By Aaron Back
BEIJING–The People’s Bank of China is hesitating to raise interest rates despite increasingly worrisome inflation, apparently due to concerns that higher rates would attract inflows of speculative capital.
If inflation keeps accelerating, however, higher interest rates appear inevitable, and it’s just a question of how the PBOC can mitigate resulting inflows.
On Friday evening the PBOC raised the ratio of funds that banks must hold in reserve. Markets, which were widely expecting an interest rate hike, viewed the PBOC’s tightening as less severe than expected.
If inflation keeps accelerating, however, higher interest rates appear inevitable, and it’s just a question of how the PBOC can mitigate resulting inflows.
On Friday evening the PBOC raised the ratio of funds that banks must hold in reserve. Markets, which were widely expecting an interest rate hike, viewed the PBOC’s tightening as less severe than expected.
Markets didn’t just shrug off the news but even rallied, with industrial metal prices climbing on the London exchange immediately after the central bank announcement. Chinese stock prices shot up Monday, with the Shanghai Composite Index closing up 2.9% on the day.
There’s little doubt that the required reserve ratio has become the PBOC’s favorite monetary-policy instrument: They’ve raised the RRR six times this year, including three times in the last 30 days.
Over the weekend former PBOC Vice Governor Wu Xiaoling explained why, saying that a hike to relatively high interest rates would further exacerbate hot money inflows by raising the return on yuan assets. Such flows could create asset bubbles, reducing the effectiveness of a rate hike.
The dilemma highlights a major downside of China’s exchange-rate policy: By keeping the yuan tied closely to the value of the dollar, China has less leeway to depart substantially from U.S. monetary policy, an increasingly absurd arrangement given the two economies’ divergent paths.
More currency flexibility could help alleviate the problem. The most likely scenario is a repeat of the last tightening cycle that ended three years ago: slow but steady yuan appreciation and successive interest rate hikes, combined with continued RRR hikes and added issuance of PBOC bills to soak up capital inflows. Critics, however, said the PBOC’s actions at the time still left it behind the curve in fighting inflation.
Barring a surprise decline in inflation, China before long will be forced to reach for the interest-rate lever. In October, when rates were raised for the first time in three years, PBOC officials said one reason for the hike was the need to address negative real returns on bank savings.
That problem has only intensified. With November’s consumer price index having risen 5.1% from a year earlier, and the one year time-deposit rate at 2.5%, savers would have made a real return of negative 2.6% over the past 12 months.
That helps explain why authorities are having a hard time reining in property prices, as savers scramble to find alternatives to bank deposits that won’t lose them money.
Nor can authorities continue to write-off inflation as merely a weather-induced blip in food prices. For the second consecutive month in November, non-food price gains accelerated, showing that inflation pressures are spreading.
The PBOC shouldn’t let markets laugh off their next tightening move. That means raising interest rates, and dealing with the consequences.
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