A healthy China would set interest rates at 10 per cent
Central bank action after spike in repurchase rate highlights that interest rates should be set at level close to nominal pace of output growth
A nasty liquidity squeeze gripped the mainland's financial markets in the third week of December.
As the country's banks scrambled for cash, the seven-day repurchase rate - a closely followed measure of market interest rates - shot up from around 4.5 per cent to hit a painful 10 per cent.
At that point the central bank stepped in, injecting enough cash into the system to bring rates back down again and restore calm (see the first chart).
But in all the reams of commentary generated by the initial panic and the subsequent relief when the authorities intervened, no one mentioned that for a fast-growing economy like China, interest rates actually should be at 10 per cent.
To most observers, however, last month's spike in interest rates was an aberration: a brief and unwelcome departure from normal conditions.
The reasons for the spike are simple enough. At the end of each quarterly accounting period, banks must show they have a loan to deposit ratio no higher than 75 per cent.
However, many of the mainland's smaller banks habitually exceed that level. To meet their loan to deposit requirements, they time the wealth management products they sell to investors to mature at the end of each quarter or half.
When the products mature, cash is paid into investors' deposit accounts, allowing the banks temporarily to meet their regulatory obligations, before they sell yet more wealth management products.
Unfortunately, there's a problem with this window-dressing. Although most wealth products are short term - 80 per cent have maturities of between one and six months - many of the loans they fund are longer term. As a result, the quarterly maturity dates spur a dash to raise cash in the interbank market.
With an estimated seven trillion yuan (HK$8.8 trillion) of wealth management products outstanding at the end of 2012, the effect is big enough to push interest rates sharply higher.
This time, as in the last big squeeze in June, the authorities provided enough liquidity to bring rates down again.
But the central bank only intervened reluctantly. Policymakers are well aware that despite official insistence that China is pursuing a "prudent" monetary policy, in reality monetary conditions have been far too loose for far too long.
Analysts generally reckon that for an economy to be healthy, benchmark interest rates should be set at roughly the same level as the nominal rate of output growth - that is the economy's growth rate before adjusting for inflation.
Considering that China's year-on-year nominal growth rate in the third quarter of last year was a brisk 10.6 per cent, an interest rate of around 4.5 per cent is clearly too low.
Worse, benchmark lending and deposit rates have been kept consistently below the economy's nominal growth rate ever since the turn of the century (see the second chart).
Initially that didn't matter too much. China was short of physical capital and badly needed the investment that low rates encouraged.
But recently policymakers have been unnerved by an expansion in lending which saw outstanding credit rise from an estimated 120 per cent of gross domestic product before the financial crisis to more than 200 per cent today.
Much of that lending, they fear, has been misallocated to projects that will struggle to ever generate an economic return.
To slow the credit boom, China badly needs higher interest rates more in line with its nominal growth rate.
Unfortunately, simply raising rates would make it more difficult for investment projects with borderline viability to service their debts, which could precipitate a bad debt crisis.
It's a tricky dilemma, and it illustrates why December's interest rate spike was no one-off, but a signal of the tensions which will dominate monetary policy during 2014 and beyond.