An American Perspective from China
October 20, 2010
by
Patrick Chovanec
I have an op-ed on
Bloomberg
today, arguing that inflation is a much bigger problem in Chinathan people realize. You can read it here.
I’ll be posting the entire article tomorrow, but today,I want to respond to all the questions I’m getting about last night’s announcement that China’s
central bank will be raising interest rates, by 25 basis points (0.25%) for the first time in nearlythree years. What does this mean for growth and inflation?I have a very unconventional take on this development.The standard assumption is that a hike in interest rates is a tightening measure, because whenthe price of borrowing money rises, demand for it should fall, reining in economicactivity. However, as I see it, in the prevailing interest rate range, both supply and demand forlending in China in relatively inelastic
—
that is, a modest 0.25% increase won’t have mucheffect on people’s willingness to borrow, or banks willingness to lend.
Given the boom
environment in China today, most borrowers either think they’re going to double their money,
or (in the case of mortgage borrowers) are desperate to keep up with skyrocketing assetprices.
In my experience working in private equity here, I’ve known borrowers to shop around
aggressively for the cheapest interest rate, but at the end of the day, regardless of whatinte
rest rate they’ll get, they’re going to take the money.
Maybe that might change if you upthe rate by 5 or 10%, but 0.25% barely registers. (The evidence for this, besides my own
experience, is that Chinese borrowers who either don’t have access or can’t
borrow any morefrom banks are regularly willing to pay rates near 20% in the informal lending market.)On the other side of the equation, banks have a guaranteed spread of nearly 4% between theregulated deposit rate (just above 2%) and the minimum lending rate (6%). To the extent theycan, they try to direct loans toward state-owned enterprises (SOEs) that they see as virtuallyrisk-free.
From their point of view, it’s arbitrage, and they are going to lend every yuan they
can, constrained only by their lending quota and reserve requirement. If the deposit rate
increases by 25 basis points, and banks can’t raise their lending rates, their spread will narrow
and so will their profits, but they still have every incentive to keep lending. But since borrowerdemand is also inelastic, they probably can raise their rates without seeing any fall-off inlending.The main constraint on bank lending in China
–
and the effective tool China’s central bank has
for tightening
—
same time, China’s central bank has been raising the RRR to just over 17% for large banks, a bit
lower for smaller ones. For the first time in living memory, the banking system as a whole hasrun out of excess reserves and is bumping up against its reserve requirement. The Chineseinterbank lending rate has shot up, and banks have been scrambling for deposits that wouldallow them to keep lending.When the regulated deposit rate is lower than CPI
—
as it has been for several months now
—
people with their money in bank accounts are losing buying power. They start withdrawingmoney from banks and either spending it or (more likely) stashing it in non-fixed return formsof savings like real estate or gold. By squeezing deposits out of the banking system, ultra-lowinterest rates in China have reinforced the reserve constraint on bank lending
—
acting, ineffect, as a
tightening
measure.
Raising
regulated interest rates actually
loosens
this constraint.
It’s bizarre, I know, and entirel
ycontradicts everything we normally think about the effect of interest rates on lending.
And I’mnot saying this is how China’s central bankers are even looking at the issue.
But I believe thedynamics I describe are accurate.Viewed in this light, Chin
a’s interest rate hike isn’t really a policy to actively head off inflation,it’s an involuntary response
to inflation. As CPI rises, the gap between CPI and the regulateddeposit rate widens, squeezing more deposits out of the banking system, putting more pressureon banks to rein in lending. At some point, in order for the banks to continue lending, you needto raise the deposit rate, otherwise their reserve constraints will force them to stop. (Of course, Chinese officials could also lower the RRR, but such an overt loosening measure wouldbe a much harder sell in the face of rising inflation). The point is that inflation is driving interestrates, not the other way around.So besides relieving pressure on banks, and keeping the money flowing, what other effect willthe interest rate hike have? Well, one thing is that it will increase interest expenses, andreduce profits, across a wide swath of the Chinese economy. Even when Chinese companieshave fixed-
rate loans, they’re effectively floating
-rate, because the terms are short (usually a
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An American Perspective From China
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