People's Bank of China Simultaneously Widens Renminbi Band and Increases Rates

The Chinese Central Bank's Triple Policy Move

On Friday (18 May), the People's Bank of China (PBoC), China's central bank, simultaneously shifted policy on reserve requirement ratio, interest rates, as well as exchange rate. The renminbi exchange rate's daily trading band will be widened from 0.3% to 0.5%, effective today. The PBoC will also raise the reserve requirement on commercial banks by 50 basis points (effective 5 June). In addition, interest rates will be lifted across the board (effective 19 May). The triple move is partly the Chinese government's effort to tame the still red hot liquidity and investment growth. The reserve ratio move marked the eighth increase since July 2006 (fifth in 2007), totalling 400 basis points and bringing the ratio to 11.5%. The interest-rate increase marked the fourth increase since April 2006. The benchmark one-year lending rate was increased by 0.18 basis points to 6.57%.

Wider RMB Band a Cosmetic Move

PBoC insisted that the wider trading band does not indicate high renminbi (RMB) volatility, nor does it suggest sharp renminbi appreciation. It is, rather, part of China's continuing effort to liberalise its exchange rate regime. Clearly, the move is also part of Beijing's effort to ease pressure from Washington on China's exchange rate policy and large trade gap ahead of the high-profile meeting between U.S. Treasury secretary Henry Paulson and China's vice premier Wu Yi on 22-23 May, the second session of the U.S.-China Strategic Economic Dialogue.

The new wider renminbi trading band will unlikely change the PBoC's conservative approach to exchange rate management. As the PBoC suggested in its press conference following the announcement of the new band, it is unlikely that the renminbi will undergo sharp appreciation or have much volatility as a result of the new band. If it was Beijing's intent to allow an appreciatively higher renminbi exchange rate, the old 0.3% band was plenty sufficient—it would allow the renminbi to appreciate by close to 7% per month. Since the July 2005 revaluation, the renminbi exchange rate movement has come close to the 0.3% limit by only a handful of times. China's exchange rate regime, in essence, remains an extremely dirty float.

Monetary Tightening Targets Heated Stock Market

The purpose of the 18 May rate increase is to raise the opportunity cost of investing in the red hot stock market. Unlike previous rate hikes, the move lifted the deposit rates more than the lending rates. The one-year lending rate was increased by only 18 basis points (less than the 27-basis-point increase that had become customary for the one-year lending rate in previous rate increases), while the one-year deposit rate was lifted by 27 basis points. Rates on deposits of longer maturities received larger increases—the five-year deposit rate was increased by 54 basis points to 4.95%. In previous rate hikes, deposit rates often were increased by less than the lending rate increases, as the government tried to stimulate consumer demand by making bank deposits less attractive. However, the low deposit rates not only did not encourage more consumer spending, but further fuelled the sizzling stock market instead. According to the PBoC, individual deposits in commercial banks in the first four months of 2007 have fallen 167.4 billion yuan from the same period of the previous year, with much of it diverted to the stock market.

Outlook and Implications

The reserve requirement and interest-rate increases are unlikely to have significant impacts. Both lending and deposit rates are still too low in China's current heated economic conditions. Nominal GDP growth is around 15%, more then 8% higher then the one-year lending rate. The 3.06% one-year deposit rate, on the other hand, is dwarfed by the stock market's 300% rate of return since 2005. In other words, the opportunity cost of investment for Chinese companies and stock investors is still too low after the latest rate increase. However, if the government continues to implement these incremental monetary tightening moves with high frequency, as it has suggested following the release of the first-quarter GDP data, liquidity growth will begin to slow and the stock market bubble could gradually deflate.

Despite the likelihood that the widening of the renminbi trading band is politically motivated, the Chinese government will likely allow the renminbi to appreciate more sharply in the coming months, as part of efforts to cool down the economy. China's stable exchange rate policy has come at a heavy price to the country's domestic economy. The government's efforts maintain the renminbi's stability, as China continues to post massive trade surpluses and attract huge sums of foreign direct investment (FDI), have translated to gigantic foreign-exchange reserve accumulations. In addition, massive "hot money" has flooded into China, speculating on sharper renminbi appreciation. These external forces, in turn, have exerted tremendous upward pressure on China's money supply growth and, hence, further fuelled investment overheating. With investment growth reaccelerating in 2007, the government is likely to utilise the exchange policy to stem liquidity growth.

Ironically, should the Chinese government employ the renminbi appreciation policy to slow down investment growth, and succeeds in doing so, China's massive trade surplus may actually widen. China's persistently large trade gap is the symptom of the excessive saving in the country's private sector, rather then an under-valued currency. Given that a country's trade gap and saving-investment differential are two sides of the national account identity, China’s running of huge trade surpluses while investment growth sizzles indicates how excessive the country's saving has been. Consequently, should investment soften, the trade surplus is likely to widen.