Earlier this week, the People?s Bank of China (PBC) hiked interest rates for the fourth time this year. This was done even though the US Federal Reserve cut its discount rate, and the probability of a Fed central interest rate cut is seen to be high. The rate hike in China will increase the interest differential between China and the US, and could possibly attract further capital flows. However, the hike does not make sense from the point of view of its impact on capital flows. What it is, though, is a typical response of a central bank struggling to harmonise all three elements of the impossible trinity?an open capital account, a pegged exchange rate and an anti-inflationary monetary policy.
The Chinese rate hike is like the rate hikes that India saw in the last two years. However, the response to higher capital inflows has been different in the two countries. While India increased capital controls by putting restrictions on ECBs, this week China eased capital controls by allowing individuals to buy securities offshore.
In the debate on India?s exchange rate policy, some commentators argue that India should keep the rupee undervalued the way China does. If China can manage the costs of such a currency policy, they argue, so should we. But there is evidence that China is having increasing difficulties in pursuing sterilised intervention as part of a consistent, sustainable monetary policy framework.
There are two consequences of a pegged currency that are often debated in policy circles. The first is the cost of holding foreign exchange reserves arising from the difference between interest rates on domestic and foreign bonds. In this context, analysts often discuss trading losses from currency appreciation (of the yuan or rupee), which make the value of reserves fall if the dollar depreciates, since the greenback is the reserve currency for the most part. The opportunity cost of reserves, the quasi-fiscal costs of sterilised intervention and the potential or actual trading losses due to dollar depreciation used to be among the main points of focus in debates on currency policy and sterilised intervention until about 2004. As the monetary implications of sterilised intervention have increased with the growing pace of reserve accumulation since, the debate has now shifted almost wholly to the implications of currency policy on inflation, interest rates, investment and growth.
Neither China nor India has been able to sterilise its forex intervention completely. This has led to excess liquidity in the system, high credit growth and inflation. Chinese foreign exchange reserves are now nudging $1.3 trillion, and increasing at a rate of about $300 billion a year. India?s reserves, at $218 billion, are barely a fifth of China?s, and with a much lower rate of growth. However, China has been able to sterilise its intervention much more successfully than India, and until about a year ago, the difficulties of the policy were not visible in the movement of inflation and interest rates.
Until recently, China was able to successfully sterilise its reserves partly because of the size of its banking sector, which is much bigger than ours. While the bank deposits-to-GDP proportion in India is 50%, in China it is much higher at 150%. This allows China to sell many more government/PBC bonds to the banking system than India can. In addition, the Chinese GDP is much bigger than India?s. These factors substantially explain how China was able to handle its reserves accumulation more easily than India.
When the PBC ran out of government bonds in 2003, it created PBC bills, which are sold only for the purpose of sterilisation. Since May 2006, the Chinese central bank issued PBC bills by means of a ?targeted issue? scheme in addition to selling though an auction. The targeted issue scheme forces specific commercial banks to underwrite PBC bills at a yield lower than prevailing market rates. For instance, on June 14, the PBC made a targeted issue of one-year maturity bills worth 100 billion yuan at a yield of 2.1138%, which is 0.4% lower than the then prevailing market rate. Of the PBC bills issued, 42 billion yuan were forced on China Construction Bank, 30 billion yuan on Agricultural Bank of China, 12 billion yuan on Industrial and Commercial Bank of China, 10 billion yuan on Bank of Communications, and the remaining 6 billion yuan on others. In 2004, the RBI created Market Stabilisation Scheme (MSS) bonds, just as the PBC had in 2003. Will the RBI now create a targeting scheme to force MSS bonds upon designated banks? It?s unlikely.
Today, more than half of domestic tradable debt in China comprises central bank sterilisation bills. As the monetary base kept growing at unacceptably high rates (30% in M0 in 2006), the PBC raised bank reserve requirements in six consecutive steps. Yet, consumer-price inflation has hit 5.6% in China, the highest in the decade. With the latest rate hike, especially while US rates go down, higher capital flows will induce heightened problems for Chinese monetary policy. Still, China is unlikely to tighten capital controls in response. That?s an indication of its external sector confidence.
?Ila Patnaik is senior fellow at National Institute of Public Finance and Policy. These are her personal views