Is a rate hike suitable medicine?
By Yi Xianrong (China Business Weekly)
Updated: 2004-06-15 11:12

[The author Yi Xianrong is director of Finance Development Division, Institute of Finance & Banking, Chinese Academy of Social Sciences.]

Soaring prices and rapid investment growth have pushed the central bank to tighten credit supply recently. But whether it is time for a long-expected interest rate hike remains controversial.

Opinions are split around academic circles.

One group thinks the interest rate hike is effective medicine to treat the overheating economy and rising inflation.

The present interest rate system is twisted, they say. It does not reflect the change in the market place. Higher rates on both deposits and loans would make macroeconomic adjustment measures function better.

If the consumer price index (CPI), the inflation barometer, gets close to 5 per cent growth, an interest rate hike would have to be made to curb investments.

Another view, however, is that the time is not ripe for an interest rate hike, as the macroeconomy is only overheating in certain sectors. Investment growth is expected to slow down and the CPI is unlikely to exceed 3-per-cent annual growth in 2004, which makes an interest rate hike unnecessary.

The third view, is that it is okay to raise only the lending rate while the deposit interest rate can remain unchanged.

As I see it, an adjustment of the present interest rate level has its pros and cons, and the complexity of the situation in China admits no simple solution.

But it is a must to improve the efficiency of macroeconomic management and adjust the present interest rate level.

Moreover, to curb the heat in investment and cool down the economy, an interest rate hike is so far the most convenient and economical measure.

Though China has been gathering pace in the transition towards a market economy, the market mechanism is not fully established.

People have been saving heavily to guarantee expenses for education, social security, employment and housing. It is hard to change the habit simply by increasing interest rates if the social and financial systems remain unchanged.

A flaw in the system and immature market mechanism have also led to the twisted structure of the interest rate scheme.

On one hand, transaction is very active in the money market (interbank and treasury bond repurchase markets), where the interest rates fluctuate according to changes in the market place and macroeconomic policy.

Here the issuing price of treasury bonds, corporate bonds and financial bonds are decided by the market.

When the government adjusted the macro policy, it would have a direct impact on the bond and interbank markets and ultimately affect the interest rates in these markets.

However, for the commercial banks, they are still adopting benchmark lending and savings rates that are controlled by the central bank.

Though the central bank is trying to liberalize the interest rates by first widening the floating range of the rates, given the present operation model of the banks, which is not fully commercialized, it is still hard to make the rates really responsive to market changes.

Sometimes, the interest rate would even move in a different direction from the macroeconomic trend.

For example, by the end of 2003, China's commercial banks and other financial institutions saw their outstanding deposits exceeding the outstanding loans by 5 trillion yuan (US$603.8 billion).

Meanwhile, however, many small and medium-sized enterprises are thirsty for funds and can not get sufficient bank loans.

Moreover, this year, the central bank has announced a series of policies to tighten credit supply, but people still stick to their saving habit and continue to make savings growth high.

Generally speaking, the interest rate standard is closely linked to the return of overall social investment.

The higher the return rate is, the higher the interest rate should be, and vice versa.

But the situation in China is different.

For years, China has been keeping the interest rate low, while the invest returns in some upbeat sectors are several times higher.

The average investment return ratio in 2003 was 12 per cent. In some sectors, it was as high as 22 per cent and even higher for the real estate industry. But the one-year deposit interest rate is still less than 2 per cent.

So the authorities should have raised the interest rate a long time ago.

The prime concern is not whether the economy is overheating or not, but whether the market has a valid demand for such fast growth.

If the market demand is genuine, then even rapid economic growth is not much of a problem for a developing country like China. But when the market demand is artificial, then bubbles would still emerge even without a high economic growth rate.

Presently, one of the root causes for the heat in the economy is over-investment in the real estate market, which is partly attributable to the fast growth of real estate consumer loans and the low lending rate of such loans.

The boom in the real estate market, either in terms of consumption or investment, is not based on actual demand in society.

If the banks increase the lending rates for real estate credit, it would directly affect real estate consumption and help burst the bubbles.

Movement of real estate prices has also become a major criteria for the authorities to judge whether the newly-made adjustments of the macroeconomic policies really function or not.

If the prices start to go down, then it means the measure to tighten money basics works well. If they move the other way round, then the authorities would have to reassess their policies.

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