Opinion

Move with far-reaching effects

By Mark Williams (China Daily)
Updated: 2010-10-26 14:17

The People's Bank of China (PBOC) delivered a jolt to global markets when it unexpectedly raised interest rates last week. Never mind that the small increase will have a negligible impact on China's economy. Even after the move, banks are charging companies less than 6 percent to borrow for a year in an economy in which output is growing at a yearly rate of well over 10 percent. At these rates, demand for credit will remain strong.

Never mind too that no one is clear what exactly was on the mind of the PBOC, China's central bank, when it announced the policy move. The first explanation most turned to was that consumer price inflation was rising too fast. But inflation only edged higher last month, and that was because of rising food prices. For everything apart from food, inflation has been falling since July.

It is hard to see how raising interest rates will help bring food prices into line - the recent price gains have been because of crop damage, rather than any surge in demand, and shortfalls in supply should prove short-lived.

Perhaps officials are worried about asset prices and want to cool investors' spirits. Yet China's share markets have been among the world's worst performers this year. Property prices have begun to pick up again. But if the goal of the PBOC was to halt their rise, it would have made more sense to raise minimum mortgage rates rather than the interest rates on all deposits and loans.

A third trigger might have been the recent pick-up in bank lending. Banks extended far more loans in September than in either of the two months before. If they were to stand any chance of meeting the government's annual loan quota, banks should have been slowing the flow of credit.

There probably is something in this third explanation. Even if inflation is not a pressing concern now, officials would still be right to worry that a new wave of lending could trigger inflation or rapid asset price gains a few months down the line. The increase in interest rates came a week after reports that the central bank had increased reserve requirements for a number of major banks, in effect squeezing their ability to lend. This was a punitive measure that singled out individual banks officials thought had let lending get out of hand.

But the PBOC usually turns to raising interest rates as a last resort if the alternative measures of raising reserve requirements and leaning on banks to slow lending have failed to have the desired effect. In this case the PBOC had only just started with the usual approach - reserve requirements had been steady since May and it was the hands-off approach of regulators toward bank lending that led to the late-summer loan surge in the first place. In other words, none of the usual motivations for a rate hike is totally convincing this time.

There is an alternative possibility, that the rate move was driven not by concerns over overheating but by a desire to tackle distortions in the structure of China's economy. The low interest rate level has been one factor in the extremely skewed pattern of growth in China over recent years.

When loans are cheap, the main beneficiaries are those who rely on capital rather than labor in production. For China's workers, the result of years of low rates has been that the country has become a global powerhouse in sectors that create few jobs. More than a third of the increase in China's trade surplus from 2005 to the 2009 peak was because of rising net exports of metals and machinery.

This has had far-reaching effects. Much of the income of a steel-maker, for example, ends up being saved or re-invested by the company, further boosting capacity. Or it is distributed to the company's typically well-off owners, who use the income to boost savings or buy property, rather than consume.

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Raising interest rates shifts the balance of incentives toward more labor-intensive companies. That means more of the income is paid out to workers in salaries and ends up being consumed. So raising interest rates has a part to play in reducing income inequality, reversing the decline in the share of national income going to workers, and reining in the surplus in foreign trade.

The intriguing prospect is that we might be seeing the first glimmer of a serious attempt to rebalance China's economy.

On this reading, the trigger for the interest rate announcement was the Fifth Plenary Session of the 17th Central Committee of the Communist Party of China that concluded the day before, at which the country's leaders agreed to frame the 12th Five-Year Plan (2011-2015) around the theme of economic restructuring.

It is too soon for this to be anything other than speculation. At the very least, many more such rate increases would be needed before their effect is felt.

What's more, even if the government has now decided to push interest rates gradually higher, there is no guarantee that its resolve will hold. Those that benefit from the status quo will push back against efforts at structural change.

But there is at least the possibility that last week's small shift in interest rates signaled a major change in thinking that will have profound implications for China and the rest of the world both.

The author is senior China economist at Capital Economics, a London-based independent macroeconomic research consultancy.