Wednesday, June 22, 2005

My friend Stephen Green at Standard Charter Global Research (based in Shanghai) just completed a remarkable paper on Chinese monetary policy. It goes through the evolution of Chinese monetary policy instruments in great details, but the conclusion is very remarkable. Basically, the more foreign exchange flows into a repressed financial system, the greater the spread is between central bank cost and income. So, with more inflow of forex, the money supply increases, which drives down interbank rates. So when the PBOC (central bank) decides to sterilize part of that inflow, banks rush to buy up PBOC bonds since they are not getting much of a return in the interbank market. Thus, PBOC is able to sell bonds at a relatively low rate, at 2.83%. At the same time, PBOC is getting over 3% for its foreign exchange assets based in USD, and they are constantly looking for higher returns through investing in asset-backed securities in the US. Contrary to the prediction of some economists ( I won't name names), the current situation, which requires the PBOC to issue billions in sterilizing instruments, is very sustainable! The beauty of financial repression.

hmm...reminds me of SE Asia in 1997. but the difference in interest rate is really small for meaningful profit though
The point is not that the PBOC is making money from this transaction. The point is that the PBOC is not hemoraging money from the sterilization process. Some economists think that current sterilization is not sustainable. Green's paper shows that it definitely is sustainable.
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