China' Dammed Banks

Throughout history, China's rulers have demonstrated their legitimacy by channelling and controlling the unruly and disruptive flow of water by damns, sluices, canals. Within the next 18 months, we'll see whether a similar command can be demonstrated over the cashflows into and out of China's financial system. Success is not guaranteed, but the financial damns, sluices and canals are at least in place.

So far, the two main observations one can draw from the Flow Essentials charts of the major economies are that:

1. in 2012 there is a risk of an upside 'growth shock' from the US, and
2. Europe's set of ratios increasingly resemble those of Japan. If its financial system could avoid implosion then the Eurozone would be able to look forward to a long period of minimal growth and demographic deterioration softened by continually rising public debt bought by a flow of private sector savings coralled by by fear and financial repression.

Actually, the chances of the Eurozone staying intact long enough to really discover its inner-Japan must be accounted slim. My guess is that Europe's ratios will look very different post-Euro, most likely with more sharply rising ROCs and, in parts, significant private sector savings deficits.

Meanwhile, China's charts record an economy in the early stages of working off the worst impacts of the huge credit-stimulus of 2009/10. In particular, from what one can tell, the misallocation of capital of that period has at least not been extended in 2011. Capital stock is probably still growing nearly an unfeasible 20% a year, but the slump in ROC indicated during 2009 and 2010 has probably been arrested in 2011. The estimates and calculations are uncertain, but they are echoed by the beginning of a recovery in monetary velocity (GDP/M2), which seems to be accelerating after 18 months' flat-lining.

This process is being helped by a stability in China's terms of trade experienced during 2011 for the first time since the end of 2007.

The key chart for China, though, is its private sector savings surplus, which is still positive, but also noticeably in retreat for the third successive year. This ratio peaked out at 11.5% of GDP in 1Q09, but had fallen to 8.7% by end-09, then to 6.8% by end-2010, and to 4.2% by 3Q11. At the current rate of deterioration, the surplus is due to disappear almost completely by the end of 2012. And of course, since this savings surplus is primarily generated by China's trade surplus, any sustained or dramatic worsening in world trading conditions will tend to accelerate the process.

(Though note, one need not necessarily concur with the expectation of a sharp slowdown in trade during 2012: inventory levels are extremely low, there is an upside growth risk in the US, and the current garotting of the Eurozone economy will be relieved one way or another.)

The importance of this ratio is that it measures the net cashflow in an economy between the private sector and the financial system. Periods when private savings surpluses turn into savings deficits tend to be marked by financial turbulence because banks suddenly discover their jobs is no longer to cope with the flood of cash coming through the doors, but rather, to find cash in order to maintain credit growth. When banks find they have to sell assets in order to generate a positive cashflow suddenly and newly demanded by the private sector, they get to discover which of their assets are correctly priced, and which aren't. Mistakes get found out.

China's financial system will discover it has made mistakes it hasn't even imagined yet. However, unlike in virtually every other financial system in which I've seen this reversal of cashflows take place, China's banking system already has a potential source of 'artificial' cashflow waiting to be deployed. Between mid-2007 and now, the PBOC raised reserve ratios from 11% of deposits to 21.5% - this was the principal way in which it drained liquidity from the banking system. Since the current level of deposits is about 167% of GDP, for every one percentage point that the required reserve ratio is lowered will release an amount equivalent to 1.67% of GDP in positive cashflow to China's banks. Taking reserve ratios back from 21.5% to 11%, then would represent an 'artificial' cashflow into China's banks equivalent to 17.5% of current GDP. Properly managed, China's financial system can live for years now without a significant private sector savings surplus. If it is to make the transition from an exogenous to an endogenous growth model, it will have to.

A final thought: cutting those reserve ratios will drag money out of Chinese government bond markets. For the foreseeable future, China's yield curve is likely only to steepen.