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Excessive Liquidity Not from Monetary Policy
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By Sun Lijian

In another government attempt to control China's excess liquidity, on April 16, it was ruled that domestic commercial banks have to comply with the new deposit reserve rate of 10.5 percent. This is the third hike in the deposit reserve rate in 2007 announced by the People's Bank of China, China's central bank.

Increasing the deposit reserve rate is traditionally regarded as one of the strongest tools to realize monetary policy targets with its powerful curb on prices in the securities market.

Defying the curbs, China's stock market continued to rise following the six hikes in the deposit reserve rates imposed by the central bank since July 2006.

The difference between theory and reality results from a change in the central bank's tactics.

The People's Bank of China has been to tighten monetary control, but in a gradual manner. And the recent policy moves were within the market expectations.

In fact, the central bank probably did not mean to solve the liquidity problem at a stroke through the deposit reserve rate hikes.

Instead, its primary object is to help the market better understand the monetary policy targets: keeping the Consumer Price Index (CPI) growth below 3 percent and maintaining the exchange rate of the renminbi at a reasonable level during its appreciation.

With consistency in monetary policy and the market's trust in the central bank based on transparency in policy targets, the authorities will probably see better policy results.

Under current monetary policy, the renminbi exchange rate keeps going up, which encourages confidence in market growth. This encourages capital to flow from banks into the securities market. The shrinking gap between deposits and loans relieves pressure on banks to make loans. As a result, inflation pressure will be eased.

A booming capital market will facilitate reform of State-owned enterprises as well as the public listings of State-owned commercial banks on the domestic stock market.

The central bank is trying to guide excessive liquidity into the securities market, rather than let it drive the growth in bank loans, which could easily lead to inflation.

The growth of the CPI was 3.3 percent in March, higher than the 3 percent target of the central bank. Once it increases further, indicating inflation, the authorities will have to be increasingly prudent in policymaking.

Over all, the central bank has done its job in a market-orientated way: It raised the benchmark interest rates for deposits as well as for bank loans by the same percentage rates in March. It was wise not to change the interest margins between deposits and loans, avoiding increased pressure on banks to make additional loans.

This solution helps direct excessive liquidity into the securities market. Both the simultaneous rises in deposit and loan rates and the consecutive small rises in the deposit reserve rate have served to control the negative influences on the economy of interest rate increases.

They also reflect tactical changes by policymakers: more transparency in policy targets and more mature use of financial tools to reach the targets.

Under these conditions, the price of capital is primarily fixed by the market. The market becomes more predictable with cool-headed calculations based on price. Excessive liquidity, a destabilizing factor in the Chinese economy, is not the result of monetary policy. It is produced by the current economic structure that depends heavily on foreign trade and foreign investment under strictly regulated exchange rates.

If this economic structure is not changed, the issue of excessive liquidity will never be solved no matter how much the central bank does to direct money to the capital market or somewhere else.

But changing the economic structure cannot be completed by the monetary authorities as long as the country is still in need of foreign investment and exports.

However, the planned establishment of the State Foreign Exchange Investment Company will help control the inflow of foreign currencies to some extent.

According to reports, the company will issue bonds in renminbi and make investments with a limited amount of the foreign exchange reserve. This will greatly help to control the excessive market liquidity and facilitate the transition toward a market economy.

Reform in the exchange rate regime is also necessary. But before this is done, numerous preparations need to be made, not only in financial businesses but also in the policymaking process and the capital market.

Note: the author is professor of finance at the Economics School, Fudan University

(China Daily April 23, 2007)

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