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Tentative Tightening


China's government is on a campaign to slow a red-hot economy by imposing restrictions on lending and foreign investment. The latest news on industrial production and the money supply suggests some success. But a new index tracking Chinese financial indicators shows Beijing may not be making the best choices.

To see how China's monetary policy affected its economy, Goldman, Sachs & Co. (GS) created a monthly Financial Conditions Index (FCI). It tracks conditions by looking at the one-year lending rate set by the People's Bank of China (less inflation), a measure of money supply called M2, and a real exchange rate weighted by trade levels with other countries.

The FCI tracks China's economic growth quite well. Goldman economists say official gross domestic product data smooth out variability too much. So instead, the investment bank gauges growth by looking at, among other things, construction, electricity usage, and trade. Movements in the FCI and economic activity since 1997 show that a one-point rise in the index, on average, leads to a one-percentage-point fall in growth within two quarters.

So far this year, the FCI has fallen by 0.2% through April. Goldman says a three-point rise is needed to slow the economy to a sustainable growth rate of 9%. Goldman's economic activity index of China's economy showed 12.2% growth from a year ago in April.

The FCI indicates that tightening has come only from a drop in M2 growth. The economists say a better approach would be if Beijing let the yuan appreciate. That would lessen the need for more rate hikes or slower growth in M2, two moves that would put more strain on the fragile banking sector.

The slow pace of tightening raises the danger of a sharp downturn in the future if free-flowing credit worsens China's investment bubble. However, if Beijing picks up the pace of tightening solely via reductions in liquidity and rate hikes, it risks a seizing-up of China's fragile financial market. That could have a far greater global impact.

The personal bankruptcy rate jumped nearly 50% from 1991 to 1997, despite an economic swing from recession to boom. The common view on this trend is that the stigma of bankruptcy has faded. But the cause may lie in the changing financial sector.

In a paper published by the Federal Reserve Bank of Richmond, economist Kartik Athreya measured the relative importance of stigma compared with economic factors such as the risk of becoming unemployed and shocks to income. Stigma, of course, isn't a value like the jobless rate. So Athreya imputed stigma by comparing actual bankruptcy data from 1991 -- such as the bankruptcy rate and the ratio of revolving debt to income -- with the higher results of a model that solely relied on economic data. He attributed the difference to the presence of stigma and assigned a value for stigma that got his model's results to closely match the actual 1991 figures.

What if Americans grew to have no qualms about filing bankruptcy? If that were the case, says Athreya, then eliminating stigma in his simulation should produce results close to the high levels of bankruptcies in 1997 despite the booming economy. Indeed, the bankruptcy rate in his model, 0.18%, was close to the actual rate of 0.2%, but the other data were starkly different.

Athreya found that reducing the cost of lending for banks yielded a better fit. He theorizes that if lending is cheaper, banks can make money on riskier customers and lend more to existing borrowers. That would explain the higher bankruptcy rate and larger credit-card balances observed in 1997.

It's widely accepted that, tax-wise, homeowners do quite well. Todd Sinai and Joseph Gyourko of the Wharton School wanted to know how big the advantage is, and if location matters.

In a National Bureau of Economic Research working paper, the two real estate professors used data from the last three censuses to examine tax subsidies to homeowners. They calculated the difference between taxes paid by owners and the amount they would have paid if the tax code treated them as landlords renting from themselves. Under that scenario, a homeowner would have to declare as income the rent he would pay to live in his home, but he could deduct depreciation and other expenses. Sinai and Gyourko found the subsidies in 1999 were $420 billion, or $6,024 per housing unit. The total is up from $284 billion in 1989 and $198 billion in 1979.

The states where homeowners have benefited the most have not changed much in 20 years (table). The authors note that states such as Hawaii and California have limited buildable land, which helps push up home values. Plus, these areas have marginal tax rates over 30%, making each dollar deducted more valuable to a taxpayer.


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