The Economist, Mar 22nd 2007
Chinese interest rates are still far too low
MOST central banks change interest rates by a quarter point here or a half point there. But the People's Bank of China (PBOC) is more particular. On March 18th, it raised its benchmark deposit and lending rates by precisely 0.27 percentage points, to 2.79% and 6.39% respectively.
Such fine calibrations may date back to the use of the abacus, and to an old Chinese convention that assumes a 360-day year for the purpose of reckoning interest payments. To make it simpler to calculate daily rates, lenders set annual rates that could be easily divided by 360. In practice this meant they had to be “divisible by nine” (because anything is easily divided by 40).
Even without an abacus, it is easy to show that Chinese interest rates are still surprisingly low. Despite the recent increase, the world's fastest-growing economy pays savers one of the world's lowest rates of interest. The ceiling of 2.79% on 12-month deposits barely compensates them for consumer-price inflation, which rose to 2.7% in February. Some economists reckon inflation could hit 3% in March, implying that the real rate of interest is probably still negative (see left-hand chart).
The rates paid by borrowers are higher, but not by much. The central bank's benchmark lending rate is above inflation in corporate-goods prices, now running at 4.5%. Even so, it looks far too low. In theory, a country's equilibrium interest rate should equal its marginal return on capital. In developed economies this is often taken to mean that interest rates should be roughly the same as the trend rate of GDP growth (a proxy for the return on capital). But China's nominal growth rate and its return on capital are both in double digits, well above the bank lending rate (see right-hand chart).
This is not to say that China's interest rates should be as high as 13% or so, in line with its nominal growth. Many other Asian emerging economies also have interest rates well below their growth rates, thanks largely to high levels of domestic saving. But, according to Jiming Ha, the chief economist at China International Capital Corporation, nowhere is the gap between the pace of growth and the rate of interest as wide as it is in China.
Mind your Ps and Qs
Central bankers can conduct monetary policy by changing either the price of money, ie, interest rates, or its quantity. In developed economies they favour interest rates. In China rate changes are less common: the latest move was only the fourth in three years, a period during which America's Federal Reserve has raised rates 17 times. China has relied more on quantitative measures, such as direct controls on lending and changes in the amount of reserves that banks must hold at the central bank. The PBOC's reserve-requirement ratio has been raised five times since July 2006.
One reason for this approach is that the economy has traditionally not been very sensitive to interest rates. Higher borrowing costs deter private-sector companies, but do not discourage inefficient state-owned enterprises, because they are less bothered about their return on capital. In such circumstances, direct controls on credit may have been a more effective way to curb overinvestment.
But leaving rates so low has its costs. Firms may borrow too much to invest in projects with low returns, thereby exposing banks to dangerous risks. Cheap loans encourage an overdependence on bank lending and hinder the development of capital markets. At the moment the most worrying distortion is that the low return on bank deposits is fuelling asset-price bubbles as households seek higher returns by buying shares and property. After plunging by 9% on February 27th, the Shanghai stockmarket has since rebounded past its previous high.
Higher reserve requirements have also lost their bite. In theory, if banks are required to hold more money on deposit with the central bank, this should increase the cost of their funds and so lead them to push up their interest rates. But banks' deposits at the PBOC are already much larger than the required ratio, so an increase does little to constrain their ability to lend.
China's monetary policy is also constrained by its rigid exchange-rate regime. Thanks to its widening trade surplus and strong inward investment, the country has experienced heavy inflows of foreign exchange, which swell domestic liquidity. The central bank has been reluctant to raise rates for fear this would attract more “hot money” from abroad. To regain control over its monetary policy, China needs a more flexible exchange rate.
A new IMF working paper* by Bernard Laurens and Rodolfo Maino argues that interest rates need to play a much bigger role in China's monetary policy. If the PBOC adopted a short-term money-market rate as its operational target, its policy would be more effective and the allocation of capital would be more efficient. The PBOC should scrap its controls on lending and deposit rates. It should also reduce banks' excess reserves to give them an incentive to borrow from each other in the interbank market, thereby enhancing the importance of money-market rates.
More controversially, the authors argue that the PBOC must be given full discretion to change interest rates. At present the State Council must approve all adjustments. The Chinese government is unlikely to grant the central bank such powers in the near future. Nonetheless, the PBOC should use all of its existing powers of persuasion to argue more strongly for higher interest rates now.
Even when free of political meddling, central banking is fraught with uncertainty. Monetary policymakers have to rely on good luck as well as sound judgment. That may be another reason why Chinese interest rates are divisible by nine: it is seen as an auspicious number. The Forbidden City in Beijing, for example, has 9,999 rooms. Unfortunately China's loose monetary policy is leaving rather too many hostages to fortune.
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