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Challenges to China's interest rates

By Sun Lijian (China Daily)
Updated: 2010-11-12 11:07

The People's Bank of China has announced it will raise the required deposit reserve ratio for financial institutions by 50 basis points from Nov 16. This will be the fourth increase by the central bank this year. And it is a further signal of tightening the country's monetary policy, following the central bank announcement in raising the interest rates of savings deposits in less than two weeks.

Why doesn't the central bank raise interest rates again, as the country's real interest rate is actually negative? Since negative interest rate is influenced by an inflow of hot money, continuously increasing interest rates would be risky.

The United States and Japan have implemented a new round of quantitative easing (QE) monetary policy. Raising China's interest rates now would cause the influx of hot money, and further increase the pressures of the yuan's appreciation and deteriorate national economy and employment.

Besides, a rise in interest rates would enhance financing costs of enterprises and influence their profit levels.

Due to worsening excess liquidity, quantitative tightening may be the major policy strategy of the future.

Recent price rises came mainly from agricultural products and the bulk commodities market, and the government has taken measures to curb inflation and reduce the dependency on expensive resources in the international market. Implementing negative interest rates is one of the measures.

However, high liquidity capital injected by the government during the crisis has not found new investment channels and will become excessive.

The scale of this idle capital would be enlarged through the snowballing of bank credit. And excessive liquidity would flow into the property, agricultural and commodity markets and be used for speculation. Thus, capital reclamation by the central bank is extremely urgent.

Tightening monetary policy will eliminate the influences of QE monetary policies.

With the implementation of QE policies in the US, global financial capital began speculating in bulk commodities. They sold the US dollar and the euro to invest in emerging economies with high savings rates and fast development. It also brings to China huge inflationary risks, assets bubbles and pressures on the yuan's appreciation.

Raising the deposit reserve requirement ratio will ease pressures from trade surpluses.

China should balance domestic and overseas demand, and not deny its comparative advantages and competitive export strategy because of the financial turmoil in the US.

The rise in trade surplus shows that trade frictions between China and the US and countries in Europe have been eased. More foreign exchange results in more yuan supply in the market and the increase of inflationary pressures.

Under strict loan policies, a rise in interest rates will enhance the costs of banks.

Although the net interest margin would remain the same for banks, a rise in interest rates would lower their revenue level.

What's more, as more capital flows into the banking industry, the shortage of an effective investment channel would be a potential risk for excess liquidity in the future.

To some degree, maintaining the negative interest rate would decrease banks' debt pressures. But capital from the banks has no choice except being reclaimed by the central bank.

The basic problem is that China lacks a new economic engine. Otherwise Chinese people and enterprises can enjoy the growth of their fortunes.

A tightening monetary policy will also ease increasing pressures on the yuan's appreciation.

China is facing two challenges. First, due to inflation, the negative interest rate needs to be raised while raising interest rates would lead to influx of hot money and the yuan's appreciation.

Second, maintaining interest rates because of pressures on the yuan's appreciation would worsen inflation. A rise in interest rates will not solve the dilemma.

Therefore, inflation should be controlled by intervention in prices and balancing supply and demand. Pressures on the yuan's appreciation should be reduced by restriction on inflow of hot money and tightening monetary policies.

In short, challenges to China's monetary policies include assets bubbles in an intangible economy and deflation in a tangible economy; the yuan's appreciation against the US dollar but devaluation in domestic market; and the influx of foreign hot money and financialization of domestic industrial capital.

Thus, on one hand, China's monetary policy should lead capital into a tangible economy and create an economic engine to remove the negative impact of the financial crisis and excess liquidity. On the other, speculation of foreign hot money and domestic idle capital should be controlled against worsening inflation and asset bubbles.

In the long term, China should use quantitative monetary policy, and implement measures of exchange rates and interest rates with caution.

The author is the vice-dean of the school of economics at Fudan University in Shanghai.