What to Do About a China Bubble?

Today's Economist


If you are in charge of monetary policy in an up-and-coming Asian economy (say India, China or Korea), you have a problem.

DESCRIPTIONSean Young/Reuters


The monetary policy authorities know this and — given what we have all seen in the last few years (or is that two decades?) — they are rightly worried about new “bubbles” of various kinds that can destabilize their financial systems and undermine their economies.

But what should these central banks do? If you fear that your economy is growing too fast, and inflation is on the rise, central bank mantra dictates that you should raise interest rates. The same mantra was, in the era of Alan Greenspan, less clear on whether interest rates should be increased to forestall unsustainable financial bubbles. With the puncturing of the Great American Bubble, including the fall of Mr. Greenspan as an icon, most central bankers are quietly willing to tighten monetary policy if they see real estate prices take off.

But this is exactly where the problem lies.


Almost certainly, you will attract more capital from overseas. This capital inflow will likely feed into your domestic credit boom and further the run-up in asset prices, housing construction and other bubble-related phenomena.

Some of the consequences can be offset if you let your currency appreciate (i.e., rise in value as the capital comes in). But most Asian countries, most particularly China, generally resist such appreciation, in order to protect their export industries; so this “feedback” or dampening mechanism is removed. And the more you resist appreciation by accumulating foreign exchange reserves, the more investors believe they will make money on a rise in the value of your currency. So the more they want to pile into your markets.

What should Asian central bankers do, and why should we care?

One view, increasingly part of the mainstream consensus, is that these central banks should tighten lending standards and otherwise lean on banks to lend less as capital comes in. This is not a terrible idea – the United States, of course, loosened lending standards during its real estate boom, and we know what happened.


Much more likely is what is now being whispered about in the corridors of financial power — beginning to consider ways to tighten capital controls, i.e., limit the amount of capital that can come into a country, or force investors to commit to stay in the country for longer periods of time.

Such capital controls are unlikely to be announced explicitly, but watch for tightening the rules around inflows. And expect discussion increasingly at the level of the G-20 about the extent to which various kinds of capital controls can now be considered “best practice.”

The United States has historically pushed the view that all capital controls are bad and should be abolished — in fact, this was a major international policy initiative of the Clinton administration, led in this regard by Lawrence H. Summers and Timothy F. Geithner (who both came up through the international side of Treasury).


For better or worse, we are likely heading toward a world in which capital no longer flows so freely across borders. Look for the start of this in Asia.

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I’m struggling with the equilibrium story where increasing interest rates leads to increased real activity. Central bank increases rates by buying assets. If capital is perfectly elastic then inflow exactly matches purchases and rates don’t change, if not and equilibrium is at higher rate then isn’t inflow necessarily less? As long as rate goes up I don’t see how demand for capital goes up as well. Unless there is a hidded credit constraint story here – borrowers can’t borrow all the local capital they want at the going rate but if the rate goes up and foreign capital comes in, they don’t face the same constraint?

Does Mao have any advice about international currency flows in his little red book?

once again, we come back to their overvalued currency, and our vested interest in keeping the status quo.

Capital knows only greed, other than greed, capital is ignorant. Even capital posing as highly educated is lacking in brain power!

Capital controls work.

Washington, DC

Mahathir Mohammed’s capital controls in Malaysia around the prior Asian currency crisis (1997 or 1998?): has history been kind to this policy? I’m pretty sure the global financial system was highly against it at the time. Can the current scenario use this history as a base for discussion?

Very informative article. Well-written so that a simple guy like me can see the issue and the likely outcomes. NYT has assembled quite a cadre of economic power hitters who have insight and who can actually write well too.

The US has to stop worshipping the simplistic ideals of “no controls” and unfettered markets. If the collapse of the soviet union proved that socialism is fatally flawed, then the late 2008 crisis in the western world has proven that lassiez faire labor, import, job-export, and market management also does not work, at least “in the large” that the federal government has control over. In a world where megacorps, markets, and capital flows are more powerful than nations, the nations, alone or in groups, do have a responsibility to keep these other power entities in check.

“The Fed” exists as the US’s first line of defense in this international economic chess game, but it is both hidden from view (because we don’t like the thought of “controls”) and has few tools to do its job, (they can either raise or lower the rates). The shotgun marriage of the treasury and the Fed is outdated. Other nations that are not hamstrung by the ideals of the US and that have a more cohesive monetary policy are going to beat the pants off of us.

Tommy Barban (Buenos Aires) July 30, 2009 · 10:55 am

Reasonable inflow capital controls in place in most major South American countries, such as Brazil and Argentina (for example requiring a waiting period before a non-resident can repatriate the proceeds of a portfolio or real estate investment; one year in the case of Argentina) have proven very effective in minimizing the impact of the financial crisis in those economies, which are now experiencing the adverse consequences of the downturn, but not suffering the type of sudden financial ruin typical of the 1990s.

