China's Monetary Policy

China's central bank takes more steps to try to cool down the Chinese economy:

China Raises Banks' Reserves Sixth Time in 10 Months

April 5 (Bloomberg) -- China ordered banks to set aside more money as reserves for the sixth time in less than a year to slow inflation and investment in the fastest-growing major economy.

The reserve ratio will increase by 0.5 percentage point to 10.5 percent starting April 16, the People's Bank of China said today in a statement on its Web site.

Central bank Governor Zhou Xiaochuan is concerned that cash from a record $177.5 billion trade surplus is stoking excess investment in an economy that expanded 10.7 percent last year, the fastest in more than a decade. The central last month raised interest rates for the third time since April 2006 to help reduce the risk of accelerating inflation and asset bubbles.

"Chinese authorities have a significant liquidity problem on their hands," said Tim Condon, an economist at ING Bank NV in Singapore. "The government's probably acting in response to the very buoyant loans growth we saw in January and February. They're going to keep watching this."

While the PBoC has also raised interest rates recently (a little), it seems that they are still primarily trying to use quantity tools (controlling how much lending banks can do) rather than price tools (at what interest rates can banks lend) to manage the economy.

The Chinese central bank's historical use of quantity tools instead of price tools is quite consistent with China's history as a centrally-planned economy. After all, the whole idea behind central planning is to have a planner dictate quantities produced, rather than allowing price signals to tell firms how much of what to produce. Managing the money supply through quantity controls is simply an application of the same principles.

But there are good arguments that suggest that the PBoC should shift toward using interest rate management more and quantity tools less - see for example "China: Strengthening Monetary Policy Implementation," by Bernard Laurens and Rodolfo Maino of the IMF. While such a shift woiuld probably a very good idea for an economy that is no longer centrally-planned, that change does not seem to be happening yet.

It's also worth wondering how much Chinese interest rates would have to go up in order to effectively cool down the Chinese economy. The answer might be quite a bit. Furthermore, raising interest rates brings with it some complications that the PBoC may be trying to avoid. Specifically, if China does indeed raise interest rates significantly, this could put a lot of additional pressure on the Chinese authorities to allow the yuan to appreciate. If they raised interest rates without allowing the exchange rate to change significantly, the PBoC could end up accumulating dollars even faster than they already are.

So it seems unlikely to me that we'll see any significant increase in interest rates in China until the PBoC is willing to allow faster yuan appreciation. Which brings us to one last point: as Menzie Chinn reminded us recently, the Chinese authorities could also cool down the economy very effectively by allowing the yuan to appreciate against the dollar.

They haven't used the exchange rate tool much in their efforts to slow down overly-rapid economic growth... but if they start finding that their quantity-management tools aren't as effective as they used to be, they might. And in combination with higher interest rates, a change in the exchange rate could very effectively sprinkle some cooling water on the red-hot Chinese economy.