Friday, October 29, 2004

Already, since I just had a few cups of baijiu and am in the middle of nowhere in Hebei, I am yet again in a self-congratulatory mood. As seen in my last posting, I did sort of predict this rate hike. I attach a pretty excellent article from the Washington Post on this topic. The article is good, but I must take issue with Professor Lang's assessment that this rate hike is bad.

This rate hike is on a whole a good thing. As he pointed out, it will not affect money supply too much, since it is such a small movement. While it might have hurt the stock market, it will not hurt the private sector by much either. The main rationale for this rate hike is to pre-empt an out-flow of RMB from the banking sector and from China itself. As the Caijing article (cited in my last post) pointed out, there was a significant movement of RMB from the banking sector in the past few months due to negative deposit rates. If inflation continues even at the mild rate of 5 or so %, you still have a negative deposit rate of 3%. This will prompt an outflow of RMB from the banks in search or other lucrative opportunities like the stock market and the real-estate market. This is why in the past month, despite a modest increase in money supply by 13%, you still have strong fixed asset investment. A rate hike is necessary to slow the outflow of RMB from the banks, and I suspect more hikes are to follow. The rate hike will not affect enterprises which want to borrow from banks, but will affect real-estate developers who want to raise money directly from investors.

If the PBOC raises interest rate by another 75 basis points in the following months, nominal deposit rate will rise to 3% and inflation should fall below 4%. It still makes for slightly negative real interest rate, but is a lot better than the situation today. There will be much less private capital sloshing around in the real-estate market. Granted, Professor Lang has a point that money invested by private investors might be more efficiently allocated than money loan out through banks. However, banks are better (major borrowers are no longer local governments but central government and large joint-stock firms), and it isn't clear if real-estate and the stock market are the most efficient way to allocate capital. The entire financial market is problematic in terms of efficient allocation.

So, with the baijiu running through my system, I dare to predict that there will be three more 25 basis point movements upward in the next three months.

Washington Post

China Touches the Brakes With Higher Interest Rates By Peter S. Goodman and Paul Blustein SHANGHAI, Oct. 28 -- China's central bank raised interest ratesThursday for the first time in nearly a decade, signaling a deep uneasewith the breakneck pace of development and an intent to curb aconstruction boom that is sowing fears of runaway inflation. The unexpected announcement by the People's Bank of China drove down oil and commodity prices, as well as the stocks of mining and metalscompanies worldwide, with the expectation that China's voracious appetite for raw materials will wane as its economy tightens. The bank yesterday raised its one-year lending rate by 0.27 percentagepoints, to 5.58 percent, effective Friday, while rates paid to depositors in Chinese banks would go up by an equal margin, to 2.25 percent. By itself, the increase amounts to a trifle, a marginal bump thateconomists said would have little if any immediate impact on the overalleconomy, now growing at more than 9 percent a year. But analystsconstrued the announcement as a clear signal that China's leaders areintensifying efforts to cool the economy when a surfeit of new factories, office towers and residential development has outstripped the supply ofraw materials and energy. Some expect more increases in coming months asthe central bank seeks to slow new investment. "This is the beginning of a long tightening process," said Dong Tao,China economist at Credit Suisse First Boston in Hong Kong. "The economymust be slowed because it's currently running at an unsustainable level." U.S. officials praised the interest-rate increase as a sign that Chinais relying more on market forces to guide its economy and may be speeding a plan to let its currency move more freely against the dollar. China now maintains a fixed exchange rate that U.S. and European officials feel iskeeping the cost of its exports artificially low. "This is a change in the direction of things that [is] very promising -- a more market-oriented financial system, monetary policy and ultimatelythe flexible exchange rate," John B. Taylor, the Treasury undersecretaryfor international trade, said in an interview on Bloomberg television. Only a few years ago, the movement of interest rates inside this stillnominally communist country was of little consequence to the rest of theworld. But China is now by some measures the world's second-largesteconomy. Its growth has fueled a surge in demand felt from the iron-oremines of Brazil and Australia, the cotton and soybean farms of the U.S.Midwest and the luxury-goods-makers of Europe. China's purchases ofmaterials such as palm oil and rubber are now the single largest sourceof economic growth in much of Southeast Asia. Its hunger for steel andmachinery has played a pivotal role in lifting Japan from years ofstagnation. China's thirst for oil -- it is the world's second-largestimporter -- is among the key factors driving up the price of that commodity. Yet even as markets adjusted to the prospect of a China slowdown,economists noted that the increase in interest rates is virtuallyinsignificant in itself. "The impact on the real economy is going to be as close to zero asanything," said Jonathan Anderson, chief economist at UBS InvestmentResearch in Hong Kong. Anderson said the increase is important as asymbolic gesture aimed at persuading depositors to keep their money inChinese banks. With interest rates unchanged for years even as inflationclimbed past 5 percent, worries have set in that China's savers arepulling their money out of banks to seek better returns in speculativeinvestments such as real estate. The state press has carried reports of a growing black market as companies with cash to spare lend it to privateentrepreneurs at higher rates of interest than banks are allowed to charge. Central bank officials have also openly fretted about the prospect ofan overheating economy -- growth so fast that it leads to high inflation. In recent months, the government has been trying to gradually ease growth and avoid a so-called hard landing, a sharp drop that could closebusinesses and throw people out of work. The root of the problem is visible in any Chinese city. As construction cranes dominate the horizon, the price of everything needed to fashion an office tower continues to climb. Shortages and bottlenecks abound. Ships wait weeks to unload atovercrowded ports. Rail and road links are overwhelmed. In most of thecountry, electricity is in short supply and being rationed, forcingfactories to limit production. With so much new money cycling through the system and urban incomesrising, prices of meat and vegetables have leapt -- a boon to farmerswhose incomes have long stagnated, but a source of worry that China'spoorest people are suffering. Concern mounts that if real estate prices unravel during a buildingglut, the banks that have lent in support of the speculative frenzy willbe saddled with billions of dollars in bad loans, adding to a tally nowestimated by private economists to be about $500 billion. As such worries intensified earlier this year, China's leaders soughtto tame growth through administrative fiat. They imposed curbs on newloans into the hottest sectors of the economy -- in particular, steel,cement and auto manufacturing. But while those measures have had some effect, inflation has continuedto climb. In its statement, the central bank declared that theadministrative curbs had "achieved good results," but that a rateincrease was required "to address recent conflicts and problems, and tofurther consolidate the results achieved." The last time China raised its benchmark lending rate, in July 1995,growth slowed by nearly half, plunging to 7.1 percent in 1999 from nearly 13 percent in 1994. One economist, Larry Lang, chairman of the finance department atChinese University of Hong Kong, said the increase was misguided. Thelargest borrowers in China have traditionally been local governmentsspending money on major public-works projects, and state-owned firms kept alive to preserve jobs, he said. If interest rates are higher, thosesorts of borrowers will continue to draw credit, regardless of theirability to repay their loans, Lang said. Meanwhile, China's emergingprivate sector, increasingly the source of new jobs and profitablebusinesses, will have a more difficult time getting its hands on credit. "This is a very stupid move," Lang said. "It won't affectover-investment, but it will hurt the private sector and it will hit thestock market." Others were skeptical that the rate increase has any broader effect onissues such as the exchange rate. Nicholas Lardy, a China specialist atthe Institute for International Economics, noted that Beijing has lowered interest rates several times over the past few years without changing its currency policy. "This time could be different, but I think the idea that this move somehow presages something on the exchange rate is putting thebest possible interpretation on it," Lardy said.

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