By Editorial Board
Published: 2007-12-17

Cover Editorial, issue no.346, December 17th, 2007
Original article:
[Chinese]

China's economic policymakers are on the verge of wielding unprecedented, tight monetary measures. On December 8th, the Central Bank of China announced that it would raise the banks' reserve ratio by one percentage point, effective on December 25th. We believe that this is only the first step in a series of monetary measures in the pipeline, given that the Consumer Price Index (CPI) has soared and struck 6.9% last month.

In facing the dual-pressure of an overheating economy and inflation, tightening monetary measures are necessary and inevitable. But how effective are such measures? What can we expect if and when the interest rates rise further? And if these policies fail to deliver, do we have better alternatives?

To begin with, we must identify the source of the problem. Academic researchers have attributed China's economic woes to the "double-surplus" in China’s current and capital accounts, phenomena they closely related to the undervalued yuan. If this is the case, monetary policies such as raising the reserve ratio and interest rates have no way to hit the nail on the head.

With the latest announcement, the required reserve ratio has reached 14.5 percent, the highest since 1985. Up to September, the saving deposits were worth 39.5 trillion yuan; based on this amount, a one-percentage-point rise in the reserve ratio means a reduction of 400 billion yuan in liquidity. As no interest is paid on the required reserves, the new measure also means that commercial banks are turning 400 billion yuan worth of deposits into idle assets. Consequently, banks, especially small and medium-size ones, are facing higher operational costs.

Another possible tightening measure is to raise interest rates. However, interest rate hikes may have its own consequences. Over the past years, expectation of yuan appreciation has caused an inflow of hot money and a surge in foreign reserves, which translate into an overheating economy and excess liquidity. As liquidity in the United States decreased due to the sub-prime mortgage crisis, the US Federal Reserve has cut interest rates several times, resulting in a lower dollar benchmark interest rate against the yuan. Thus, if there's another interest rate hike in China, the gap would become wider and attract yet more hot money from abroad. As a result, the Central Bank would have to perform more frequent counter measures to reduce the mounting liquidity.

Moreover, interest rate hikes can't prevent domestic banks from giving out credit. Thanks to excess liquidity, savings deposits have soared and been funneled into current accounts in some major banks over the past several years. The recent interest rate bumps haven't increased lending costs for most banks, since there is a mere 0.09 percent increase in the current deposit rate. Some state-owned banks can even afford to lower their lending rates. Therefore, interest rate increases are actually enlarging the deposit-lending spread and thus stimulating banks' desire to provide more credit.

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