China`s Policy Dilemma Intensifies as Monetary Tightening Cycle
ECONOMICS: ASIAN PERSPECTIVES—OCTOBER 22, 2010
China’s Policy Dilemma Intensifies as Monetary
Tightening Cycle Begins
Asian Sovereign Strategist—Global Economic Research, + 852 2918 7846
After signaling a shift to monetary policy, the People’s Bank of
China raised benchmark lending and deposit rates this week as
it once again faces the challenge of fighting hot-money inflows
and limiting the extent of currency appreciation, while attempting to maintain an independent interest-rate policy.
Deposit-Rate Increase Is Long Overdue
China’s Real Interest Rates*
The People’s Bank of China (PBOC) finally
consumer price inflation running at 3.6%
triggered the interest-rate normalization
year on year in September, the real interest
cycle this week by raising the benchmark
rate after this week’s increase is still
one-year lending and one-year deposit
negative on the one-year deposit rate, at
rates by 25 basis points to 5.6% and 2.5%
minus 1.1%. On the five-year deposit rate,
respectively. The move was not a total
the real interest rate is a positive but skinny
surprise. The 50 basis point increase in the
0.6%. China needs a much higher real
reserve requirement ratio (RRR) for six
deposit-rate structure to help prevent
major banks a week earlier had already
liquidity from flowing out of the financial
signaled a shift to monetary tightening
system and into the asset markets (mainly
(see “China Tightens Bank Reserves,
real estate), and the current low or
Fearing Flood of Hot Money if US Extends
negative real interest rates are hardly in
Quant Easing,” Asian Perspectives,
tune with the policy of moderating activity
tightening measures currently in force on
October 15, 2010). This week’s move left
in the property market.
the property sector—an appropriate move,
interest rates on demand deposits
As of October 1, 2010
*Interest rates minus CPI. October CPI has yet to be released and
is assumed to be the same level as in September at 3.6% year on
Source: CEIC Data and AllianceBernstein estimates
in our view, given the recent revival of
unchanged, but raised them on longer-
There was arguably less urgency about the
term (two-to-five-year) deposits by 25–60
need to raise loan rates, but an increase
property prices and transaction volumes.
basis points. This was more than the 20
was inevitable in order to preserve state
basis point increase on bank loans of more
banks’ interest margins following the
So, what is the outlook for interest rates?
than one year.
deposit-rate increases. The important point
From the inflation and real interest-rate
to note, in our view, is that the combina-
angle, the PBOC may need to tighten a
The higher rate increases on bank deposits
tion of RRR and lending-rate hikes signals
few more times in the next six months to
relative to bank loans were widely
that credit control is a policy priority—de-
instill a much more prudent rate structure.
expected. Indeed, they were a long
spite the fact that the economy’s growth
With food inflation likely to continue to
overdue corrective measure to the growing
cycle has already peaked. Moreover, higher
drive headline inflation higher (to above
negative interest-rate structure of
lending rates will lead to higher mortgage
4% year on year) before it peaks out in
household deposits (Display). With
rates, as the PBOC broadens its policy
first quarter 2011, we think the minimum
target for the one-year deposit rate should
policymakers may control two of the
exacerbate speculative inflows seeking a
be 3.0%–3.5% with a slightly smaller
variables, they are unlikely to master all
large currency return on top of a high
increase in the lending rate. We do not
however, as the interest-rate outlook is
During the 2007–2008 episode, the
We still think that a sizable one-off RMB
overshadowed by the risk of unusually
RMB/USD peg was rock solid and the
revaluation is unlikely, and that China will
large hot-money inflows (detailed in last
PBOC did indeed raise interest rates to
probably try to muddle through the cycle
week’s Asian Perspectives).
fight the commodity-driven spike in
using a similar policy cocktail to the one it
inflation, increasing the one-year lending
applied last time. On a brighter note,
Battle of Evermore
rate by a total 135 basis points. The central
inflation risk is much less severe than it
There is a risk that the PBOC faces exactly
bank, however, was also forced to engage
was in 2007–2008 when the oil price hit
the same policy dilemma as in 2007–2008,
in rounds of severe sterilization operations
US$140 a barrel, implying that the
when it had to fight hot-money inflows
to curb excess foreign inflows.
required increase in domestic interest rates
view this as a high conviction forecast,
and limit the extent of currency apprecia-
will be less severe too. Beijing also seems
tion while also attempting to maintain an
This time, the juggling act will be much
more willing this time around to allow a
independent interest-rate policy. The name
tougher in the face of US quantitative
gradual currency appreciation, and this
for this juggling act, the “Impossible
easing, while heightened external pressure
may prove to be a helpful relief valve. n
Trinity”, reflects the experience that, while
for a revaluation of the renminbi will only
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OCTOBER 22, 2010 ECONOMIC PERSPECTIVES