Thursday, June 29, 2006

Newly released PBOC data indicate that M2 growth in May remains a robust 19.1% from last year. Although the PBOC managed to maintain it below the 20+% earlier this year, it is nonetheless alarming. A main question is why doesn't the PBOC raise rates further. In a new Standard Chartered report, Stephen Green and company point out that the PBOC typically tries to maintain a 3% gap between PBOC rates and Fed overnight rates to discourage hot money inflows. The gap is now over 50 basis pts above that gap, so the PBOC should be able to raise rates further from its current 1.7% without attracting too much hot money. I think one explanation is political. In essence, Zhou is basically trapped between a rock and a hard place. On the one hand, it would solve his (excessive) liquidity problems, but on the other hand, he finds it politically unpalatable to increase the cost of financing for powerful SOEs and local governments before a Party Congress, where he wants a promotion to the State Council.

Thus, we will see more sterilization through PBOC note issuance and more adjustments in reserve requirements and cut-backs on excess reserve rates. If M2 continues to grow above say 18% in the next month or two, we might see 25 basis points increase in PBOC rates, but probably not much more.

I don't think that the explanation works because Zhao Xiaochuan, as head of the PBC, is already a member of the State Council. Even if he wants a promotion to vice-minister or state councilor, he'd have to wait until at least next year or more likely 2012, as this year is not an "election year." (Note the quotes.)

The real reason I think that the PBC isn't raising interest rates is that that doesn't cool down the economy as well as reserves and light administrative controls. The rise in interest rates in 10/2004 actually seem to cause M2 to accelerate.

My pet theory is that because the rates that banks lend out is set by the market whereas the rates that the banks pay out is fixed (and very low) that raising interest rates might actually cause banks to lend out more money.
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