Measures such as low long-term deposit rates and investment spree only help wealth flow to certain interest groups

The People's Bank of China issued two sets of bills on Thursday at opposite rates, as domestic banks faced with tighter monetary conditions seek higher returns from longer tenors.

The central bank set the yield for 6 billion yuan of three-month bills at 1.4492 percent, or a rise of 4 basis points, a move that reflected extremely weak demand from domestic banks.

Conversely, the yield for the three-year tenor fell by 2 basis points to 2.70 percent, suggesting that even the 120 billion yuan on offer was not enough to meet domestic banks' strong demand.

The divergence underscored the extent to which the country's monetary conditions have tightened in the last few weeks, particularly after the implementation of the higher reserve requirement ratios by the central bank on May 10, the third rise this year that locked up an estimated 300 billion yuan.

China is faced with excess liquidity despite three reserve requirement ratio hikes and other moves to drain funds from the market. A relaxed monetary policy has been adopted in China over the past years to curb its economic slowdown in the context of the global financial crisis.

The value of assets held by the country's central bank has so far risen to 23 trillion yuan from the 5 trillion yuan at the end of 2002, statistics show.

The Chinese authorities have excessively depended on microeconomic measures, such as credit control, to manage some of its macroeconomic problems, believing that its competent administrative means have given the country some advantages over Western countries in macroeconomic regulation. However, any strict administrative limitations or barriers will not be able to prevent profit-pursuing private funds flowing to those sectors that will fetch high returns.

The strong expectation of inflation, together with a loose monetary and tightened credit policy, has resulted in bullish demand within the country for government debt, as indicated by the orders for three-year central bank bills doubling the volume of its issuance. That is also indication that the public has very low expectations about the country's long-term deposit rates.

Friedrich von Hayek, an Austria-born economist, believed that enterprises and ordinary people would hold a very low, and even negative, expectation on the long-term rate after a relaxed monetary and an expansive credit policy is adopted.

As a result, they would choose long-term investment options in certain areas to prevent property devaluation. This, however, will give rise to the unreasonable distribution of resources or an unscientific investment spree, both stoking bubbles.

The de facto existence of a negative interest rate in China has pushed the country to develop in this direction. The country's consumer price index (CPI) is now higher than the interest rate of its benchmark one-year deposit rates, which has precipitated domestic investor fears over inflation and pushed them to seek new investment channels.

As a result, it has inflated the real estate bubble and the prices of some raw materials have risen faster than the returns from one-year deposits. A hike in interest rates will help change investment activities among enterprises and ordinary investors, affect their expectations for investment returns and help them refrain from some irrational investment decisions.

However, the possibility that China's central bank will raise interest rates by a large margin in a short period is very slim. A gradual increase will inevitably lead to the inflow of more foreign capital into the fledging financial market in the pursuit of high profits.

From January to April, China had increased by 1.1 trillion the renminbi counterpart of its foreign exchange reserves.

The additional amount was largely contributed by cross-border capital flows under strong inflationary expectations other than its trade surplus or foreign direct investment (FDI). The expectation of a renminbi appreciation has stemmed from a fast growing Chinese economy under the effect of a series of stimulus packages.

To curb inflation and the risk of bubbles in some of its sectors, the country should carry out sweeping reforms in its monetary institutions in addition to such measures as a tightened monetary policy, raising its long-term interest rates as well as efforts to contain local governments' unrestrained investment impulse and their expansive fiscal demands.

Under the current economic environment, the central bank will remain particularly cautious about raising interest rates. That is because local governments have incurred heavy debt over the past years as a result of their large-scale investment campaigns.

The local governments' debt level is expected to touch 10 trillion yuan by the end of this year. This means that an increase in the interest rate by one percentage point will increase local governments' annual debt burden by an additional 100 billion yuan.

Domestic banks also hope the current low interest rate regime will last as long as possible so that they have more bullets in stock to fend off any possible outbreak of bad debt.

As the two key players of the Chinese economy, banks and local governments have served as the key factors hindering the country's efforts to raise interest rates.

If the government always values the interests of local governments, banks and some monopolistic departments and only takes measures that help the country's wealth flow from ordinary people to these groups, there is little hope of structural economic transformation.

The author is an economist with the Institute of Finance and Banking under the Chinese Academy of Social Sciences.

(China Daily 05/25/2010 page8)