A poor way to cool China's
red-hot economy By Mark A
DeWeaver
China surprised the markets last
Thursday by raising the benchmark one-year lending
rate for the first time since October 2004 in an
effort to cool the world's fastest-growing major
economy. The People's Bank of China (PBOC), the
central bank, raised the lending rate by slightly
more than a quarter of a percentage point (0.27)
to 5.85%. (The one-year deposit rate remained
unchanged at 2.25%.)
Foreign investors saw
this as bearish news, but locals, who had been
expecting a more aggressive increase of 0.5 to a
full percentage point in the deposit reserve rate,
saw it as a buying
opportunity. Chinese stocks
listed in Hong Kong dropped after the
announcement, while the Shanghai and Shenzhen
markets rose.
Higher interest rates are
actually an unlikely remedy for the perceived
problem of overheated investment and loan growth.
The investment problem is mainly due to a boom in
local-government spending at the start of the new
Five-Year Plan. This will require administrative
measures to solve. And money-supply acceleration
is being driven primarily by the monetization of
foreign-exchange inflows, which calls for either a
stronger yuan (which held steady) or, if anything,
an interest-rate cut.
If China had a
floating-exchange-rate regime, these inflows would
lead to currency appreciation as excess demand for
local currency would push up the exchange rate.
But the present system requires the monetary
authorities to keep this from happening by buying
up as much foreign exchange as anyone wants to
sell. This inevitably leads to increases in the
money supply; when the central bank purchases
foreign exchange, it must issue local currency to
pay for it.
With the exchange rate still
basically fixed, there really isn't much room for
interest-rate policy to be effective. Higher rates
only encourage greater capital inflows and make
the money supply more difficult to control. As
there is no reason to doubt the technical
competence of China's central bankers, it is hard
to believe that raising interest rates would have
been their policy tool of choice. Indeed, rumor
has it that they would have preferred the
deposit-reserve-rate increase that local market
participants were expecting.
In China,
however, this choice isn't the central bank's to
make. PBOC decisions on monetary policy must be
approved by the State Council before they can be
implemented. This time it seems that the central
bankers were overruled.
But even a
reserve-rate increase would not really address the
underlying problem of excess foreign-exchange
inflows. Raising the reserve rate reduces
money-supply growth in the short term because it
reduces the percentage of total bank deposits that
can be lent. But this is a one-off effect; while
the supply of lendable funds falls in the current
period, there is no effect on future money-supply
growth rates.
To keep the money supply
under control using this tool, there would have to
be a series of reserve-rate increases. This is, in
fact, a strategy the PBOC employed once before,
during a period of high and rising inflation in
the late 1980s. But with inflation in March (the
last reported month) down 0.1 percentage point
from February at just 0.8%, it clearly isn't an
option this time; the result would almost
certainly be a deflationary spiral.
Last
week's interest-rate increase was a weak move. As
a signal that a series of interest or reserve rate
increases has begun, it is hardly credible. And if
it is true that the PBOC's preferred policy was to
raise the reserve rate, it is evident that it has
been forced to move less aggressively than it
originally intended and is now "behind the curve".
None of this is to say that the Chinese
government is powerless to slow the economy. But
this will have to be done using administrative
measures, such as the restrictions recently
announced on investment in the aluminum,
ferrous-alloys, coke and cement sectors. The
PBOC's main role will be in supporting such
policies by restricting lending to overheated
sectors. What it does with interest rates can be
little more than a sideshow.
Mark A
DeWeaver, PhD, worked as a research analyst in
Shenzhen from 1991-95, first for W I Carr and
later for Peregrine Brokerage. He manages
Quantrarian Asia Hedge, a fund that invests in
Asian equities (on the web at
www.quantrarian.com), and can be reached at
deweaver@quantrarian.com.
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