Tuesday, June 28, 2011

Why PBoC NOT Raising Interest Rates Promptly

Do you ever think of the real reasons why People's Bank of China (PBoC), the Chinese central bank, always looks cautious in raising policy interest rates promptly? The below shall explain this in details with some real reasons behind, we believe, such as:

(1) To properly feed over 1.3 billion people and also provide sufficient new jobs for people moving from rural to urban areas, China unavoidably needs continuous economic growth. Chinese policymakers are worried that higher interest rates may choke economic growth. This directly explains why the increase in Chinese interest rates barely keeps pace with rising inflation.

(2) There are also internal conflicts between various Chinese government bodies, like PBoC, the National Development and Reform Commission (NDRC) and the China Banking Regulatory Commission (CBRC) etc. In fact, the Chinese central bank, PBoC, has never been given full power in national credit control and bank loans. Any decision for raising interest rates is not independently decided by PBoC, but is decided by a group of government bodies and PBoC is only one small of them. PBoC has always to take a cautious manner and would only raise interest rates in a gradual attitude for keeping economic growth.

(3) PBoC itself is a profitable government body. There are only two ways to keep PBoc profitable: repress RMB interest rates at lower level and keep RMB exchange rate relatively weak. Why? In the current foreign exchange control mechanism, whenever there are inflows of foreign capitals into China, PBoC needs to print extra RMB that it can then exchange for the foreign currencies. Since this kind of RMB money supply is additional to domestic market and may cause potential inflationary concerns, PBoC has to mop up the extra RMB cash by offering RMB-denominated bonds back into the domestic economy. The foreign currencies, for example USD, PBoC receives from the above exchange operations are then promptly re-invested into USD-yielding securities (like U.S. Treasury Bonds). As there is normally a mismatch between the yield PBoC offers on its RMB-denominated bonds domestically, and the yield it receives on its U.S. holdings of Treasury Bonds (usually PBoC manages to repress RMB domestic bonds at lower yield level than of the U.S. treasury bonds), PBoC can then enjoy the "free lunch" and make profit if the exchange rate between USD and RMB remains relatively stable. Any interest rate hike or RMB appreciation, however, will erode capitals of PBoC.

(4) Raising Interest rates would eventually prompt even more foreign hot money inflows to speculate RMB appreciation. China authorities do hate to attract additional hot money inflows. The increase of foreign reserves in China is basically aimed at reducing monetary velocity, thus neutralizing the foreign capital inflows into China.

(5) RMB appreciation will also trigger drop in China exports. China is still heavily dependent on its exports for economic growth. If exports drop off dramatically in China then it risks resulting in large scale of unemployment, fueling civil unrest and posing a dangerous threat to social stability. Although China already planned to restructure its economy towards greater domestic consumption and lesser exports as per 12th 5-Year Plan and Government Work Report, this goal can hardly be achieved overnight. Drop in exports, by itself, would normally just brings lesser money to Chinese households, reduce their purchasing power and cannot expand domestic consumption at all. Before Chinese policymakers can see sustainable expansion of domestic consumption, it is unlikely that they would allow free drop in China exports. Based on this reason, the economy restructure plan for China can only be executed carefully and gradually.

(6) In China, it has not just been the PBoC addicting to the repressed level of interest rates. Many years of low borrowing cost has also made a huge dependency on low interest rates among many State-owned Enterprises (SOEs), Chinese local governments, and many other creditors of the bond markets and even the Chinese bankers themselves. All of them are actually funded by the long-suffering Chinese savers who are providing subsidies to the addicted borrowers in need.

(7) Many Chinese local governments are currently burdened with heavy debts, especially after the so-called "RMB 4 trillion stimulus program" for economic recovery to counter the 2008 global financial tsunami. Local governments did the borrowing mainly through special financing vehicles (SFV) from Chinese banks to fund the projects of constructing airports, roads, and many other infrastructures. The stimulus, however, has created a lot of investment misallocations in China. The China Banking Regulatory Commission (CBRC) once mentioned that around one-fifth of the Chinese bank loans disbursed to local governments are to be questionable. Raising interest rates would have to put more pressure on Chinese state-owned banks and would unavoidably increase their ratio of non-performing loans. Having rapid credit expansion with large amount of investment misallocations supported by low borrowing cost in these years, and China has denied Reuters report of cleaning up debts of Chinese local governments (Reuters reported on 31 May 2011 that Chinese central government planned to take off RMB 2 to 3 trillion from local government debts), it seems that only the repressed interest rates can artificially reduce the borrowing costs of the Chinese local governments and keep their investments viable.

(8) Many State-owned Enterprises (SOEs) in China are also burdened with debts. Raising interest rates would simply put some of the marginally profitable SOEs into financial difficulties, thus resulting in unemployment and requiring bailout from the central government. As the Chinese government emphasizes stability in SOE reform and also the employment market, it trends to use interest rates as the last resort and any interest rate hike would be mild to assist the SOE sector.

(9) Raising interest rates would encourage savings in China, while high inflation punishes Chinese savers. In China there already has a high enough rate in personal savings.

(10) Globalization nowadays has made it impossible to conduct effective monetary policy in a single country. A country like China can no longer fully control its own inflation rate by adjusting interest rates on her own (and neither the U.S. nor other western economies can do so on their own). It seems a more effective way is to coordinate multilateral monetary policy with other major countries needing the same set of raw materials as the price of which really determines real inflation rate. As a result, Chinese policymakers trend to take interest rate adjustments in western countries into account and do not want to raise interest rates too forcefully before developed countries do so, especially as the U.S. fiscal problem and the European sovereign-debt crisis are still not over yet.

We hope the above 10 main reasons can let you better understand why PBoC always looks cautious in raising its policy interest rates promptly.


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