery (GDP growth was 11.9% in the first quarter and 10.3% in the second quarterof 2009). To prevent a ballooning of the bubble and rising inflation, the "exit strategy"
of monetary policy, including a rate hike, needs to be implemented in a timely manner(box).

IV. Foreign exchange intervention could cause the expansion ofliquidity
Finally, if the central bank tries to place the policy emphasis on stabilizing theexchange rate, it will be necessary to intervene in the foreign exchange market, andthis will considerably constrain the independence of monetary policy.
In Japan, the yen appreciated sharply following the Plaza Accord. Prompted by theLouvre Accord reached by the G7 in February 1987, which recognized that acorrection of the strong dollar had been achieved and sought to stabilize the dollar, theBank of Japan began buying dollars actively. This served to encourage monetaryeasing as well as the expansion of liquidity, and in turn the ballooning of the asset
bubble. As described, it should be understood that the cause of the bubble economy
was not the appreciation of the yen itself, but the foreign exchange intervention tostop the yen from strengthening further and the monetary easing to attenuate thedeflationary pressure associated with a stronger yen.
The foreign exchange intervention to contain the appreciation of the yuan is also
expanding liquidity in China. To stabilize the economy, the exchange rate should beallowed to float more freely, giving the central bank more room to pursue an
independent monetary policy. China’s move to further reform its foreign exchange
rate regime announced on June 19, 2010 should be welcome as a major step in thisdirection.

Box: Monetary policy exit strategy begins in China
Chinese monetary authorities are beginning to execute the exit strategy from theexpansionary monetary policy they had adopted to maintain stable growth ("China Monetary
Policy Report, Fourth Quarter, 2009" of the People's Bank of China, February 11, 2010).
To begin with, in April and May 2009, the People's Bank of China called for commercial banks
to pay attention to a rise in the credit risk associated with the rapid increase in loans. It has also

Some Possible Lessons for Japan from China's Economic Reforms

4been further stepping up "window guidance" since the middle of the year. Subsequently, inJuly, the PBC resumed the issuing of the one-year central bank bill for the first time in sevenmonths and obliged some banks where loan growth was deemed excessive to purchase thecentral bank bill (at a yield below the market rate).
With these measures, growth in lending (year on year) fell to 18.6% in August 2010, downfrom 34.4% at its peak in June 2009. Growth in monetary supply (M2) has also slowed,declining to 19.2% in August 2010, down from 29.7% at its peak in November 2009. For
further monetary tightening, an annual target of limiting the growth rate of M2 to 17% was setin the Report on the Work of the Government delivered by Premier Wen Jiabao in the National
People's Congress held in March 2010.
As part of the credit restraint, the PBC raised the statutory reserve requirement applied tolarge banks twice by a total of 1.5 percentage points starting from the beginning of this year.
This means that even if financial institutions have reserves corresponding only to the statutory
reserve requirement, funds of 900 billion yuan (1.5% of deposits of 60 trillion yuan) will befrozen because of this measure. However, as the excess reserve ratio of financial institutions(the ratio of reserves held that exceeds the statutory reserve to the deposit balance) reached1.96% as of the end of March 2010, the tightening effect of the higher statutory deposit reserve
requirement is limited at this moment, as the banks subject to the higher requirement are not ina situation where they have to claw back lending immediately to boost their reserves.
Should inflation continue to climb, the PBC would have no choice but to raise interest
rates. .

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