CHINA’S inflation rate rose to 2.7% in February from 1.5% in January, prompting many to anticipate an interest hike soon by The People’s Bank of China (PBC). This has dampened investor sentiment somewhat. In many countries, maintaining price stability is often the primary if not the sole mandate of the central bank.
In China, the responsibilities of the PBC are not that straight-forward. For example, while conducting monetary policy to maintain stable economic development is listed as one of its main functions, ensuring that the renminbi’s exchange rate is at a reasonable level is also an important responsibility of the PBC. Hence, before deciding whether to raise the interest rate, the PBC needs to take many issues into consideration, not just the inflation rate.
Figure 1 shows China’s inflation rate as measured by the consumer price index and the change in the benchmark one-year lending rate. When China raised interest rates in July 1995, the inflation rate had already fallen substantially from the peak in 1994. Then, as disinflation turned into deflation, the interest rates were cut many times from 1997 to 1999. When inflationary pressures returned in 2002, the PBC let the inflation rate rise above 5% before deciding to raise interest rates at the end of September 2004. By then, the inflation rate had already turned down.
Then, the PBC raised interest rates two times in 2006 when the inflation rate was a mild 1.2%-1.3%. As inflationary pressures accelerated, the PBC raised rates aggressively in 2007. Then, when inflation rate was still above 4% in September 2008, the PBC began the first of five consecutive rate cuts over the course of four months. This shows that inflation is not the only factor that determines the change in interest rates.
Negative real interest rate is another commonly cited reason in support of an imminent increase in benchmark interest rates. The one-year fixed deposit rate currently stands at 2.25%. With a 2.7% inflation rate, savers are receiving negative real deposit rates. Negative deposit rate is undesirable because it discourages savings and drives up inflationary pressures.
Figure 2 plots the change in the one-year lending rate against the difference between the one-year fixed deposit rate and inflation rate. From 1995 to 2009, there were three periods when negative deposit rate occurred for a prolonged period, i.e. in 1995, 2003-2005, and 2007-2008. In all the three times, the one-year lending rate was raised.
In the first time, the lending rate was raised more than one year after negative deposit rate first occurred. In the second time, the lending rate was raised 11 months after negative deposit rate first occurred. In the third time, the lending rate was raised before negative deposit rate occurred. However, the one-year lending rate was lowered in September 2008 even when it was still in a negative deposit rate environment.
The first two instances suggest that the PBC would definitely raise interest rates if there is a sustained period of negative deposit rate, but not immediately after negative deposit rate occurred. The third instance showed that the PBC raised and lowered interest rates for reasons other than negative deposit rate. This again shows other factors were at play as well.
Figure 3 plots the change in the one-year lending rate against China’s quarterly real GDP growth. It shows that the one-year lending rate was raised after China’s economy registered above 9% growth for an extended time period, as indicated in 1995, 2004, 2006 and 2007. In 1996, although real GDP growth remained above 9%, interest rates were lowered in response to falling inflation rate.
Apart from showing that the PBC does not rely on a single variable to determine its interest rate policy, the three figures above also suggest that the PBC is less hesitant in lowering interest rates than hiking them. The PBC would lower interest rates once economic growth is threatened.
In contrast, when it comes to raising interest rates, the PBC has been more careful. For example, after China’s economy had recovered from the Internet bubble bust and inflation was rearing its ugly head towards the end of 2003, the PBC waited until the economy had fully recovered from SARS before raising interest rates.
The quantum of changes during interest rate hikes has usually been smaller than when interest rates were cut. It would appear that when conducting its monetary policy, the PBC places the highest priority on economic growth ahead of containing inflation.
China’s economy surged 10.7% in the fourth quarter 2009. A similarly spectacular performance is expected for the first quarter 2010, due partly to a low base effect. As the low base effects taper off, economic growth is expected to grow at a more moderate pace.
i Capital is of the opinion that three things must first take place before the PBC will raise interest rates.
One, economic growth must grow at a self-sustaining pace, creating sufficient employment opportunities. Two, property prices continue to surge unabated despite selective tightening measures being introduced to cool the property market.
Three, the inflation rate shows no sign of easing in the months ahead, especially in the second half of the year, indicating embedded inflationary pressures. Hence, i Capital expects the PBC to wait a while before making its next move.