American and Chinese Monetary Policy : A Macro Perspective (1/2)

For years, observers have turned to the ECB to provide them a comparison-basis to judge theFED and its policies. As Europe is likely to undergo an extended period of under-par growth andinternal questioning, and as China gains momentum on the international scene, attention will turnto the Chinese central banking model and how it fares relatively to its Northern Americancounterpart.Comparing China and America is a perilous exercise given the stark differences between bothcountries. A country of 1.3 billion inhabitants which has undergone in the past 30 years thefastest-paced political and economic streamlining in history cannot fall under the broad definitionof being a "capitalist" or "communist" country.Moral hazard, defined as governmental intervention to bail out insolvent parties, is often referredto when describing the USA. Not China. There is no Xiaochuan put. What the US spent to saveAIG, the Chinese government used to build infrastructures.In the 1980's, benefiting from the opening up of the local market, western banks started settling inChina and making a series of bad loans to local entities. They took for granted the Chinesegovernment would step in and prevent national companies from failing. It didn't.As embodied by chairman Bernanke's reelection, trying and failing is accepted, if not rewarded, inthe US. In China, accountability of governmental institutions is the first pillar of social rest. InChina, the Party cannot fail. It has to "cross the river by feeling the stones(1)".How monetary policy is considered, channeled and judged is highly impacted by these divergentmantras.

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Correlated Quantitative Easing, Mixed Results

Bernanke had announced(2) he would fight deflation at all costs, referring to Milton Friedman's"helicopter drop" of money. The least is to say he held tight to his principles, adding $813 billionto the FED's balance sheet in the 5 months to August 2008.With hindsight, it seems that decoupling presented to heavy an opportunity cost for China and itsgovernment. Lacking internal demand and economic knowledge, China had to make do with theUS, and reciprocally. Even today, it is hard to say where the USD would stand if the renminbi peghad not be resumed in mid 2008, triggering in the process a rally in the greenback.Whether it was targeted at sustaining national economic growth, limiting the downside risk on itstrade account, or maintaining the renminbi/USD peg, China correlated its monetary stance to itswestern counterpart's. Monetary mass expanded y-o-y by 32% in China, leaving the countryawash with liquidity.Chimerica had committed to quantitative easing.Confidence is the backbone of monetary policy efficiency. Without confidence, monetaryexpansion boils down to pushing on a string.On the one hand, the FED's credibility had been eroded in the wake of the IT bubble with the socalled Greenspan Put. On the other hand, People's Bank of China is ran by the Chinesegovernment which, contrarily to the prevalent opinion among China bears, is supported by itspeople.In the US, banks witnessed how market speculation had triggered a run on Bear Stearns, andfear grew they were exposed to similar margin call risks. In China, People's Bank of China has asignificant stake in local banks and is hence capable of influencing their policy.This diverse drivers resulted in similar quantitative easing policies being channeled in deeplydivergent ways, and thus entailing different outcomes.

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Where did the money go?

As a major share of their assets were valued according to mark-to-market standards, fadingconfidence resulted in a rapid downsizing of American banks' balance sheets. Relying on riskmodels based on the erroneous assumption of normally distributed returns, banks were caughtoff-guard. Being granted almost overnight a "free lunch" by the FED's easy money, they used thefreshly printed dollars to increase their reserves and thus hedge their margin call risk exposure.The central bank is entitled to supply aggregate reserves. The FED did so by expanding itsbalance sheet to record levels. However, it is the bank's role to supply end money (currency incirculation). It is their behavior which drives the

Deposit expansion multiplier.

Designating theincremental money in circulation for each dollar added to the monetary base, the money multiplier is correlated to the banks' willingness to lend.