Is Liquidity the Culprit of China's Alleged Overheating

With the latest investment numbers stronger than expected(read more here), it is expected that another round of macro-policies with the aim of cooling off the red hot Chinese economy is in the works.

Today's edition of SCMP reported that, "Yesterday's strong growth numbers and the excessive liquidity in the economy means the central bank must intensify efforts to drain capital from the financial system. With broad money supply having grown 19.1 per cent year on year in May and new lending having nearly doubled, to 209.4 billion yuan, People's Bank of China governor Zhou Xiaochuan said yesterday that the central bank would "fine-tune liquidity"."

Some commentators blame excessive liquidity as the culprit of the rapid lending growth, implicitly endorsed by Zhou as the above quote shows. Is Liquidity really the source of all evil?

China is still a developing country. That implies, at least at its level of development right now, capital is still a relatively scarce factor of production compared with its vast pool of labor. In other words, all that liquidity can be put to good use if the mechanism that allocates capital works reasonably well. Therefore, liquidity in and of itself should not be viewed as the culprit. By implication then, high investment growth should not worry us too much, again this is important, if the mechanism that allocates capital works reasonably well.

Unfortunately, the mechanism that allocates capital in China does not work reasonably well. The culprit, then, is the mechanism that allocates capital and in China's case, where stock market only plays a secondary role, that pretty much means banks, especially the big 4 state-owned banks.

According to Wen Wei Po (sorry no links, and the story is available in Chinese only anyway), about 50% of new loans made in the first quarter of this year were made by the big 4 state-owned banks. With so much capital allocated through state-owned banks, the quality of those loans are indeed questionable.

Bottom Line: Any measures that do not address the weaknesses inherent in China's capital allocation mechanism would not work in helping to lift the quality of its investments.