Commentary: For China, another rate decision looms
By Andy Mukherjee Bloomberg News Tuesday, November 2, 2004
It had been a topic of such intense speculation, and for so long, that when China did finally raise interest rates, the move was something of an anticlimax. Last week, the central bank raised the benchmark one-year lending rate by 27 basis points to 5.58 percent.
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That move "will have as much impact on the Chinese economy, as putting a bicycle in front of a speeding locomotive," according to Bob Prince and Jason Rotenberg, researchers at Bridgewater Associates, a Westport, Connecticut-based money manager.
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How will a tiny increase in interest rates curb overheating when draconian measures to cut bank lending to aluminum, auto, cement, steel and real-estate companies have had only a limited impact on the economy since they were introduced in April?
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Fixed-asset investment in China increased 28 percent from a year earlier in September. The much-touted deceleration in the economy - gross domestic product grew a reported 9.1 percent in the third quarter, down from 9.6 percent in the previous three months - was merely due to a statistical base effect, according to Dong Tao, an economist at Credit Suisse First Boston in Hong Kong.
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People's Bank of China cannot put the inflation genie back into the bottle with a token increase in rates, when consumer prices have been climbing uncomfortably close to a seven-year high of 5.3 percent for four months.
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Still, the interest-rate decision isn't without significance. To six strategists surveyed by Bloomberg News, the rate move indicates that the Chinese currency could be allowed to trade more freely by the end of next year.
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The clue lies in what the central bank can - or can't - do next. One argument is that, with the debate on the merits of raising rates now resolved, the central bank can come up with more and bigger increases.
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That won't be easy. Monetary policy in China is compromised by the yuan's peg at about 8.3 to the dollar. If Chinese rates rise too much too fast, more foreign capital will flow into China. The central bank will have to buy the incoming dollars to hold the peg, adding more liquidity in the banking system and aggravating inflation.
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"A flexible exchange rate is needed," says Rob Subbaraman, a Lehman Brothers economist, "in order to have policy independence in moving interest rates." Net inflow of overseas capital into China that wasn't linked to business investment rose to $9 billion in the third quarter, up from $3 billion in the previous three months, Subbaraman estimates.
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Government controls on money entering and leaving the country are not nearly as strict as they need to be for China to sidestep the "impossible trinity" - the principle that no country can simultaneously keep its exchange rate fixed, its monetary policy independent and its capital markets open to the world.
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Put another way, bets on a stronger yuan aren't off just because China has decided to raise interest rates.
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"China is excessively cheap and highly productive," Prince and Rotenberg of Bridgewater said in a report. "The problem will eventually be rectified by a substantial exchange rate adjustment."
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That should be music to the ears of Treasury Secretary John Snow of the United States, who has been calling for China to let the yuan's value be determined by the market. Many U.S. manufacturers, and some lawmakers, consider the yuan to be undervalued by as much as 40 percent, giving China an unfair trading advantage. The U.S. trade deficit with China reached $124 billion last year, and is expected to be higher this year.
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What is encouraging is that People's Bank of China is also scrapping the ceiling of 9.03 percent from one-year bank lending rates. Giving banks freedom to charge more for riskier loans will help ensure that efficient private borrowers are not deprived of credit even as unprofitable state-owned enterprises use their connections to borrow cheaply.
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Still, if the exchange rate, and not the interest rate, will have to be the critical weapon in the fight against inflation, then why raise lending rates at all?
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According to Jonathan Anderson, an economist with UBS in Hong Kong, the lending rates have been raised because deposit rates had to be increased to 2.25 percent for one year, from 1.98 percent. Policy makers are concerned "at the prospect of deposits potentially leaving the banking system in favor of other assets or the sidewalk cash market," he said.
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Chinese households are borrowing too much against future earnings to preserve their wealth, says Andy Xie, Morgan Stanley's chief economist for Asia. "Ten years ago, Chinese people bought refrigerators and TVs to hedge against inflation," says Xie. "Property is now the hedge."
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Property is also the big worry. "Anecdotal evidence suggests that borrowers are currently committing between 40 percent and 60 percent of their monthly income to mortgage repayments," says Kenneth Tsang, head of research for Greater China at the real estate broker Jones Lang LaSalle.
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By signaling that mortgage rates should rise, the central bank may be trying to prick the property bubble now, before it bursts with disastrous consequences for the economy.
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