1. Stodder: Monetary Pollicy, July 1 Challenges for Monetary Policy in China: I. Overheating and Financial Depth, II. Adverse Selection and Credit Rating Error, III. Macro-economic Stability and Loan-Loss-Reserve Regulation

2. Stodder: Monetary Pollicy, July2 I. Overheating 1. Evidence of Overheating 2. Inefficient Capital Allocation 3. Informal Financial Intermediaries 4. Excessive Money Supply 5. Small Government Bond Market

3. Stodder: Monetary Pollicy, July3 1. Evidence of Overheating: Inflation Spike Source: CIA Factbook, and June 2007 Figures

4. Stodder: Monetary Pollicy, July4 Evidence: Real Estate Prices

5. Stodder: Monetary Pollicy, July5 Evidence: Shanghai Engineers’ Salaries Higher than in Thailand, Indonesia, Philippines Source: METI - China and ASEAN4

6. Stodder: Monetary Pollicy, July6 2. Capital Allocation: State Banks to State-Owned Enterprises Source: McKinsey

7. Stodder: Monetary Pollicy, July7 Capital Allocation: Too Scarce in Inland Areas Source: METI

8. Stodder: Monetary Pollicy, July8 Capital Allocation: Can Heighten Regional Inequalities Source: METI

9. Stodder: Monetary Pollicy, July9 3. Money Supply : China’s M2/GDP out of proportion Figures for 1999/2000 CountryGDP per capitaM2/GDP(%) CHINA$2,001150.0 Singapore$12,96390.0 Korea, Rep. of$5,62640.0 Malaysia$2,36870.3 Thailand$1,46669.5 Philippines$70631.8 Indonesia$58041.1 Sri Lanka$46630.5 India$35846.1 Pakistan$33639.7 Bangladesh$20031.3 http://www.allcountries.org/china_statistics/index.html

10. Stodder: Monetary Pollicy, July10 4. Informal Finance: “ All small business start with loans from family and friends. I’m not aware of any business that was started with bank financing.” - Manager of one of Shanghai’s 10 largest Private Firms (McKinsey)

11. Stodder: Monetary Pollicy, July11 Informal Financial Intermediaries Source: McKinsey 28%

12. Stodder: Monetary Pollicy, July12 5. Small Government Bond Market: Makes Central Bank’s Job More Difficult Source: McKinsey

13. Stodder: Monetary Pollicy, July13 II. Adverse Selection by Credit Rating Error Think of two firms which must go through a long difficult process – just to achieve the same credit rating. Think of two firms which must go through a long difficult process – just to achieve the same credit rating. But say the 1 st firm is a good risk, while the 2 nd firm is a poor risk. (So there is Rating Error.) But say the 1 st firm is a good risk, while the 2 nd firm is a poor risk. (So there is Rating Error.) Which firm will be more determined to complete the rating process? Which firm will be more determined to complete the rating process?

14. Stodder: Monetary Pollicy, July14 Empirically Based Simulation of Credit Rating Effects: “Modeling the economic value of credit rating systems”, by Jankowitscha, Pichlera, and Schwaigerb “Modeling the economic value of credit rating systems”, by Jankowitscha, Pichlera, and Schwaigerb Journal of Banking & Finance Volume 31, Issue 1Journal of Banking & Finance Volume 31, Issue 1, January 2007, Pages 181-198

15. Stodder: Monetary Pollicy, July15 Adverse Selection: History of 30,000 Austrian Corporate Loans Source: Jankowitsch et. al., Journal of Banking & Finance (2007)

16. Stodder: Monetary Pollicy, July16 Adverse Selection: Basis Point Improvement in Change from Low Credit Rating Accuracy Portfolio Quality Δ low to medium Δ low to high Δ low to perfect Good 30.843.744.8 Average 32.645.946.8 Weak 39.056.458.7 Source: Jankowitsch et. al. (2007)

17. Stodder: Monetary Pollicy, July17 Adverse Selection The study finds this improvement in return is mostly due to less adverse selection – not better loan pricing. The study finds this improvement in return is mostly due to less adverse selection – not better loan pricing. As a very distinguished banker friend of mine once said: As a very distinguished banker friend of mine once said: “If you lose the principle, it’s hard to make it up on interest payments.” “If you lose the principle, it’s hard to make it up on interest payments.”

18. Stodder: Monetary Pollicy, July18 III. Macro-economic Stability and Loan-Loss-Reserve Regulation “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way, along with his fellows, so that no one can really blame him.” “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way, along with his fellows, so that no one can really blame him.” – J.M. Keynes (1931)

19. Stodder: Monetary Pollicy, July19 Macro Stability: Keynes noted the “Paradox of Thrift” Consumers cut back on their spending and save more during a recession. This only makes the recession worse. Consumers cut back on their spending and save more during a recession. This only makes the recession worse. Similarly, Loan Loss Reserves (LLR) are often raised in a recession, just when banks can least afford them – often ensuring their collapse and worsening the recession. Similarly, Loan Loss Reserves (LLR) are often raised in a recession, just when banks can least afford them – often ensuring their collapse and worsening the recession.

20. Stodder: Monetary Pollicy, July20 Macro Stability: Perverse Loan-Loss Regulation Laeven, Luc & Majnoni, Giovanni, 2003. "Loan loss provisioning and economic slowdowns: too much, too late?," Journal of Financial Intermediation, Vol. 12(2), April, pages 178-197. Laeven, Luc & Majnoni, Giovanni, 2003. "Loan loss provisioning and economic slowdowns: too much, too late?," Journal of Financial Intermediation, Vol. 12(2), April, pages 178-197. Can be downloaded from World Bank: Can be downloaded from World Bank: http://ideas.repec.org/p/wbk/wbrwps/2749.html

21. Stodder: Monetary Pollicy, July21 They argue that LLR should be ‘pro-cyclical’, built up in good times, so that it is available for bad times.

22. Stodder: Monetary Pollicy, July22 Instead, LLR growth ‘counter-cyclical’: Weak LLR in booms spurs inflation, Strong LLR in busts worsens recessions Dependent Variable: LLR % EuropeU.S.Japan Latin America ASIA Earnings (EBT)/Assets***.209***.207***.545***.280*.053 Negative earnings (?)****-.373***-.541***-1.329***-.444***-.590 Loan growth***-.008***-.006***-.016***-.009***-.010 GDP growth***-.070***-.160***-.1480***-.091 R-squared0.150.320.480.240.30 Bank-year observations2,4772,2881,016570951 No of banks438388145126166 (***: p-val < 1%, **: p-val < 5%, *: p-val < 10%)

23. Stodder: Monetary Pollicy, July23 Tentative Conclusions: China’s Monetary Policy challenge is very difficult, with few policy instruments China’s Monetary Policy challenge is very difficult, with few policy instruments A good Credit Rating System has great potential for improved financial returns from banking A good Credit Rating System has great potential for improved financial returns from banking However, poor regulation based on credit rating has the potential to increase macro- economic instability However, poor regulation based on credit rating has the potential to increase macro- economic instability