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Interest Rates the Cure for Excessive Liquidity
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Yi Xianrong


The People's Bank of China, the central bank, announced on January 5 that it would raise the required reserve ratio for financial institutes engaging in deposit business by 0.5 percentage points from January 15.


It is the fourth increase of the deposit reserve ratio since July 2006 in an attempt to reduce excessive liquidity and ease the pressure of a boom in bank loans.


This move consolidates the accomplishments of the past year's macroeconomic controls.


The central bank has taken a series of measures to cut down excessive liquidity, which include increasing deposit reserve ratio and increasing interest rates. But nothing seems to have worked and the redundant liquidity is still a major headache for China's financial market.


If decision-makers cannot pin down the core of the problem, any policy tools implemented may only have limited effects on tackling the problem.


It is generally expected that the domestic financial market will see an over-supply of capital in 2007, which will be of primary concern for the authorities.


This opinion is based on two facts: The astronomically high foreign exchange reserve keeps increasing and domestic bank deposits are rising with the same strong momentum.


However, both these facts are likely to persist for quite a while. As long as the country does not change its foreign currency settlement mechanism, the foreign exchange reserve is not going to slow its increase because of the strong expectation of renminbi gains in the long term.


The bank deposits are not going to slow their increase given the current demographics of China: The average urban family has no more than three members, which drives the family to save heavily for their future.


The central bank's various moves to control liquidity in the banking sector are targeted at these two factors because they are thought to be the real reasons for the excessive liquidity. But as we have seen, the moves are far from effective.


The only explanation is that there is another factor behind the excessive liquidity. And that is the low interest rates under the government intervention.


The low interest rates, in other words, the low price of capital on the financial market, are a distorted signal to the market about the value of money. As a result, money holders become active in the market seeking more rewarding investments or assets. The price increases in real estate and stocks are the outcome of such excessive liquidity.


Therefore, the excessive liquidity in the banking system will not recede as long as the interest rate policy remains unchanged, and the investment fever will appear in different fields. Problems caused by excessive liquidity will pop up in new areas even as previous ones are pressed down by the government by administrative means.


The authorities should also sort out the fundamental factors behind the rise in the foreign exchange reserve.


When the financial markets, both at home and abroad, strongly believe that the renminbi will quickly appreciate, it is only natural for individuals and businesses, especially the hot money in the international market, to try their best to put their money in China to cash in on renminbi appreciation.


Several of my personal friends in other countries believe they can make a 25 percent profit if they invest in Chinese properties with loans from foreign banks. And this viewpoint seems prevalent.


To curb the inflow of foreign exchange, the renminbi exchange rate must be kept stable to ease the market expectation of its appreciation.


Otherwise, speculators on foreign exchanges will always find a way to convert their currencies into renminbi and the authorities will see the continuing growth of the foreign exchange reserve.


It is also necessary to facilitate Chinese citizens and businesses' holding their foreign currencies or their investments in these fields. They would be reluctant to have foreign currencies or assets in foreign currencies if they could not find rewarding investment projects or they believe these assets are in danger of depreciation.


Of course, the authorities have achieved a solid success in this field. The launching of Qualified Domestic Institutional Investors (QDII) in 2006 helps domestic investors find attractive channels of investment for their foreign currency. And the plan has been warmly accepted here.


Hoisting the deposit reserve rate has directly cut down the liquidity of commercial banks, but the decreased liquidity is a very small percentage of the total holdings, especially for the larger commercial banks. It will not significantly influence the business of commercial banks, nor will it impact the stock market, nor the daily life of ordinary people.


The increase in banks' required reserve ratio is going to have a limited effect on the real estate market. Despite the overall shrinkage in bank credit in 2006, the real estate sector still outpaced the previous year in its growth of bank loans. The banks may not cut back their loans for the industry after the latest round of lifting.


To sum up, the central bank's effort to reduce the excessive liquidity of commercial banks by increasing the deposit reserve rates will only have partial success. When the authorities change the low interest rate policy and stabilize the exchange rate of the renminbi, the excessive liquidity will be reduced substantially.


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


(China Daily January 11, 2007)


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