Comparing monetary policies
Financial Express, 23 August 2007
Early this week the People's Bank of China hiked interest rates for the fourth time this year. This was done even though the Fed cut discount rates and the probability of a Fed rate cut is now seen to be high. The rate hike in China will increase the interest differential between China and US and could further attract capital flows. The rate hike does not make sense from the point of view of its impact on capital flows. It is, however, a typical response of a central bank struggling to have all three elements of the impossible trinity -- an open capital account, a pegged exchange rate and an anti-inflationary monetary policy.
The Chinese rate hike is like the rate hikes that India saw in the last two years. However, the response to higher capital inflows has been different in the two countries. While India increased capital controls by putting restrictions on the ECBs, this week China reduced capital controls by allowing individuals to buy securities offshore.
In the debate on India's exchange rate policy some commentators argue that India should keep the rupee undervalued as China does, because if China can manage the costs of the currency policy so should we be able to. In the last few months we find evidence that China is having increasing difficulties in pursuing the policy of sterilised intervention as a consistent, sustainable monetary policy framework.
There are two consequences of a pegged currency that are often debated in policy circles. The first is the cost of holding foreign exchange reserves arising from the differences between interest rates on domestic and foreign bonds. In this context, analysts often discuss trading losses from currency appreciation, of the yuan or the rupee, which make the value of reserves fall if the dollar, in which reserves are mainly held, depreciates. The opportunity cost of reserves, the quasi-fiscal costs of sterilized intervention and the potential or actual trading losses due to dollar depreciation used to be seen among the main points of focus in the debates on currency policy and sterilised intervention until about 2004. As the monetary implications of sterilized intervention have increased with the growing pace of reserve accumulation since, the debate has now shifted almost wholly to the implications of currency policy on inflation, interest rates, investment and growth.
Neither China nor India have been able to sterilise their forex intervention completely. This has led to a build up of liquidity in the system, high credit growth and inflation. Chinese foreign exchange reserves are now nudging USD 1.3 trillion. They are increasing at a rate of about USD 300 billion a year. India's foreign exchange reserves, at USD 218 billion, are barely a fifth of China's dollar reserves. The growth rate of the reserves is also much lower. However, China been able to sterilise its intervention much more successfully than India has, and until about a year ago, the difficulties of the policy were not seen in the movement of inflation and interest rates.
Until recently China was able to successfully sterilise its reserves partly because of the size of its banking sector which is much bigger than ours. While bank deposits to GDP in India is 50 percent, in China the ratio is much higher at 150 percent. This allows China to sell many more government/PBC bonds to the banking system than India can. In addition, the Chinese GDP is much bigger than India's. These factors substantially explain how China was able to handle its reserves more easily than India was.
When PBC ran out of government bonds in 2003, it created PBC bills which are sold only for the purpose of sterlisation. Since May 2006 the Chinese central bank issued PBC bills by means of a "targeted issue" scheme in addition to selling though an auction. The targeted issue scheme forces specific targeted commercial banks to underwrite PBOC bills at a yield lower than prevailing market rates. For instance, on June 14, the PBC made a targeted issue of one-year maturity bills worth 100 billion yuan at a yield of 2.1138%, 0.4% lower than the then prevailing market rate. Of the PBC bills issued, 42 billion yuan were forced on China Construction Bank, 30 billion yuan on Agricultural Bank of China, 12 billion yuan on Industrial and Commercial Bank of China, 10 billion yuan on Bank of Communications, and the remaining 6 billion yuan on others.
In 2004, RBI created the Market Stabilisation Scheme bonds in 2004, following in the footsteps of PBC which did this in 2003. Now will RBI create a targeting scheme to force MSS bonds paying below market rates on designated banks?
Today more than half of domestic tradable debt in China consists of central bank sterilisation bills. As the montary base contintued to grow at unacceptably high rates, such as a growth rate of 30 percent in M0 in 2006, PBC raised bank reserve requirements in 6 consecutive steps. Yet, inflation in China is rising and the consumer price index based inflation hit 5.6 percent, the highest in the decade. With the increase in interest rates, especially if US interest rates go down, higher capital flows will induce heightened problems for Chinese monetary policy. Yet, it does not appear that China is planning to increase capital controls in response.
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