China’s conspicuous silence

China’s conspicuous silence
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First Published: Mon, Aug 02 2010. 07 58 PM IST
Updated: Mon, Aug 02 2010. 07 58 PM IST
Last week, the Reserve Bank of India (RBI) raised both the repo and the reverse repo rates—the latter by 50 basis points—and thus reduced the width of the interest rate corridor. The central bank also promised to announce interest rate decisions once in six weeks rather than once a quarter through mid-quarterly announcements. RBI has engaged in some deft work here.
The Reserve Bank of New Zealand increased the overnight cash rate to 3%, but projected that the future pace and size of increases would be more moderate than predicted in the monetary policy statement of June 2010. It held the strength of the New Zealand dollar to be inconsistent with the softening in the country’s economic outlook and moderation in the country’s export commodity prices. We agree with it on the New Zealand dollar.
The US Federal Reserve published the Beige Book survey on 28 July. The introductory paragraphs were positive, but the contents were less than stellar. Increase in consumer spending was modest. Real estate and construction—both residential and commercial—were rather weak. Loan demand was soft and the total outstanding loan volume had decreased in recent months.
James Bullard, president of the Federal Reserve Bank of St Louis, wrote a paper (“Seven Faces of The Peril”) in which he warned that the US was closer to Japanese style deflation than at any time in recent history. He suggested that the Federal Reserve buy treasurys directly up to around $2 trillion. Bare Talk has often maintained that the next round of quantitative easing (QE) in the US was a matter of WHEN and not IF. The Beige Book and this “kite flying” only reinforce the eventual inevitability of QE-2 in the US.
The only central bank that is maintaining a conspicuous silence on interest rates is the People’s Bank of China (PBoC). Instead, the PBoC deputy governor had published four short pieces on the website of the central bank on exchange rate management of the yuan. The last piece talks of the complementarity of managing production factor prices and the exchange rate.
The deputy governor makes the case for allowing the exchange rate to respond flexibly (appreciate) to rising production factor prices. Production factors are mentioned as labour and resources. Together with an earlier note that stressed the need to see China’s exchange rate policy in the context of its effective exchange rate and not just against the US dollar, this note suggests that China’s nominal effective exchange rate has to appreciate so that rising factor prices do not damage the country’s competitiveness. If that does not happen, then the rising factor prices would cause a real appreciation.
This indicates that China would be more open to letting the currency appreciate, as the economy turns more domestic rather than external-oriented. That is what India seems to be doing, in any case, with its currency.
However, the papers are silent on interest rates. China seems to be looking at the exchange rate in isolation without looking at the reform of financial asset prices holistically. In fact, while the rest of Asia (with the exception of Japan) is looking at tightening monetary policy, China has relied on a curious mix of administrative measures and sector-specific steps throughout this year. Look closely, however, and one would find a road map.
China is putting exchange rate reform ahead of interest rate reform or deregulation. One would normally expect the order to be reversed. There is a method to this approach. Well, that is the interpretation of Bare Talk, however. China’s intent is to firmly anchor expectations of appreciation with a view to popularizing the internationalization of the currency. No foreigner would want to own a currency that does not appreciate as a store of value.
In contrast, any reform of domestic interest rates would follow the clean-up of local government finances and bank recapitalization. The elimination/control of shadow banking (kerb transactions—both deposit-taking and loan disbursements) would also have to be part of the process.
The fact that China is approaching this rather gingerly is an acknowledgement that its domestic credit markets retain a soft underbelly. That is an invitation for the rest of the world to keep up the pressure on the exchange rate to appreciate, which might necessitate domestic interest rates staying low. That would perpetuate the current imbalances in the domestic credit market. In fact, without wanting to get there, China might arrive at the situation that Japan found itself in, in the second half of the 1980s—strong/appreciating currency and low interest rates. That combination led to asset price bubbles and busts.
Of course, the Chinese leadership is too shrewd not to have missed this potential danger. It will be interesting to see how it plans transition to the top of the global league tables, which appears to be on track so far.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at
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First Published: Mon, Aug 02 2010. 07 58 PM IST