For the sixth time this year the People’s Bank of China raised interest rates, which was not a surprise. The PBoC raised its 1-year benchmark lending rates by 18 bps to 7.47%. Changes in deposit rates were a little more complex. The 1-year benchmark deposit rate went up by 27 bps to 4.14%, the 6-month deposit rate rose 36 bps to 3.78%, and the 3-month deposit rates rose 45 bps to 3.33%.
The PBOC actually cut the deposit rates on current deposits by 9 bps to 0.72%, from 0.81%. The PBoC statement accompanying the hike claimed that the move "will guide more money into short-term time deposits to help consumers better handle rising prices while maintaining enough liquidity." I think here the concern is that a lot of money has been held in current deposits in order to take advantage of IPOs, and as huge amounts of money flow from current deposits to brokerage accounts, they cause spikes in sort-term rates that really hurt the smaller banks. By encouraging depositors to tie up their money, the PBoC may hope that it reduces the amount of IPO oversubscriptions.
Overall it is pretty clear that the PBoC is trying to encourage savers from withdrawing deposits – with CPI inflation over the past four months averaging over 6%, depositors have to be very unhappy with the return they are getting on their savings.I am not sure about the exact mix of deposits, so I don’t know what the interest spread is, but the spread between one-year deposits and one-year loans has narrowed by 9 basis points (I think altogether it has narrowed by 27 basis points this year, but I have to check). Banks rely on the interest spread for 85-90% of their profits, so the continued squeezing of the spread, along with the ten minimum reserve hikes this year, should have two impacts: it will put serious pressure on bank profitability next year, and it will create strong incentives for bankers to lengthen loan maturities.
There may be problems with China’s strategy. On their website the PBoC argued that "This adjustment will be beneficial in preventing the rapidly growing economy from turning to overheating, and prevent the structural rise in prices from becoming clear inflation." If raising the deposit rates is intended to fight inflation and prevent overheating, I imagine that it would do so by constraining consumption. However constraining consumption will also mean constraining import growth, which of course means adding further upward pressure on the trade surplus, and so further upward pressure on money creation as the PBoC monetizes these inflows.
In addition it is pretty clear that these increases in interest rates cannot help but make speculative inflows even more profitable – even if the dollar-RMB “arbitrage”, as some argue, is not the main reason for speculative inflows.
A lot rides on which model for explaining inflation and overheating is the correct one. If it is excessive lending and temporary food price increase that have caused the two, and if rising inflationary expectations are the main concern, then the current strategy may be the right one to combat the problem.Restraining spending and calming inflation expectations should do the trick.
If, however, the fundamental problem is the lack of monetary policy caused by the currency regime, then these solutions will only make things worse. Anything that encourages inflows through the current or capital account will simply make the PBoC’s job of managing the domestic money supply even more difficult and will exacerbate the overheating and inflation problems.We may find ourselves in a vicious cycle.
The numbers tell me that that the incredibly high readings (which has only become higher since) of fixed asset investment (about 4o% of GDP) comprise mainly of construction. Construction of new factories, new roads to factories, new plants to power factories, new houses to accomodate workers of factories moving from inland, and offices for the factories management. The actual purchase of equipment (capital goods) is only about one fifth of all capital formation. I assume much of this is driven by the export demand coming from US and the West. I have also read a few years ago, that the military has many enterprises chiefly in heavy industry and construction. Also I guess most state held enterprises are in the sector of heavy industry and construction because its just the way it is in a (post)communist country.
So the growth of China is very strongly based on construction, and it seems to me that construction is actually more important than the export industries themselves. Easy to create jobs for the uneducated and politically influential. So the undervalued currency and booming export industries are only tools in the hands of the all influential military and state lobbies holding vested interest in the construction and heavy industries.
I just make a very rough guess that about 1/3 of all fixed asset investment is driven by export growth. If the export growth stalls, thus 1/3 of fixed asset investment becomes unnecessary then 1o% of the GDP just disappears. That could mean an abrupt, outright recession in China as soon as the export demand begins to stagnate.
I guess this is what very likely can happen in 2oo8 if US demand stalls and Europe/India cannot replace. This can be the story of 2oo8 if it happens.
I don't know much about China, never been there, except for an hour long stopover in Hong Kong, I live in Europe, so what I wrote here is pure speculation. Please advise me whether my model makes any sense.
By Gabor - 12/29/2007 1:18 AM
I am not sure, Gabor. I need to think about this some more.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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Comments (2) for "China's risky bet on overhea...
December, 2007
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