Time to raise interest rate, or face cost later
By Yi Xianrong (China Business Weekly)
Updated: 2004-09-20 10:45

After the August consumer price index (CPI) statistics were released, the issue of interest rates emerged again as the hottest topic for the media and financial circles.

People are wondering whether the central bank will raise the interest rate, when, and how.

In a developed market economy, a change in the interest rate is only the concern of the central bank. And the central bank makes the decision in line with economic conditions. The public could speculate on the change, but the heated debate about the interest rate between determined supporters and aggressive opponents, like what is taking place in China, seldom happens.

Both parties in the debate have abundant reasons to justify their arguments. The opponents hold that a higher rate will burden businesses with extra financing costs, attract international hot money and limit investment and consumption.

So, raising the interest rate at an improper time would suppress domestic demand in addition to the already-sluggish demand for Chinese products in the rest of the world, hence increasing the chances of the economy suffering from a hard-landing.

The supporters think a higher rate would initiate market-driven mechanism in macro control against the backdrop of rising prices, lowering individual deposits and the under-zero actual interest rate for businesses.

All these reasons are well-grounded in certain respects. It is natural because everything has different facets. But to give an exact evaluation, we must decide which are the major facets.

Therefore, the crux of the issue about China's interest rate change is to have a correct judgment about the role of interest rates in the financial market and even the whole economy.

Since China has not established a mature financial market, some think it unnecessary to judge the practices here with the theories applied in mature markets.

Such an opinion is correct in many cases, but not about the role of prices in the market, which is at the core of the market economy. It would be misleading to deny the essential value of prices in the market simply because China does not have a well-functioning market.

As a matter of fact, the role of the interest rate, as the prices of capital in financial market, in the market economy can never be overstated.

Through market competition, the interest rate could serve as a pointer to allocate the capital to sectors with better revenue. In developing countries, capital is one of the scarcest resources in economic development. To make better use of this badly needed resource, the interest rate should be decided by the market so that the most lucrative businesses can get the capital and the ones with poor returns would be thrown out of the market.

One of the biggest puzzles in China is how a new round of overheated investment always occurs soon after an old one was checked and duplicated construction and projects seem to be impossible to prevent.

The key to such a phenomenon is the government's rigid regulation of the interest rate, which prevents the interest rate from manipulating the flow of capital.

The interest rate could also lure the individuals to put their idle money into the banks, which in turn would be pumped into businesses through bank loans.

However, according to the latest figures from the National Bureau of Statistics, in the first seven months of this year, the average growth of individual deposits dropped by four percentage points over the same time last year.

This is hailed by some as a signal of acceleration in China's industrialization and the upgrading the consumption structure.

But this is not so. The decrease in individual deposits is caused by the low nominal interest rate and negative actual rate for bank savings. Under such circumstances, people would naturally choose more profitable investment tools, like bonds, funds and property. The dip in individual deposits would be recovered instantly after the interest rate rises.

From the above, it is clear that the interest rate in China is malfunctioning in almost all of the fields it is supposed to play a role. And this is caused by the government's regulation of interest rates.

To make matters worse, the rigid interest rate is not well-run under such an arrangement and even impedes economic performance.

When interest rates in other countries are lowered, the authorities cut the domestic interest rate accordingly, from which the State-owned banks and enterprises benefit a lot.

But when raising interest rates becomes popular in other nations, the domestic interest rate remains unchanged. This way, the government has allocated financial resources in favour of State-owned businesses with its single-handed control.

As a result, State-owned enterprises are insensitive to changes in interest rates, meaning that they are also insensitive to their costs for financing. The underground financial market prospers and the fever of fixed-assets investment is hard to be contained.

The authorities choose to fix the interest rates at a set level because they are concerned that interest rate could not have the due function to help economic control. Yet, the function can never be restored when the rates are so rigidly regulated.

Economic performance figures have also proven that the rates should be adjusted immediately after the economy shows signs of overheating. Even after the efforts of macro control over the past few months, the growth rates of gross domestic product (GDP) and fixed-assets investment remain above 9 per cent and 31 per cent respectively for the first seven months of this year.

Macro control carried out through administrative intervention without the assistance of raising interest rates would only serve as a temporary cooler to the overheated economy. Fluctuations in the steel and cement sectors add a proper footnote to such a judgment.

At the same time, the average individual, who diverts his savings to more profitable financial tools, will also benefit from a rise in interest rates.

A survey in Shanghai showed that more than 90 per cent of residents would like to see an interest rate rise. After all, most average people think putting the money in the bank is the safest way, despite the emergence of other means of investment.

To sum up, both the theories and the practices have proven the necessity of raising interest rates under the current economic situation. If the central bank loses the a good chance to do it now, it may costs much more later.

[The author Yi Xianrong is director of the finance development division at the Institute of Finance and Banking of the Chinese Academy of Social Sciences.]

Close