The author Yi Xianrong is a researcher with the
Institute of Finance and Banking under the Chinese Academy of Social
On May 18, the People's Bank of China, the central bank, announced it would raise the
deposit reserve requirement, lift the interest rate and widen the floating band
of renminbi against the US dollar.
Dubbed a "multiple punch", the simultaneous use of three policy tools by the
authorities is targeted at enhancing the management of liquidity within the
financial sector, maintaining sound growth in bank credit as well as investment,
and keeping inflation under control.
the move had only minor influence on the capital market, especially the stock
market. The indifference originated from two facts: the rate hikes were not
significant enough to impose shocks and the market had been expecting the
In this situation, the central bank should resort to interest rates, the most
effective, convenient and frequently used policy tool in any market economy.
The interest rate lies at the core of a market economy. A market-orientated
interest rate can help allocate resources effectively.
China has been working on marketization of interest rates since 2000 and
great progress has been made. Yet the benchmark interest rate, the rate for
one-year deposits, is still under State control.
As a market price for capital, the interest rate should be decided by
multiple factors. At the very least, it should agree with the basic rule of the
The economic soundness of a country can be judged from the growth of its gross domestic product (GDP). If the economy prospers, the revenue from all productive
factors increases: salary, business profit, interest rate and rent for land.
While the United States sees an annul GDP growth of about 3 percent, its
federal funds rate, the US benchmark rate, stands at 5.25 percent.
China has enjoyed nearly 10 percent annual growth for more than two decades,
but its benchmark interest rate is only 3 percent. The huge gap cannot be
explained under any theoretical economic framework.
The low-interest rate policy is the very origin of many distorted economic
activities, including the overheated investment in fixed assets, the white-hot real estate market and the stock
When the interest rate is kept at an unreasonably low level, people find it
rewarding to invest with borrowed money since loans are cheap.
Consequently, the economy sees over-heated investments, not only in fixed
assets but also in all available investment tools.
As more money flows into the investment market, the price of investment
tools, including financial products and the property, rises. This in turn
attracts more money.
Much of this money comes from bank loans. With the relatively big gap between
interest rates on deposits and loans, banks are more than glad to lend money,
the simplest way to make a profit.
Actually, the banks do have strong lending impulses. The roaring property
market is a result of the real estate speculation on borrowed money since
housing mortgages are viewed as a safe and convenient form of loan.
The low interest rate can have another effect: Capital, one of the factors in
productivity, is substituted for other factors because of its low cost. After
making a cost comparison, businesses would probably prefer more capital over
Since 1994, business investment has been growing at six times the rate of
employment, which indicates that Chinese businesses are relying more on capital
than on labor.
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