Interest rate hikes an effective economic tool

By Yi Xianrong (China Daily)
Updated: 2007-08-24 07:06

For the fourth time this year, the People's Bank of China, the central bank, raised interests rates on Wednesday.

The interest rate on bank deposits was raised by 27 basis points, and the lending rate by 18 basis points. After the hikes, the benchmark one-year deposit rate is now 3.6 percent while one-year lending rate is 7.02 percent.

The central bank said it raised the interest rate to "control money supply and credit, and stabilize inflation expectation".

Judging from the series of moves by the monetary authorities, it is not hard to detect the new preference of the decision-makers in choosing policy tools. The frequent adjustments of the interest rate this year indicate that the authorities are attaching more importance to it.

It is encouraging the central bank has resorted to the strongest tool in the market to improve the efficiency of the country's monetary policy.

After the central bank raised the interest rates earlier this year, there had been doubts on whether it would have any effect on the economy.

Some people said stock market indexes climbed after the interest rate hike instead of slumping on the news. Property prices had the same response. So these people concluded that interest rate hikes do not work in Chinese financial market.

Such an opinion does not hold water. The previous rounds of interest hikes did not have remarkable effects in cooling the economy because the interest rate of China is too low considering its economic growth.

Interest rates decide where the financial resources are allocated. It would only lose its effect when the rate does not reflect the real demand and supply of the resources. When the interest rate is lower than reasonable, it cannot function normally to guide the flow of financial resources.

The repeated interest hikes are actually correcting the situation, propelling the interest rate closer toward the reasonable level. Without these rises, the interest rate would not become an effective policy tool for controlling the economy, nor will the Chinese financial market get mature.

After the National Bureau of Statistics released the latest indicators of economic operation on August 13, the market had been expecting another interest hike. After all, the annul growth in the consumer price index (CPI) of 5.6 percent in July is a record high in a decade.

The Shanghai Composite Index climbed 0.5 percent to 4980.07 on Wednesday, the first day of the interest hike. The readiness of the market for the hike has proven that the central bank's monetary policy has become predictable for the market. The market and the monetary authorities are building up some kind of interaction.

This understanding between the policy-makers and the market is precious, for it marks a start of transparent, scientific and modern policy making here.

The central bank raised the interest rate on deposits by 27 basis points while the bank loan interests were lifted by 18 basis points. Thus, the current difference between the interest rates of deposits and loans is narrowed. In other words, the banks' profit margin has been reduced.

The central bank has obviously done so in the hope that the commercial banks could make money from sharpening their competitive edge rather than relying on the official interest difference.

According to the central bank stipulation, the commercial banks could float their bank loan rates within a set limit above or below the official rates. But the difference between the deposit and the loan rates has been about 3.5 percentage points for years. Hence, the commercial banks were blessed with a profit margin which has incurred a lot of public criticism.

The central bank has responded by narrowing the differences and encouraging the commercial banks to improve themselves.

Among all the policy tools, an interest hike is the most effective one to ensure the economy is cooled down gently and safely. The stock market and the estate market have both be troubled with huge bubbles. The price bubbles in the two markets are actually a result of the lower-than-reasonable interest rate.

The bubbles are quite dangerous to the economy, but the means to break them should be selected with prudence. Administrative intervention might have an instant effect, but it would also make the economy suffer from drastic fluctuations

The interest rate hikes can change the market expectations of businesses and individuals, influence their decision-making, and prick the price bubbles one by one. Hence the economy is diverted away from overheating and retains its normal pace.

When interest rates are raised by small percentages it does have a dramatic influence on the market, but its long-term weight cannot be neglected.

Currently, the interest rate hike is the best way to achieve a soft-landing and the central bank is obviously making good use of it.

After this round of interest hikes, the actual interest rate for one-year deposit will be 1.82 percent under zero if the CPI growth in August remains the same as in July. The central bank may have to consider more raises when the time is proper to lift the actual interest rate above zero.

With the monetary policy being more market-orientated, the central bank has become more efficient in achieving its policy goals. It could have an even better performance if its independence was better guaranteed.

The author is a researcher with the Institute of Finance and Banking under Chinese Academy of Social Sciences

(China Daily 08/24/2007 page10)

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