China is beset with a very complex situation as far as monetary issues are concerned. Interest rates, the value of the yuan and the efficacy of administrative controls are all involved in the government's attempt to find balances between sustained growth and overheating, inflation and deflation and domestic and external demand.
The complexity of the situation partly stems from China still being in a transition phase to a market economy, and partly from global conditions over which China has almost no control.
Although China has largely completed its transition to a market economy as far as most of the goods manufacturing, services and foreign trade sectors are concerned, the financial sector is still to a significant extent operating in a different era.
This is not surprising. The financial sector is the most delicate and the one whose stability is especially vital to social stability. As Korea found during the Asian crisis, a mismanaged move from a state-controlled banking system to a private sector one responding to market signals can lead to crisis. Caution is even more necessary concerning subjecting the value of the currency to market forces and the ebb and flow of capital.
The modest rise in interest rates in October was a reflection of the government's willingness to continue to move towards market mechanisms in the financial arena, but only slowly and deliberately. At the level of the cost of funds, the move could be viewed as insignificant. Twenty-seven basis points is little even for low growth economies with zero inflation. For a China growing at upwards of 8% and with inflation back above 3%, it could be viewed as meaningless.
But interest rates can be signals as much as anything: signals that other measures may be imposed if the rise fails to achieve the desired result.
Caution was also necessary for two other reasons. Any larger increase would have created a bigger gap between Chinese and US rates and thus attracted even more capital into China's banking system. China must operate in a world where interest rates are mostly at unnaturally low levels. This is particularly so in the currency to which the yuan is informally pegged – the dollar. The real US Federal Funds rate is minus 1.0%!
The consequent rise in China's monetary base from a bigger rise in interest rates would likely more than offset the contractionary effect on credit growth the rise was designed to achieve. It would also add to foreign exchange reserves and pressure for a revaluation of the yuan.
Secondly, a bigger rise might have sent too strong a signal of desire to cool the economy. The fact is that no one quite knows the impact of the administrative measures previously announced to slow credit growth. On the face of it, results have been modest. Overall credit expansion has slowed but not dramatically and the economy as a whole does not appear to have cooled significantly.
However, it is notoriously difficult to fine tune China's economy. The unreliability of growth statistics and the big variations in regional and other circumstances create huge problems for top officials. There may, for example, be property bubbles in a few locations such as Shanghai but not one overall. Some sectors, such as cars, may have hit a rough patch, but only after growing at break-neck speed in the previous two years. Is this a brief pause or a prolonged plateau?
Another factor is that big projects, especially in infrastructure, cannot and should not be halted from one day to the next. There may be too many power stations and refineries at the foundation stage, but the immediate story is of shortages of many items, power in particular.
It will anyway be difficult to move away from administrative measures entirely whilst the government still controls the banks and many key industries. So long as this linkage exists, many lending decisions will continue to be made on the basis of relationships and official policies even as interest rates are freed up and play a larger role in overall economic management.
Tilt toward strong yuan
The currency issue is a further complication. Some senior economic advisers are beginning to see the merit in using a stronger currency to dampen the forces of inflation. The return of some inflation globally has been primarily driven by commodity prices. These are more important for a developing economy such as China with its huge requirements for steel, copper, cement etc than for a service and high-tech oriented, advanced economy. A stronger currency would in theory spur domestic demand at least as much as it hurts exports. In Korea, the central bank recently – and in the face of government opposition – came around to the merits of a stronger currency to spur laggardly domestic demand. The same could happen in China.
However, a change in the currency has run up against three problems. First, a political one: no one wants to be seen caving in to US pressures. Secondly, a probably exaggerated fear of the impact on employment as labor-intensive industries suffered most. And thirdly a concern that China's import demands would continue to grow faster than exports, especially as US demand cooled, so that a revaluation now could lead to balance of trade problems later.
One thing that will not happen is China ending capital controls and floating its currency. So if it is to change at all it has the difficult task of devising and defining a new system, presumably some sort of managed float against a mix of dollars, euros and yen. But when to start?
If recent significant rises in euro, won and yen are sustained, China may find that a decision to move to a currency basket would be much easier – and reduce the cost of the capital equipment and sophisticated intermediates that it mainly buys from Europe, Japan and Korea.
In any event, currencies are now in play after a sustained period of dollar strength. China may want to stick with its fixed rate but is learning that the currency level and interest rates are related. The yuan's value is now a key influence in the overall economy, not just in China's foreign trade competitiveness.
Moves towards a market driven banking and financial sector will continue. But the juggling act is difficult enough at walking pace. Do not expect China to run and juggle at the same time.