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Thursday, February 13, 2014

Chinese Interest Rates: Is Hike a Good Bet to Cool the Economy?

China knows what is good for it. More than that it has the best timing sense for its execution.

It is after a gap of almost 30 months that China raised its interest rates. The benchmark one year lending rate has been raised by albeit a minuscule 27bp, from 5.58 to 5.85%, effective April  28, 2006. Similarly, interest rates on loans with other maturities were adjusted accordingly. Intriguingly, it has not changed the deposit rates. One apparent reason could be that it doesn’t want the consumers to dump their savings on banks that are already flush with liquidity.

The reasons for the current rate hike are not far to seek. According to the People’s Bank of China (PBOC), the current hike is meant to “consolidate achievements of the macroeconomic management, maintain the good momentum of the sustainable, rapid, balanced, and healthy development of the national economy and enable the market to play a greater role in resources allocation as well as in macroeconomic management”. Viewed against this context, the current rise in interest rate does sound pretty modest. Yet, it is a very significant move, for, it gives the right signal about China’s intention in letting markets play a greater role in shaping its economy. However, it fades out if juxtaposed along with that of the US, which has raised its interest rates 18 times in the recent past. Incidentally, this also prods one to infer that interest rate is still not a significant tool of China’s monetary policy nor can it assume that status so long it sticks to its pegged exchange rate regime.

Overheating economy
Nevertheless, one thing is evident: the top leadership of China is pretty jittery about its overheated economy and is anxious to cool it off at the earliest. This well reflects in what ZhouXiaochuan, the Governor of PBOC, said: “The economy is a little bit hot, so we are aiming at some fine-tuning.” Even its President Hu Jintao had the same to say: “We do not want, nor are we pursuing, over-rapid economic growth.”  Now, let us figure out what their economy has got to say. China’s gross domestic product grew 10.2% in the first quarter of the year. The fixed investment was up 32.6% YoY in March this year, while loan growth rate continues to accelerate. New lending is reported to have grown by Rmb 1,260 bn in the first quarter of the year, which is almost more than half of the bank’s target for whole of the 2006. In January to April its imports rose 22.1% to $240.48 bn and exports rose 25.8% to $274.23 bn. All this indicates that its economy is growing at a fast pace, perhaps fueled by easy credit and its investment in fixed assets.

Admittedly, such a fast pace of investment has resulted in overcapacity in sectors such as steel and other manufactured goods. Over and above, it is feared that such surplus production and the resulting surging exports may create tensions with the US and other trading partners—including anti-dumping protests. Considering “arresting the speed in credit disbursals” as the obvious way out to stave off such unpleasant developments, the Chinese central bank might have hiked the interest rates on loans. But, one only wishes it is that simple, but before getting into that, let us take a quick look at how the world reacted to the rate hike.

World reaction
The current interest rate hike by China, instantly raised fears in the global stock markets about the probability of China’s economic growth faltering and the resulting slump in the demand for commodities from China. This fear indeed reflected in the fall in share prices of European mining, utility and oil companies, immediately following the announcement. Although these reactions are overblown, there is nevertheless a cause for concern. All along it has been China which has fueled demand for commodities in the world market. It is estimated that 40% of current demand in the oil market is from China. So, this sudden anxiety from the leadership of China to slowdown its economic growth instantly dampened the market spirit across the globe. This is evident in the global copper market too.

But the US has welcomed the rate hike, describing it as a positive step for a country that was till now known to intervene in the market through bureaucratic fiat. It is however, not all that enthused by the current move, for, it believes that as long as China manages a sort of fixed exchange rate, it cannot arrest growth rate merely through interest rate hike. True, in a globalized economy where monetary policy and its implementation are severely influenced in various ways by what happens in the external environment, a mere hike in interest rate, that too, by a margin of a quarter percent can hardly make any difference by itself.