The answer to the problem at hand is in the blog post, that is that asian export based economies should let their currencies appreciate. This may hurt the export sector of the economy with regard to the price of finished goods, but they’ll make it up with increased buying power for raw materials and petrolium. One thing letting the currency appreciate will not do is ease the trade deficit the us has with these countries, which we saw actually grow with regard to china from 2005-08 when china let the rmb appreciate by 20%, which is no small feat and exactly what we’d been screaming for them to do for years.
Letting the currency appreciate may harm the export sector in the short term, but it has a lot more long-term benefits. This will also help Asia/China in their quest for an end to dollar hegemony. It will also help us manufacturers and exporters by increasing the buying power of asian consumers, which is something else that asia/china could do to strengthen their domestic economies.

As Padma Desai put it:

2. A fixed exchange rate

Pick two of the three.



The Chinese are still in the lecture America phase. Soon enough they will be in the denial phase before they need to mobilize the army to deal with riots of their own people during the order at all cost phase.

Wow -an interesting and thoughtful discourse on economics without insults or blame. How refreshing in MSM today. We might have actually learned something. Kudos to the writer.

China has always controlled capital flows, and these controls remain in place. So far, they seem to have worked quite out quite well for the Chinese government, if not for international investors.

Capital controls while preventing outward flow also discourage investor inflow. In the last decade, Americans have been negative savers or overspenders. But we did not self destruct because of the thrifty Chinese who saved and lent to us liberally.
If we control capital, we must be prepared to save and build saving instituitions. In the meantime, prepare to pay high interest rates from the current historic low of 5% to levels of 15-20% plus. That would be the Interest Rate Bubble.

what a dumb article.

yes, it is no big secret at almost all other currencies are devalued compared to $.. $ is overvalued because every country needs one to buy oil.. more demand, less supply => overvaluation.

If US is bothered about high $ price, then ask Soudi king to accept payments in other major currencies as well. (Hint: Chinese Yen, if it is the problem)

I studied college level economics in the 1960s under the tutorage of William McChesney Martin’s personal secretary. The only comparison I can think of would be studying the Nixon Administration through the eyes of Rose Mary Woods. Anyway, Prof. Behrens taught us well, in spite of Paul Samuelson’s text. I came away from her class convinced that Economics was no more a science than Political Science, my own field. In spite of all the jargon and charts, it still belongs on the shelf with alchemy, astrology, etc. Economics is no science. If anything it’s an art, a black art I suspect. When the asians and other “booming” economies realise this, we’ll all be better off.

foreign capital flow in and out is a coin with two sides.it creats jobs as well as makes asset more expensive

Everybody is printing money, and Mao is just doing enough to keep their currency pegged to the dollar. At the end, Mao will have to let their currency gain value and a couple of heads will roll on his table, but the devaluation race will end. When the dust settles, we will owe Mao less than we owe today, and we will all be happy, of course, minus the heads that rolled.

Sundar Srinivasan July 31, 2009 · 11:07 am

Interesting thought. And an absolute possibility. More and more dollarization would blow the bubble bigger. A sudden capital account reversal may cause this bubble to burst and affect the entire world, because China and India are certainly too big to fail.

There are too less policy options for these countries in a currency crisis. I think these countries have to soon start re-reading Paul Samuelson’s neoclassical synthesis.


Interesting article, one way or another it’s all going to end in tears.

Massive bubble to pop…. again.

Good article. My only problem is that, if rapidly rising asset prices in China fail to dissuade capital inflow, why would one expect rising yuan exchange rate would do the trick?

The only reason China is purchasing massive amounts of T-bills is because they’re trying to hold down the yuan exchange rate. If they let the yuan float, their central bank would have no dollars to purchase any more T-bills, and they would have to start sell those T-bills once captial starts to flow out of China en masse.

Also, if the US public debt results in hyperinflation in this country, that inflation would be exported quite effeciently over to China. The $2 trillion worth of foreign exchange reserve the PBoC holds is bought with $2 trillion worth of yuan that the PBoC borrowed from Chinese institutions. If that $2 trillion lose a large porion of its value, the PBoC would have to crank up that yuan print press to make up the difference, driving up inflation in China. So the yuan is not such a great haven from US inflation precisely because the PBoC is so invested in the dollar. The valuation of the two currencies are coupled thru that investment.

How effective are these tools, in the face of the rising loan sharking, black markets for currency, unofficial exchange rates, money laundering, and “other” ways of beating the controls? In countries were tough controls exist, is there a corresponding corruption index, and do they correlate?

We did not relax the lending standards.
Clinton and Bush administrations FORCED banks to lend to the poor so that they could become home owners.

It was increased regulation, not deregulation that promoted this economic disaster.

Get the government out of business. It is not their money to spend.