Global Insight Perspective | |
Significance | The PBoC raised leading one-year lending and deposit rates by 0.27% to 6.12% and 2.52% respectively. The adjustment marked the first time in two years that lending and deposit rates have been increased simultaneously. |
Implications | The move clearly signals the intent of authorities to curb surging investment, which has been fuelled by above-target money supply growth. Over-investment runs the risk of fuelling a fresh generation of non-performing loans (NPLs) in the banking system while aggravating excess capacity in the economy and weighing on domestic demand. |
Outlook | Global Insight expects the PBoC to implement two more rate increases before the end of the first quarter of 2007, along with the imposition of additional administrative controls. Investment, and hence growth, will begin a modest slowdown in the later months of 2006 or early-2007. |
Tightening the Screws
On Friday (19 August), the People's Bank of China (PBoC) lifted deposit and lending rates at the same time for the first time in two years. Benchmark one-year lending and deposit rates were both raised by 0.27% to 6.12% and 2.52% respectively. The move marked the fourth tightening of monetary policy since April 2005. Lending rates were raised by 0.27% in April, followed by two 50-basis-point increases in the reserve requirement ratio for commercial banks.
Outlook and Implications
Monetary policy is being tightened, despite the persistence of benign inflation. The consumer price index (CPI) rose by just 1.0% year-on-year (y/y) in July, slowing from a 1.5% gain in June. Final-stage prices have remained weak, despite increases in production costs, driven in large part by high commodity prices. Producers remain reluctant to pass on costs to consumers, as domestic demand remains circumscribed by high unemployment and significant wage disparities across the country.
Aiming to Restrain Investment
However, the prime target of policy is investment and money supply, which have been growing out of the central government's control. Despite the earlier imposition of administrative controls to slow down local lending and investment, urban fixed investment and money supply have been rising at respective rates of around 30% and 20%. Driven by heated investment spending, the economy expanded at a torrid rate of 11.3% during the second quarter of 2006, gaining further momentum from the already heated 10.3% growth rate recorded in the first quarter.
Hard Landing Unlikely, but Risks Grow
While a busting of the current growth cycle is unlikely, given the weak state of inflation, continued heated investment will further worsen China's excess capacity and create more bad loans in the banking system, which is currently subject to a major restructuring programme. Still-deficient risk management and surveillance systems and legacy relationships between state-owned banks and enterprises increase the risks associated with asset and loan quality. The repeated tightening of monetary policy is intended to send a clear signal to state-owned banks that the government is serious in its intention to tame heated investment.
Additional Tightening, but Major Yuan Revaluation Counterproductive
However, moves thus far are still too modest to have a significant impact on credit and, hence, investment growth. Global Insight expects two more rate increases within the next six months, as well as the imposition of additional direct controls. A major crackdown on feckless provincial governments is already in progress, while state banks have been instructed to restrain lending, although such measures are irrelevant in the private sector, which now accounts for more than 50% of total investment. Conversely, the transmission effect of increases in policy rates is undermined by the underdeveloped state of market instruments. Short-term rates posted only modest increases today in response to the central bank's action, rising by 0.1% to around 2.5%. Given the balance of forces, investment—and, therefore, growth—will begin a modest cool-down in the later months of 2006 or early-2007. Our revised forecast projects that the economy will expand by 10.6% in 2006, before slowing to 9.2% growth in 2007.
Nevertheless, it is premature to conclude that authorities will allow the yuan to appreciate more sharply, in order to slow growth in monetary aggregates. Money supply growth is being fuelled by central bank interventions to mitigate the impact of huge capital inflows on the yuan exchange rate. However, letting the yuan crawl up more aggressively would be counter-productive, generating more speculative or "hot money" inflows, exerting additional pressure on China's money supply growth. Moreover, capital controls ringfencing the domestic financial system cannot be lifted until the banking system, exposed by the recent investment boom, is stabilised. As state sector restructuring continues, the maintenance of export-led growth at a level sufficient to absorb shocks remains a key policy priority, and a counterpoint to accelerated exchange rate appreciation. Global Insight maintains its forecast for a 3.0% appreciation in the yuan during 2006, strengthening to 5.0% in 2007