Relative Liquidity Surplus, Economic Transformation, and Financial Restructuring

Author: [Mu Zi]
Source: [Fund Analysis]
Article type: Regular article
Published: 2007-5-10 16:41:07
Column: Expert Perspectives

Whether from media reports or economists' forums, excess liquidity is already an undisputed fact. Every economic phenomenon, once labeled with the tag of excess liquidity, is painted as a ravenous flood. Yet nobody questions: is this kill-all excess liquidity truly the root of the contradiction? Using water as an analogy: if the River Lord's waters pour into a small pond, the liquidity surplus overflows and the flood waters rage. But if poured into the ocean, where is the excess liquidity? The key is not how fierce the flood is, but whether the waters flow into a small pond or the ocean.

Excess liquidity is only relative, never absolute — it is related to the current capital-absorbing capacity constructed by the relevant economic, financial, and other structures. Floodwaters can only be channeled, not dammed. Any attempt to dam up excess liquidity through administrative or financial means shares the fate of Gun, who tried to block the Great Flood. Only by channeling the waterways so the waters flow into the sea can excess liquidity be truly addressed. Capital is like water, existing in many forms. The reason Earth's water cycle maintains stability is that its various forms can smoothly convert between one another. The financial structure's existence relative to the economy functions similarly. Savings, bonds, and the like are the ocean; stocks, futures, and the like are the glaciers; production, consumption, and the like are the rivers, clouds, and mist. Whether various capital forms can smoothly convert depends on the prerequisite of having a capital market capable of long-term, effective absorption of massive capital. A strong, multi-tiered capital market is not the culprit of excess liquidity — rather, only through the extraordinary, accelerated development of the capital market can relative excess liquidity be properly addressed.

Currently, China faces a profound transformation of its social and economic development model, requiring effective allocation of massive economic and social resources. All of this equally demands the urgent establishment of a strong, multi-tiered capital market. The relative excess liquidity existing within China's current financial structure provides the most basic precondition for this. Those who blame excess liquidity on the capital market not only confuse cause with effect but have things completely backwards. The current relative excess liquidity is not a highly dangerous economic phenomenon at all; rather, it is a necessary precondition for China to complete its profound social and economic transformation. Without a well-developed financial structure and a strong capital market, the provision of robust and effective resource allocation for the transformation of social and economic development models can only remain empty talk.

In the foreseeable future — particularly as the RMB still has broad upward space and China's trade surplus continues expanding — relative excess liquidity will necessarily be the norm for China's economy, thereby providing the opportunity and impetus for upgrading China's capital structure, financing structure, and wealth structure. In the irreversible historical tide of capital globalization, the mark of China's inevitable rise is not becoming a manufacturing great power but becoming a capital great power. Only by becoming a capital great power can there be a true economic great power. The foremost prerequisite of a capital great power is having a financial market capable of accommodating massive capital and full liquidity. An extraordinarily developed capital market is the most important aspect thereof.

The current relative excess liquidity is fundamentally caused by prior economic transformation and financial restructuring steps being too timid, capital market expansion being too slow, and the speed of China's evolution into a capital great power being underestimated. While China's foreign exchange reserves rapidly grew from $286.4 billion to $1.0663 trillion between 2002 and 2006, the pace of financial market construction severely lagged. To this day, the scale of government bonds, corporate bonds, and other fundamental markets remains critically undersized; the ChiNext board continues its endless gestation of design; multi-tiered capital market construction remains all talk; and the financial derivatives market brings nothing but endless debates about risk. Meanwhile, arguments about foreign capital inflows creating excess liquidity rage on, while ignoring the most basic premise that, in the historical process of China's inevitable rise as the world's greatest capital power, China's financial markets must absorb the world's capital at super-massive scale. Compared to that, the current capital inflows are but a drop in the ocean.

The greatest risk to China's economy is not excess liquidity, not inflation, not any other possible economic phenomenon — it is missing the development opportunity in the current greatest historical tide of capital globalization, making the dream of China as a capital great power forever just a dream. Any economic phenomenon has its corresponding solution. But historical opportunities come once and cannot be sought — once missed, they are missed forever. This is the most basic perspective that must be maintained when facing all current economic phenomena. Standing in the historical process of China becoming the world's greatest capital power, restructuring the financial market at corresponding scale and standards, developing the multi-tiered capital market at extraordinary speed, thereby harnessing excess liquidity so that ten thousand streams flow into the sea, providing powerful yet controllable energy output for the thorough transformation of the economic development model — this is the fundamental path to solving today's problems.

(Special Senior Advisor to this publication, Mu Zi)