It's hard to imagine that a little over a year ago Chinese economists were worrying about the prospect of deflation.
Overstocked inventories and sluggish consumer spending meant falling prices and fears abroad that China was exporting its deflation.
But in late October this year the People's Bank of China (PBOC), the country's central bank, raised interest rates for the first time in nine years in an attempt to combat inflation that had reached its highest point in seven years.
Admittedly, the rate rise was small – just 0.27 percentage points higher for the benchmark lending and deposit rates, which moved to stand at 5.58% and 2.25% respectively – but it was seen as a necessary first step to deal with inflation and the resulting negative real interest rates.
With the consumer price index (CPI), the headline measure of inflation, hitting 5.3% in July and August and 5.2% in September, the prospect of putting money in the bank at a deposit interest rate of just 1.98% was hardly appealing. The negative real interest rate meant that money in the bank would actually be worth less a month after it was deposited.
Did not compute
Many depositors did the math and decided they were better off withdrawing their funds and investing in more speculative assets. Not the dismal stock market, which Chinese investors have learned to avoid, but property – one of the sectors the government has been trying to cool down with the tightening measures introduced over the last year.
The central bank had talked about raising rates since May this year and with growing inflation and rates rising around the globe many wondered why it hadn't moved earlier, especially considering China's experience in the late 1980s and again in the early 1990s when inflation went from mild to raging double-digit in no time.
The reaction of the Fed, for example, to the first hint of inflation would have been to signal well in advance that it planned to raise benchmark rates. The PBOC, on the other hand, twiddled its thumbs for six months of high CPI numbers and then raised rates suddenly at a point when inflation seemed to be tapering off.
Why such caution? The most obvious reason was the government hadn't given its permission. It has been widely assumed the PBOC had looked to raise rates for much of this year but that important parties within the government had resisted an increase. There were those who argued an increase would mean higher borrowing costs for sickly state-owned enterprises (SOE), which could risk, in turn, more bad loans, more closures and more lay-offs, adding to the potential for social unrest.
There was also the problem of speculation from so-called "hot money" flowing in from abroad. Although the capital account is closed in China, large flows of speculative capital still manage to come in, increasing pressure for an RMB revaluation as well as adding to the problem of overheating.
Which brings us to another reason rates were not raised earlier. Economists largely agree it is not the economy as a whole that is overheating, but only certain sectors – such as automobiles and property and closely related industries such as steel, aluminum and cement – that have witnessed rampant irrational investment and need to be cooled. The government was justifiably worried that by raising borrowing costs across the board it could hurt some sectors of the economy that, if anything, still show some of the deflationary pressures of last year.
Decrees instead of markets
All this explains why Beijing decided against a rate increase and opted instead to issue administrative decrees discouraging lending in the hottest sectors.
The decision to increase rates was announced abruptly to avoid a stampede of companies rushing to take out loans. A borrowing surge by unprofitable enterprises with connections in local government would just create a whole new crop of bad loans – regarded as the biggest single danger facing the banking sector and the economy.
The abrupt rate rise made the headlines. But it was the announcement that accompanied it that was more significant for the longer term. The PBOC raised the ceiling on what the banks could charge high-risk customers – to nearly 14% pa from the previous cap of about 9%.
This change should give banks more freedom to lend to riskier businesses such as SMEs, which in China are generally much more profitable and have better asset quality. Relying on personal, rather than political, connections at banks, SMEs have had a hard time getting access to credit. Banks couldn't set rates that matched the risk of lending to smaller private firms that wouldn't be rescued in a recession, unlike big SOEs which were always safer to lend to because they were too big for the government to let them fail.
At present about two-thirds of bank loans go to SOEs but that should change as smaller private enterprises gain more access to credit. In the end, letting banks price risk is far more significant news than a tiny interest-rate increase – even if it was the first in nine years.