Yi Xianrong

 

The People's Bank of China's interest-rate hike, which took effect on August 19, has not produced a big bang as the one in October 2004 did.

 

Why not? The 2004 interest-rate increase was the first since China's entry into the World Trade Organization (WTO) in late 2001 and also the very first after the domestic financial market became highly market-orientated. Furthermore, the 2004 hike directly impacted the people who borrowed loans from banks to buy housing. All this combined to raise the media's and people's concerns about the interest-rate rise.

 

This time, however, the increase came at a time when the market has become more mature and the central bank has put in place a policy of preferential interest rates for housing buyers.

 

But the most talked about issue is whether or not the latest interest-rate rise would boost pressure on the renminbi to appreciate.

 

The generally accepted theory dictates that an interest-rate hike automatically pushes up the value of the currency. By this theory, the current interest-rate rise would raise the expectations of investors and, in turn, encourage overseas capital to flood into China, betting on the renminbi's revaluation. This kind of capital, as expected by investors, could reap profits from the renminbi's interest hike as well as from its appreciation. Moreover, the investors would be able to profit by having access to the domestic stock and real estate markets and the markets of resources-based products, killing three birds with one stone.

 

Garnering such fat profits, however, is conditioned on a number of factors. First, the renminbi and foreign currencies must be freely convertible into one another. Second, the return rate on the international financial market must remain lower than the margin in which the renminbi is revaluated. Third, the domestic capital market must boom while barriers to market access are non-existent.

 

None of these preconditions have currently been met.

 

To begin with, the renminbi does not enjoy free convertibility at present, though international investors are craning their necks for the appreciation of the Chinese currency, which constitutes a kind of pressure for revaluation.

 

Free flow of capital between international and domestic markets is either made possible by strict market-access standards and qualified foreign and domestic institutional investor regimes, or prohibited.

 

In other words, the markets of the renminbi and hard currencies are separated from one another, and free flow between the Chinese currency and its foreign counterparts remains impossible. As a result, the fluctuation in interest rates cannot be translated into real leverage in this respect via pricing mechanisms.

 

If the exchanges between the markets of the renminbi and hard currencies remain free, for example, the spree of buying hard currencies should have happened when the interest rate of the US dollar was raised again and again over the past few years. But nothing happened in the country insofar as selling renminbi to buy US dollars was concerned. This largely brings home the reality that the renminbi and foreign currency markets are insulated from each other.

 

In addition, the US Federal benchmark interest rate has reached 5.25 percent as a result of 17 interest-rate hikes in recent years. The interest-rate difference between the renminbi and US dollar is roughly 2.7 percent if we treat the Chinese's currency's one-year deposit interest rate as the benchmark, which stands at 2.52 percent after the latest hike. This far outstrips the 1.6 percent margin by which the Chinese currency has been revaluated over the past year or so.

 

If the margin by which the renminbi appreciates does not outstrip the interest-rate difference between the Chinese currency and the US dollar, the speculation betting on the renminbi's revaluation would be rendered unprofitable. In this scenario, the latest interest-rate rise would have little impact on the renminbi's appreciation.

 

Also, the domestic financial market remains far inferior to the international monetary market in terms of investment tools and return rate for investment. The return rate for the one-year treasury bond in China, for instance, is below 2 percent, in contrast with the much bigger 4.5 percent return rate offered by US treasury bonds.

 

To make matters more complex, it is very hard for overseas funds to access, say, the domestic stock and real estate markets, in view that strict control is imposed on the entry of overseas money into the domestic market. This is evidenced, for example, by the government's newly issued circular that bans speculation on housing by overseas capital.

 

Some people believe that the market's expectation of a renminbi revaluation is likely to be subjected to the influence of macroeconomic regulation. Following this logic, the market anticipates that the central bank would finally resort to the foreign-exchange tool to speed up the appreciation of the Chinese currency in case the interest-rate hike proves unable to brake the bank loans' increase and rebound of investment. In other words, revaluation also constitutes a primary tool in putting a brake on the fast expansion of bank loans.

 

This author has time and again emphasized that the pressure for the renminbi's appreciation comes from institutional defects in the country's foreign exchange system and economic disequilibrium internationally.

 

In view of this, it is imperative to bring about effective mechanism of the renminbi's exchange rate, increase its resilience and flexibility and gradually liberalize the control on fluctuation margins between the Chinese currency and the US dollar.

 

Overall, interest-rate hikes are the most effective means of macroeconomic co-ordination and regulation. The influence of this on the renminbi's appreciation is insignificant. While the theory that the rise in the renminbi's exchange rate can put a brake on the overheating of the Chinese economy sounds plausible, it will do harm to the economy when put into practice.

 

The author is a researcher with the Institute of Finance and Banking under the Chinese Academy of Social Sciences.

 

(China Daily August 31, 2006)