News, cover
July 11, 2011
Translated by Song Chunling 
Original article: [Chinese]

In early July, China’s central bank raised benchmark interest rates by 25 basis points, the third increase this year and the fifth since 2010. The move is an indication of the central government’s determination to combat inflation.

Although many market analysts are predicting that this latest hike marks the end of the current tightening cycle and that rates are unlikely to be lifted again, we urge the central bank to keep raising interest rates until inflation is under control.

With prices rising, attention is once again focused on the price of pork. In many areas the price of pork has risen to record highs and still continues to increase. Given that pork is widely eaten in China, the swift rise in pork prices directly impacts on most daily living costs of most ordinary people. China’s premier Wen Jiabao has also recently committed the central government to the task of reversing rising pork prices.

Governments are arranging for pork reserves to be released onto the market in an attempt to lower price pressures and it’s likely that these moves might be effective in the short term. However, as pork reserves are limited, the market should play a more important role over the longer term.

Analysts expect pork supply to pick up after a few months as farmers, responding to price signals, increase the supply of pigs. But given the volatility in pork prices over recent years, many farmers still hesitate when deciding whether or not to increase output.

The recent sharp increase in prices has been influenced by both the outbreak of diseases as well as a drop in supply that followed a significant drop off in pork prices last year. The Ministry of Commerce also notes that the rising cost of feed and rural labour has also put upward pressure on prices.

However, the root cause of the increase in prices can be traced back to the huge amount of credit that the nation’s banks began issuing in late 2008 in order to counteract the possible negative effects of the global financial crisis.

This excessive liquidity has caused various asset bubbles to emerge and is the root cause of spiralling pork prices. Therefore, unless monetary policy is tightened and excess liquidity is absorbed, all attempts to rein in prices are only temporary solutions. 

While the central bank has been willing to raise the ratio of reserves that Chinese financial institutions are required to hold six times in the past year to a to a record 21.5 percent for the biggest lenders, it has been less willing to lift interest rates.

Although raising reserve ratios can help to absorb excess liquidity without increasing the burden on companies and individuals looking to borrow, the frequent adjustment of the deposit reserve ratio has caused disorder in capital market. Banks are desperate to raise deposits by any means possible, while a great number of small- and medium-sized enterprises (SME) are unable to get loans.

In fact, many of these SME are more willing to pay higher rates in order to have enough capital to keep their business ticking over rather than having no access to finance at all. This also explains why, despite the fact that private lending rates are as much as 10 times as high as official rates; supply in the private banking sector can still not satisfy the demand for credit. 

Since last February, when the CPI climbed by 2.7% and China’s official one-year deposit rate was at 2.25%, China has had negative real interest rates.

After the latest rate hike and the announcement of June’s CPI figure, real interest rates are almost at -3%. Since China has a high proportion of savings, persistent negative real interest rates reduce the wealth of depositors and we should not underestimate the extent of the harm that is being done to ordinary people due to these policies.

Given the fact that inflation is closely tied to people’s future expectations, if negative real interest rates continue to persist, depositors will choose to withdraw their savings from the bank in order to seek out more profitable investment channels.

Given that this means that more capital is leaving the banking system, the effectiveness of lifting deposit reserve ratios as a means of reducing excess liquidity is reduced.

Similarly, as depositors turn their backs on the banks, this will also have the effect of exacerbating the “deposits drought” faced by financial institutions.

Over recent months, a large amount of deposits have already been shifted out from bank accounts, this should serve as a warning for the central bank.

We are convinced that market reforms, not administrative measures, should form the basis of any policy aimed at combating inflation. The most important task is to reverse negative interest rates – not only will this protect the interests of depositors, it will also help to lower inflation expectations and allow price signals to work effectively in the capital markets.

This means that in the current circumstances, the central bank should be more cautious about using quantitative tools like adjusting the reserve ratios of the banks and at the same time the pace of interest rate increases should not suddenly be cut short.

This editorial was edited by Paul Pennay