On March 17, the People's Bank of China, the central bank, announced a 0.27 percentage point hike in key interest rates. This was dictated by current major economic indicators.
Macroeconomic readjustment policies in 2006 seem to have not worked effectively to put a brake on runaway real estate prices.
If housing prices keep rising rapidly, the ongoing increase in property investments is not expected to slow. As a result, overheated fixed asset investment will continue and, in turn, ever expanding bank loans will keep gaining momentum.
In addition, the banks are feeding growing real-estate investments with their readiness to make loans.
Starting from the latter half of 2006, the central bank, confronted with overheating investment, rapid growth in bank loans and increasing trade imbalances, implemented a host of macroeconomic readjustment policies. To slow growth in bank loans, the central bank raised the deposit reserve ratio and required market operations to be more transparent.
However, these policies had limited effect.
The price mechanism is at the core of the market infrastructure. This means that the relationship between supply and demand is modulated by the price.
In the monetary market, the price of capital is nothing more than the interest rate. The price mechanism works in the form of interest rates' ups and downs.
In China, whose economic set-up is still in transition from the planned economy to a market oriented one, the price mechanism is still at the core of the general economic operation.
Currently, many problems in the Chinese economy have their roots in the low-interest-rate policy. It leads to overheating in fixed asset investment and excessive growth in the country's favorable trade balance.
In the context of low interest rates, it is profitable for investors to borrow money from the bank. The investors, who borrow low-cost money, feel no restraint in investing in high-risk projects. The capital easily flows into economic operations, particularly real estate and the stock market. Under such circumstances, it is only natural that stock and real estate prices keep soaring.
The central bank's latest interest rate hike by 0.27 of a percentage point may be insignificant beside the 16.8 percent investment return ratio seen by the average Chinese enterprise, even more so beside the fat profits reaped by real estate developers. But the interest rate rise is aimed at gradually changing the government's low-interest-rate policy, upgrading the government's macroeconomic readjustment tools and bringing down enterprises' and individuals' expectations for easy profits.
Taking all this into account, the role played by the interest rate hike is important.
We will soon see that higher interest will have significant impacts on the real estate market, though it will have limited influence on most enterprises and other markets. To be more exact, people who borrow money to buy housing for themselves or for investment will be affected most, rather than property developers.
Take Taiwan. Real estate prices shot up three times in a short period of time in the 1980s and 90s, fueled by a low interest policy and appreciation of the Taiwan dollar. This trend was, however, reversed by the rise of interest rates in the 1990s. By 2003, the housing price had dropped by more than 60 per cent.
In Hong Kong, real estate prices plummeted by 67 percent between 1997 and 2003. The price has, however, shown signs of rising in the last couple years when interest rates are lower.
The same can be expected on the Chinese mainland. An interest rate hike not only increases costs for real estate developers and investors but also dampens the high expectations of individuals who buy housing for themselves or for investment. Particularly, when they anticipate that the central bank will adopt a package of austerity policies with respect to the property market, they are likely to withdraw from the market. Their pullout will bring down the demand for housing. If the supply remains the same, the dwindling demand naturally brings down real estate prices, helping to cool the overheated housing market.
In sum, the interest rate is the most effective instrument for macroeconomic readjustment. Although a small margin hike in interest rates plays more of a warning role than actually cooling off the market, it has great influence on the real estate market, especially on people who borrow money from the bank to buy houses.
It is hoped that, with this as a turning point, the central bank will really switch to implementing price-mechanism-oriented tools in macroeconomic readjustment.
The author is a researcher with the Institute of Finance and Banking at the Chinese Academy of Social Sciences
(China Daily March 21, 2007)