I have an op-ed on Bloomberg today, arguing that inflation is a much greater threat in China that people realise. 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 nearly three 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 when the price of borrowing money rises, demand for it should fall, reining in economic activity. However, as I see it, in the prevailing interest rate range, both supply and demand for lending in China in relatively inelastic — that is, a modest 0.25% increase won’t have much effect 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 asset prices. 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 what interest rate they’ll get, they’re going to take the money. Maybe that might change if you up the 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 more from 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 the regulated deposit rate (just above 2%) and the minimum lending rate (6%). To the extent they can, they try to direct loans toward state-owned enterprises (SOEs) that they see as virtually risk-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 borrower demand is also inelastic, they probably can raise their rates without seeing any fall-off in lending.
The main constraint on bank lending in China – and the effective tool China’s central bank has for tightening — is the reserve requirement ratio (RRR). Last year, as I note in my Bloomberg article, Chinese banks drew down on their actual reserves from 21% to around 17%. At the 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 has run out of excess reserves and is bumping up against its reserve requirement. The Chinese interbank lending rate has shot up, and banks have been scrambling for deposits that would allow 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 withdrawing money from banks and either spending it or (more likely) stashing it in non-fixed return forms of savings like real estate or gold. By squeezing deposits out of the banking system, ultra-low interest rates in China have reinforced the reserve constraint on bank lending — acting, in effect, as a tightening measure.
Raising regulated interest rates actually loosens this constraint. It’s bizarre, I know, and entirely contradicts everything we normally think about the effect of interest rates on lending. And I’m not saying this is how China’s central bankers are even looking at the issue. But I believe the dynamics I describe are accurate.
Viewed in this light, China’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 regulated deposit rate widens, squeezing more deposits out of the banking system, putting more pressure on banks to rein in lending. At some point, in order for the banks to continue lending, you need to 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 would be a much harder sell in the face of rising inflation). The point is that inflation is driving interest rates, not the other way around.
So besides relieving pressure on banks, and keeping the money flowing, what other effect will the interest rate hike have? Well, one thing is that it will increase interest expenses, and reduce profits, across a wide swath of the Chinese economy. Even when Chinese companies have fixed-rate loans, they’re effectively floating-rate, because the terms are short (usually a year), and the interest rate hike will kick in when they roll over. This bottom-line impact, particularly on SOEs, is probably why Chinese officials were so reluctant to raise interest rates for so long, and why they’ll probably take a lot of heat for it now. Even if higher rates are (perversely) a loosening measure, to most Chinese companies it will still feel like a tightening measure, even as they keep borrowing.
(By the way, one last thought. I mentioned Chinese borrowers regularly being willing to pay 20% rates in the informal credit market. The last time I remember people willingly paying such rates to fund business expansion was during the Dot-Com Bubble, when people were financing start-ups on their credit cards. It’s a good illustration of the boom mentality prevalent in China right now).