What economic policy should China adopt?

Professor Rogoff from Harvard and author of the book This Time is Different, commented that Chinese real estate is facing a burst, which will lead to a nation-wide recession, which will in turn impede regional and global growth. His prediction is based on his extensive research on financial crisis in that every financial crisis is preceded by a run-up in real estate price that is unsustainable, and ultimately leads to a banking crisis and then to a currency crisis. However there is something dubious in his arguments. Though the run-up in real estate prices is a necessary condition for a financial crisis, it is not a sufficient one. His extensive documentation did confirm the former, but not the latter. Thus the fear of a full-blown financial crisis is overly-exaggerated. Second, even if a burst in real estate takes place and leads to a banking crisis, the following links are less concrete and my observation on the subject leads to the conclusion that the burst might be a blessing in disguise, which I will analyse shortly.

Even though the rising real estate price does not justify over-pessimistic forecasting, it should be noted that the distortion in real estate prices has and will impair the efficiency of Chinese economic development. Then how should the central government respond? My prescription differs from many policy makers and economists in that it accepts "cold-therapy" as the optimal way of deal with the bubble. In other words, it turns away from the method of "constraining the bubble" and let price decrease in a gradual way, which might be theoretically appealing, but impossible in practice. Another difference lies in its holistic treatment of three major monetary areas: inflation, exchange rate and over-heating. Here is how it will work:

1. through fiscal policy, monetary policy and administrative policy of command economics, the government should burst the real estate bubble in one stroke.

2. what many feared--NPL (non-performing loans) will take place for sure. The banks will suffer, but the PBC can purchase all these NPL's from the commercial banks by printing money. Meanwhile, the PBC should increase reserve requirement (RR) dramatically to freeze liquidity to prevent possible inflation resulting from increase in money supply. This act will return a healthy balance sheet to commercial banks, which never had that.

3.Inflation should not be curbed to 2%. It could be higher. The reason we fight inflation is that common people's life will be harder because of inflation, but once the real estate price has decreased, the life is much more bearable even with inflation, and with a low housing price, people do not have the need to save that much for housing in the future, as will lead to an increase in domestic demand.

4. Inflation could be beneficial. Assuming relative PPP holds, RMB will face depreciation pressure, relieving it from appreciation pressure. Hot money inflow will decrease, further relieving the PBC's need to sterilize and maintaining an onerous international reserve.

5. Who will get hurt? Speculators' in the real estate market. Fortunately, they are the robber barrons of the country with disproportionate amount of wealth. (They were first from the export industry from Wenzhou, and now the coal mining barrons from the notorious ShanXi province). Thus a negative wealth shock to them will not significantly reduce aggregate demand. Another benefit is to teach the Chinese investors an lesson on risk, which they have forgotten after thirty years of relative calm and stable development. This lesson will be valuable especially if China wish to liberalize its financial sector in the future.

6. Financial Reform MUST be carried out at the same time! With a bail-out, the moral hazard problem must be contained with regulation. "No second bail-out" must be made credible, whether through criminal laws or other way. State for example should refrain from coercing the banks into policy lending through administrative tools. Policy lending can still be carried out, but not through coercion but through more market-oriented ways--like subsidy to lending, or partial insurance on that specific policy lending. This part, I admit, is hard to implement, both because of political reasons but also economic ones.