People's Bank of China Raises Interest Rates for Sixth Time in 2007

The New "Tightening" Monetary Policy Stance Begins with Timid Rate Increase

China's central bank, the People Bank of China (PBoC), yesterday announced that it would raise interest rates today. The move marked the first rate increase since the central government announced that it would shift its monetary policy stance from "prudent" to "tightening". The announcement was made at the annual Economic Work Conference (EWC) in early December, attended by China's top leaders.

The PBoC's latest rate increase is extremely timid, however, especially on the lending rates. The most significant increases were on deposit rates, particularly on rates of deposits of one-year or less. The rates on one-year, six-month, and three-month deposits were lifted by 27, 36, and 45 basis points, respectively (but on demand deposits, the rate actually was cut by nine basis points, rather then lifted). Whereas the rates on one-year and six-month loans were increased by only 18 and nine basis points, respectively, the interest rates on loans of five years or longer, as well as mortgage rates, were not changed at all.

The Latest Rate Increase Targets Inflation Rather Than Investment Growth

This "heavy on deposit rates/light on lending rates" rate increase reveals that the PBoC's concerns are tilted towards containing inflation rather then cooling overheated investment growth. In the press conference following the announcement of the rate increase, the PBoC spokesperson indicated that the rationale for raising short-term deposit rates by more then lending rates was to induce the Chinese public to park their funds in the banks, to reduce the inflation erosion of the public's savings, and to contain inflation expectation.

Consumer price inflation has indeed reached the highest level in more then a decade. Consumer price index (CPI) inflation reaccelerated in November to 6.9% year-on-year (y/y), from 6.5% in October. High food price inflation remains the major cause for the CPI's faster increase. Food price inflation in November reached 18.2% y/y, compared with 3.7% in November 2006. Meanwhile, investment growth has remained heated. Fixed-asset investment (FAI) in urban areas expanded by 26.8% y/y in the January-November period.

Increasing Interest Rates Not PBoC's Favourite Policy Tool

The 21 December interest rate increase is in fact the second tightening move since the EWC's "tightening" policy stance announcement. On 8 December, the PBoC announced it would lift the reserve requirement ratio (RRR) for commercial banks by 100 basis points on 25 December. The RRR increase marked the 10th reserve ratio increase in 2007 for a total increase of 550 basis points, bringing the ratio to 14.5%—an all-time-high level. The Chinese authorities have also indicated they will implement additional administrative controls on liquidity growth by enforcing a strict lending cap in 2008.

The PBoC's moves on the interest rates, on the other hand, have been much more conservative. The latest rate increase marked the sixth hike in 2007. The six hikes in 2007 totalled only 135 basis points. It thus appears that the PBoC is trying to directly remove liquidity from the economy (repeated increasing RRR, administrative control on lending) while limiting the rise in borrowing costs for corporate China, particularly the state-owned corporate China.

Outlook and Implications

It is questionable whether the PBoC's deposit-rate focused rate increase will be effective. With consumer price inflation reaccelerating to close to 7% in November, the latest rate increase still leaves China's short-term deposit rates in real terms (i.e., nominal rate less inflation) deep in the negative territory. Moreover, it is questionable whether higher deposit rates could effectively combat the rising consumer price inflation, which is mostly driven by supply-shortage-induced surging food prices. Meanwhile, investment growth has remained extremely heated, completely overshadowing the PBoC's tepid lending rate increases.

Furthermore, the tightening moves so far are still unlikely to generate a serious dent on liquidity growth. The aggressive reserve requirement ratio increases have simply been ineffective in reining in bank lending. The fact is years of administrative controls on lending following the 1997/98 Asian financial crisis have left the banks with much excess reserve; the reserve ratio increases of recent quarters simply did not matter to the banks. Indeed, both loan growth and broad money supply (M2) growth have picked up in 2007, despite the repeated increase in the reserve ratio. Moreover, if the heavier increase on deposit rates does indeed succeed in inducing the public to move their funds to bank deposits as the PBoC has intended, it will in fact boost the banks' reserve level and offset to some extent the PBoC's reserve ratio increase. Consequently, investment growth may not slow if the PBoC does not change its monetary policy course.