PBoC rate hike small move and very late
China raised its benchmark lending and deposit rates for the first time since 2007 after inflation accelerated to the fastest pace in 22 months. The one-year deposit rate will increase to 2.5 percent from 2.25 percent, effective tomorrow, the People’s Bank of China said on its website today. The lending rate will increase to 5.56 percent from 5.31 percent, it said.
China’s inflation quickened to 3.5 percent in August, highlighting overheating risks that have prompted the government to curb credit and clamp down on the real-estate market this year. Higher interest rates may encourage inflows of speculative capital from abroad, complicating management of the fastest-growing major economy.
This is definitely good news. It increases household income by raising the return on savings, which is a necessary part of the rebalancing process. It (very slightly) reduces the incredible incentive to borrow money and splurge on manufacturing capacity, investment and real estate development. And it signals that the PBoC is concerned about overinvestment.
But it is a pretty small move and very late. The PBoC has been, very unwillingly I think, behind the curve on interest rates. Most of us believe the PBoC has wanted to slow investment growth and to raise rates for a quite a while now, but it isn’t easy to do so. One of the problems is that the economy – especially local and provincial governments and SOEs, not to mention the central bank itself – is so dependent on artificially low interest rates to remain profitable or viable, that even a small increase in interest rates can raise put pressure on cash flow and financial distress costs
Beijing hasn’t raised interest rates in nearly three years (December 2007), even though deposit rates are clearly negative and the lending rate may well be close to zero or even negative – depending on what you consider the right measure of inflation. There have been rumors about a rate hike for the past three weeks. Earlier this month Chen Long, my assistant at SWS, told me that the there was a lot of talk about a hike in the deposit rate some time this month.
We thought it would be very unlikely that the deposit rate would be hiked without an equivalent hike in the lending rate. The very wide spread between the two (306 basis points for one-year maturities, which does not take into account the typical maturity mismatch between depositors and borrowers) is the main part of a bank recapitalization process which many believe necessary to protect the system from an anticipated surge in non-performing loans.
But Chinese borrowers are too dependent on artificially low interest rates for their viability, so we felt there really wasn’t much room to raise the lending rate. Our conclusion: the PBoC might raise both deposit and lending rates by up to 25 basis points, mainly as a way of reversing some of the decline in real lending rates during the past year, but they wouldn’t be able to do anything more aggressive.
The key is to see if they follow this up in the next month or so with more rate hikes, which I doubt, but it depends on what the balance of power is between the various economic views. More rate hikes would be great news for the medium term rebalancing process. Real rates in China have declined rapidly this year and, as I have argued many times before, this is a real problem for the economy. Declining real rates exacerbates China’s already serious over-reliance on excess investment. But I don’t think there is much they can do about it without causing a serious slowdown in growth, and before the leadership transition in 2012 I don’t think there is much appetite for a slowdown, no matter how badly needed.
On a related note the most interesting piece of news last week for me was the new lending number. Net lending grew in September by RMB 596 billion, a lot more than the expected RMB 500 billion. This may have helped convince Beijing that they needed to do something more drastic and probably helped the decision to raise rates.
New lending totaled RMB 6.3 trillion for 2010 year to date (84% of the RMB 7.5 trillion quota). To get a sense of comparison, in 2009 new lending in September was RMB 517 billion, with the year-to-date total being RMB 8,7 trillion (90% of the year’s RMB 9.6 trillion total). In 2008 new lending in September was RMB 378 billion, with the year-to-date total being RMB 3.5 trillion (71% of the year’s RMB 4.9 trillion total).
We are talking some pretty big numbers. Last week the PBoC also raised the minimum reserve requirements for the six biggest banks by 50 basis points. Here is what my assistant at SWS, Chen Long, said at the time:
The PBoC unexpectedly lifted the reserve requirement rate for two months by 0.5% for the 6 largest banks, which will freeze RMB 200 billion in the banking system. The PBoC’s open market operations had injected RMB 181 billion into the market with 3-month, one-year, and three-year bills and notes. Short-term money market rates dropped while long-term rates rose.
The RMB accelerated its appreciation this week, and we believe it will continue. USD remained very weak, but the RMB actually depreciated again a basket of currencies in the last week as other currencies (AUD, JPY, SGD and EUR) rose. What is happening now is exactly what we expected: Beijing is appreciating RMB, but does not dare to tighten the credit. Liquidity is very loose and is the main reason driving up the stock market.
It looks like there has been a lot of unsterilized money creation in the third quarter, driven at least in part by what seems to be a pick up in hot money inflows, and the reserve hike was probably aimed at mopping up some of that money. There is some concern that today’s raising of the deposit rate might cause an increase in hot money inflows, but I am skeptical. I don’t think 25 basis points one way or the other is going to drive hot money in such a volatile economy.
I suspect the PBoC actions on minimum reserves also represent what seems to be a split among policymakers. One the one hand for many, especially in monetary circles in Beijing, loan growth is already excessive and they are very worried about the implications of yet more investment. I discuss why both in last week’s Financial Times article and in an article in Monday’s South China Morning Post, where I talk about the implications for China of Japan’s post-Plaza Accord policies.
On the other hand many policymakers, especially I suspect provincial and municipal leaders and SOE heads, are opposed to any slowdown in loan growth that may cause a real decline in the growth rate of investment and so in GDP and employment growth. They have made it very difficult for the monetary “conservatives” to tighten their leash on new lending, and I wonder if the PBoC reserve hike, which probably doesn’t require state council approval, reflects PBoC worries. The small interest rate hike is also probably part of this tug-of-war.
Net new lending has to average 400 billion a month for the rest of 2010 if we are to make the quota. Let’s see if that happens. It averaged RMB 310 billion a month in the last three months of last year, although that number was distorted downwards by the explosion in disguised short-term lending earlier in the year.
I am betting that policymakers will be hard pressed to keep the numbers within the quota, but who knows? They may be determined this time around. There are very strong rumors that next year’s quota will be only RMB 6 trillion. This would be a good thing over the longer term (and may represent lobbying by the next generation of leaders), but it will automatically mean, unless we see an explosion in the fiscal deficit or in disguised lending, a sharp slowdown in growth – even more so if the trade surplus is forced down, as I expect it will be.