Why interest rates are stuck in China
By Jamil Anderlini

SHANGHAI - China's inflation is at its highest point since 1997 but the People's Bank of China (PBOC), the country's central bank, has so far opted not to raise interest rates. The base one-year lending rate has not been raised for nine years and currently sits rock solid at 5.31% while the benchmark one-year deposit rate set by the central bank hovers at just 1.98%.

Meanwhile, official inflation hit 5.3% for both July and August and dropped only slightly to 5.2% in September, a sharp turnaround from the deflation China was experiencing as recently as early 2003. From a Western economic perspective, when inflation starts to pick up, the usual first response should be to raise interest rates. By making the returns on savings and the costs of borrowing higher, the central bank slows down economic activity and prices stop going up.

Back in May, a number of media reports indicated that the PBOC was planning to lift interest rates if the headline consumer price index (CPI) measure of inflation went above 5%. The governor of the PBOC, Zhou Xiaochuan, has hinted on a number of occasions that rates would indeed be lifted and that China had learned its lesson in the late 1980s and the early 1990s, when inflation went from relatively mild to raging double digits in a very short span. So the question is: why hasn't the central bank raised interest rates yet?

Victor Shih, a political economist at Northwestern University who specializes in China's banking and macro-economic policy, pointed out that there are a number of competing forces within China's economic leadership and that at present, the low-interest crowd is winning. "China has seen inflation much worse than 5%, so the technocrats in Beijing have so far not had a very strong argument for raising interest rates by a lot," he told Asia Times Online.

Barry Naughton, economics professor at the University of California in San Diego, agreed: "I think it's pretty clear that the PBOC has been wanting an interest rate increase since the beginning of the year. They haven't raised rates yet only because they've been unable to convince the top political leadership of the necessity to do so," he said.

An increase in the general interest rates means state-owned enterprise (SOE) borrowing costs would increase and SOE profits margins would decrease - and there are strong official voices that argue against that. Also, the ministry of finance would have to increase bond rates to match increases in bank interest rates in order to attract buyers. So the ministry is probably resistant to interest rate increases as well. Then there is the problem of speculation from so-called "hot money" flowing into China from abroad - although the capital account is closed in China, large flows of speculative capital still manage to find their way in.

But speculation of another kind is a growing problem in China right now. Because banks are only allowed to set their interest rates within a narrow band relative to the PBOC rate and inflation is quite a bit higher than the benchmark deposit rate, anyone who puts his or her savings into bank deposits is basically going to be earning negative interest on their money. In other words, if you put your money in the bank to earn interest, you will actually be able to buy less with it in a month or a year than if you spent it right now.

This situation encourages consumers to take their money out of deposits and invest it in speculative assets –chief among which is property, the very sector that the government has been trying to slow down with the macro-economic cooling measures it has introduced over the last year or so.

According to an article in the latest Caijing (Finance) Magazine, an authoritative biweekly journal, there has been a net loss of 100 billion yuan(US$12 billion)from the state banking system as depositors have withdrawn their money to speculate in real estate. Shih said this would explain why fixed assets investment is still relatively high (27.9% growth in September)while China's money supply grew by just 13.9% in September, well below the central bank's stated goal of 17% growth.

"In other words, the new investment in property is now fueled by withdrawn bank deposits, not bank loans," he told Asia Times Online. This new investment is the main contributing factor to China's rapidly rising housing prices, which rose 13.4% in the first nine months over the same period last year, according to the National Bureau of Statistics.

So does this mean that a rate rise is now definitely on the cards? Not necessarily, according to Jonathan Anderson, chief economist for Asia at UBS Securities. He told Asia Times Online that he thinks there is a 50:50 chance of a rate rise in the next month or two. If a rise doesn't happen by then, he thinks it is unlikely there will be one for at least a year.

There are a number of reasons for this. First, he pointed out, the primary component of inflation is still volatile food prices and that "core" inflation is still relatively low. Second, although third-quarter gross domestic product (GDP)growth in China was still 9.1% (well above the government's goal of 7% for the year), he said all data are pointing to a soft landing for China's economy. Third, inflation has peaked and is on its way down – a judgment supported by the slightly lower consumer price index (CPI) figure of 5.2% in September – and is expected to decelerate to an average rate of about 2% next year.

Shih said there are quite a few figures inside and outside the government who worry that credit growth has come down too much, and for this reason any interest rate rise is unlikely to be very large if it comes at all. He is looking for a 0.5-0.75% hike in both the deposit and lending rates as a way for the authorities to signal their willingness to adjust further if required. Deutsche Bank predicted China will raise interest rates by up to 0.75% over the next 12 months and by at least 0.25% by the end of this year. Shih agreed that even if there is to be an increase, it won't be a big one.

Like most of those interviewed by Asia Times Online, Philip Tang, general manager at Bank International Ningbo (a private Indonesian-owned bank based in China's eastern Zhejiang province), is betting on an interest rate rise. He pointed to rising interest rates around the world as evidence of a global trend away from freely flowing cheap credit.

But the rise in US interest rates also contributes to the argument against raising Chinese benchmark rates at the moment. With speculative capital attracted toward the US and away from China, the pressure on China's currency to appreciate has diminished. Despite constant rumors among currency traders, most authoritative sources interviewed do not expect China to move on its currency in the near future, and a lessening of the pressure to do so would seem an attractive proposition to the People's Bank of China, the central bank.

The Asian Development Bank (ADB) joined the debate over interest rates in late September when its representative in Beijing, Bruce Murray, recommended at a press conference that China raise interest rates gradually to counter negative real rates. At the same time, he conceded, the impact of monetary policy would be blunted because of the incomplete nature of reforms in China's financial sector.

It is clear that continued interest rate liberalization in China is essential to enable banks to properly price risk. This liberalization will have to be somewhat tentative in order to avoid undue shocks to China's technically insolvent "Big Four" state-owned banks, two of which are preparing to list on domestic and overseas stock markets in the near future. But even PBOC head Zhou Xiaochuan acknowledged in a speech last December, "Due to the excessive regulation of rates, China's financial institutions don't have the ability to price financial products, particularly loans."

Jamil Anderlini is the former editor of China Economic Review. He can be reached at Jamilanderlini@sinomedia.net.

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