On April 11, the People's Bank of China announced that it would raise the reserve requirement rate for commercial banks, the second such move in less than a month. With this action, the central bank must surely have put to rest the long-running debate over whether China's economy is overheating. But what took so long?
If the government had taken steps to cool the economy earlier, the cost might have been much lower. China's policymakers have been regrettably hesitant. Conflicts of interest among local governments and industries silenced open discussion of the overheating issue.
At the beginning of this year, analysts outside China began talking about a 'hard landing'. When the annual financial working conference was held in Beijing in January, Premier Wen Jiabao clearly pointed out that the economy was at a critical stage. There was, nevertheless, still no public discussion of the matter until the National People's Congress convened in March.
The central bank first announced it would raise the reserve requirement rate on March 24. Financial institutions with a low capital adequacy ratio would have to meet a reserve requirement of 7.5 per cent, half a percentage point higher than the rest. On April 11, even before the first rise had been implemented, the bar was edged up another half a percentage point. With the second tightening so close on the heels of the first, Beijing clearly demonstrated its determination to strengthen macroeconomic regulation and rein in the runaway economy.
Because there had been no general acknowledgement that the economy was overheating, tightening measures that were implemented last year had limited benefit. Whenever central authorities attempted to impose lending or other regulatory restrictions, local governments would simply approve and launch more projects. This only stoked the economy even more, threatening its stability. The result: the supply of coal, electricity, oil and transport services cannot meet demand, causing bottlenecks that are getting worse each day. Inflationary pressure has mounted. Tighter monetary policy became imperative.
The situation is urgent. Yet raising the reserve requirement rate is a high-handed measure with limited effectiveness. The more direct and powerful tool is the interest rate. In the domestic banking industry, except for the Bank of China, the other three large commercial banks are not short of yuan funds. Increasing the reserve standard, therefore, mainly affects other financial institutions and does little to slow the general expansion of credit. Increasing the interest rate would raise the cost of capital and highlight the difference between good-quality investments and bad ones. This will help put the brakes on the surging economy.