A test of nerves
Targeting interbank rates to control money supply in China and India produced massive volatility, with little to show for it, analysts say
The bold monetary experiment that the Chinese and Indian central banks engaged in this year might one day be hailed as a success. So far, the result has been unprecedented market volatility and little else.
Both central banks targeted interbank rates to control the supply of money, aiming for a more surgical monetary tool than orthodox bank reserves or policy interest rates.
The People's Bank of China and the Reserve Bank of India were worried that sticking with traditional policy rates or bank reserves would have had a greater impact on the overall economy and slowed growth.
"They shifted to a more interest-rate-based system in both cases. Both central banks should be applauded for doing that," said Frederic Neumann, co-head of economic research at HSBC.
Both central banks are looking to liberalise their markets, but they are adopting a similar policy strategy in very different situations and for different reasons.
China is now using its open-market operations almost exclusively to try to rein in a credit binge. Apart from growth concerns, the PBOC feared that raising policy rates or reserve ratios would have added unwelcome fuel to a rally in the yuan.
India had similar gross domestic product concerns after growth slumped in recent years. But, unlike China, it urgently needed to shore up its currency, which dropped in August to a record low, and tame steep inflation.
Economists feel it is too soon to pass judgment on these policies and they are impressed that the two giants tried to move towards market-based pricing in what has been a challenging year for emerging markets.
The experiment is an attempt by both countries to release some of their central grip on the economy and develop deeper roles for markets. But for middle-income countries such as China and India, there is no boilerplate recipe.
South Korea's experience in trying to liberalise its financial system and currency in the late 1990s was riddled with policy missteps, bankruptcies and crises.
Until this year, Beijing and New Delhi had countered the classic "impossible trinity" of trying to control capital flows, interest rates and their currencies at the same time through quantitative measures: bank reserve ratios, lending quotas and regulated investments.
Despite now using more market-oriented tools, the policy mix remains tilted towards controls.
Whatever the long-term prognosis, the policies have created extreme short-term volatility and uncertainty, which can only be partly explained away as the price of trying to deepen markets.
"The problem arises with the transparency of it, whereby it's not clear what their policy target is," Neumann said.
India created a wedge between its regular policy rate and its emergency funding rate as the rupee slid 20 per cent this year to a record low in August.
In China, where the PBOC's new tool is the reverse repurchase agreement funding window, interbank rates hit record highs in June when it withheld lending for about three weeks and the seven-day benchmark rate trebled to 11 per cent. That was followed by mini-surges in September and last month.
The rises reverberated through global markets. The A-share index fell as much as 20 per cent in June.
China wants to keep its economy expanding faster than 7 per cent annually, while curtailing a five-year lending binge that has led to excessive investment, manufacturing overcapacity and a surge in property prices. By keeping markets guessing on when it will supply cash, the PBOC has spawned huge uncertainty.
"The volatility is wholly self-inflicted," ING chief Asian economist Tim Condon said. "They obviously can control interbank liquidity with their indirect measures, but they seem to do it in a ham-handed fashion. Why the spikes?"
The volatility might also be the result of a centrally planned economy rapidly liberalising interbank markets while other parts of the economy are still closely controlled. China lacks deep bond markets and money market funds to smooth over volatility, but it also has to deal with the impact of hot money flows on a non-convertible currency.
"Quantitative management could arguably be the most effective monetary policy tool in China because decades of planned economy have made local governments completely insensitive to the price of money," said Wang Haoyu, economist at First Capital Securities.