Domestic concerns
That said, let us take a peep into what rate hike means for China domestically. Analysts fear that the very fact of not hiking the interest rate on deposits may tempt banks to increase their lending for they can arbitrage on interest rate differences between loans and deposits for realizing better profits. Secondly, no one can rule out the influence of regional leadership in making banks to lend to state enterprises whose growth has a direct bearing on the respective region’s economic activity. Thirdly, Chinese banks rarely bother to charge higher rates of interest for riskier borrowers. Even today, it is reported that Chinese banks grant loans at or slightly below the Central Bank’s benchmark rates. The net result is accretion of bad debts, particularly, during periods of downturn. There is yet another strong reason for the likely growth in loan disbursals in the coming months. One section of economists still argue that some amount of lending would continue on account of booming exports and FDI inflows that are converted into yuan on account of sterilization activities of the Central Bank. This is perhaps one reason why markets fear that China may in the near future opt for “administrative intervention” to suck overflowing liquidity by raising the cut-off limit for the money that banks have to keep as deposits with the Central Bank. Such a move is expected to automatically cut down the flow of loans for investments. In fact, this observation stands vindicated by the plethora of restrictions that the government has recently imposed “to rein in the property bubble”. It raised the down payment required for purchase of larger homes from the present 20 to 30%, put restrictions on lending to property developers and imposed a transaction tax on homes resold within five years. All this encourages one to conclude that the current hike in interest rate too megre to deliver the desired results.

The real culprit
This brings us to the other side of the game: the exchange rate. There is a strong argument in Western markets that China is manipulating its exchange rate at a very low level vis-à-vis the US dollar. Of course, it is in last July that China did allow yuan to appreciate 2.1% against the dollar. But since then it has just allowed it to float by hardly 1% over it. The American treasury department argues that China, by keeping the yuan weak against the dollar, is making its goods artificially inexpensive in the US and American goods artificially expensive in China and hence they insist that Beijing practice more flexibility in the exchange rate with the ultimate goal of free float. They also insist that to even out the global trade imbalances, China must encourage domestic consumption. Else, China, in their opinion, would continue to cater to the external world, which means unabated inflows of capital, making, whatever hike in interest rate that it has recently effected, redundant.

Looking at China’s popularity with foreign investors and its swelling trade surplus, one is more tempted to believe that this phenomenon will indeed continue. Incidentally, a study carried out by Geonan Ma and Robert N McCaulel, revealed that since 2003, “China’s rapid accumulation of foreign reserves is more out of non-FDI capital inflows than the surplus of the basic balance.” They have also observed that remittance inflows jumped by about 40% during both 2002 and 2003, which suggests that capital inflows through overseas relatives are mounting up under current account transactions. And no wonder some of these flows are quite in response to the relative yields and currency expectations. An extension of this logic would only mean any consideration of possible currency revaluation gains on long yuan coupled with the interest rate incentives is all set to build up huge yuan deposits against dollar borrowings.

What a paradox! Should that happen, the gush of foreign capital would only create more pressure on the economy. To defuse this pressure, China’s Central Bank must purchase dollars and release yuan into the domestic market and that brings it back to square one. It’s a different matter that China has initiated steps to stimulate domestic consumption besides encouraging imports by reducing tariffs. But, as long as its savings continue at the current level, no appreciable increase in consumption can be expected. One encouraging phenomenon that is surfacing in today’s China is that its leadership is willing to raise interest rates further, if needed, to cool the economy.

Intriguingly, there is a section of economists in America—including Noble Laureates—led by Ronald McKinnon of Stanford University who argue that China should not revalue its currency for it “could send China into the kind of deflationary slump that hit Japan during the 1999.” They predict that such a move would lead to economic slowdown in Asia, reduced foreign investment and increased unemployment in China.

Great sense of timing
Amidst these built-in controversies, China, though not surprisingly, allowed the yuan to briefly breakthrough the current barrier of yuan 8.0 to the dollar. The Central Bank, by allowing the psychologically important level of 8 yuan for dollar that was maintained for quite sometime, to breach and fetch less than 8 yuan for dollar, sent a strong signal about its willingness to let yuan appreciate at a faster rate. Economists opine that this move might generate momentum across Asia for currencies’ appreciation, which could help eliminate global economic imbalances.

Whether or not major Asian currencies appreciate against the dollar, economists are certain that China should allow yuan to appreciate in order to tackle its overheating economy and prevent a sudden crash. Isn’t this what China is doing now? Ironically, even in a non-democratic setup, leadership cannot wish away political compulsions for looking brave by not yielding to the pressures exerted by the American treasury to revalue their currency. But once the US treasury proved to be a “paper tiger” in its presentations to senate committee, the Chinese leadership started attending to its domestic compulsion—the compulsion for allowing yuan to appreciate. And thus started the appreciation of yuan and it is believed it would continue at its own defined pace, just to cool off its overheated economy and sustain the growth rate with no hiccups.

And, all for its own!

(July, 2006)


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