China central bank’s dilemma: how much financial tightening is too much?
Nimble tweaks in the interbank market by China’s central bank have paved the way for a decision on how far and fast to continue with the policy
When China embarked on a massive credit stimulus in late 2008, the job of the People’s Bank of China became relatively easy: it just had to provide as much cheap credit as banks wanted in the interbank market.
China’s central bank faces a much trickier situation now. On the one hand, it must become less generous in giving funds to banks and needs to allow rates to rise so that financial risks won’t worsen. On the other hand, it must be careful not to overdo its more parsimonious approach to avoid causing a money-market crunch or hurting on-the-ground economic activities.
PBOC’s bit-by-bit tightening, often via nimble tweaks in the interbank market that are barely noticed by the general public, puts it close to a moment of truth on how far and fast it should continue going in the same direction.
Zhang Xiaohui, an assistant central bank governor, wrote in an article published this week that a slight drainage in liquidity by the central bank has already triggered loud complaints from a few financial institutions that have gotten used to an unlimited supply of credit. “They often use horrifying words such as…‘money crunch’ or ‘market crash’” in pleading with the central bank to relax, Zhang wrote.
China’s central bank is constantly sending dovish signals to calm the market.
Shortly after Moody’s downgraded China’s sovereign rating last week, PBOC told banks it will be generous in providing money in June. In response to worries that China’s central bank may shrink its balance sheet, a sign of tightening, PBOC said it’s not certain that will happen.
What is certain is that PBOC’s ambiguity will be tested. Once the US Federal Reserve raises the curtain on interest rate hikes and tightening, China has to follow suit or risk greater capital-outflow pressure.
“If the Fed hikes interest rates, PBOC at some point has to stand closely enough to the US dollar,” said Christopher Balding, an associate professor at the HSBC School of Business at Peking University in Shenzhen. “In interest-rate terms, they cannot get too far apart.”
The one-year Shanghai Interbank Offered Rate has climbed to a two-year high and is now higher than the prime loan rate, or the interest banks charge to their best clients. Meanwhile, the central bank has kept its benchmark loan and deposit interest rates unchanged.
Steven Zhang, chief economist with Morgan Stanley Huaxin Securities, said China has no choice but to let interest rates rise as well, given the high stakes for Beijing.
“Without proper response to the Fed rate hikes, capital outflows would threaten China’s financial stability at a time when Beijing requires market stability to ensure a smooth power reshuffle around the [Communist] Party’s 19th congress this fall,” Zhang said.
But a rise in interest rates, together with enhanced regulation from China’s financial regulators, could translate into tension within China’s fragile financial system.
“If they do it too quickly, it would trigger a stampede out of the debt products ... so they seem to tap on the brake rather than slam on the brake,” said Balding.
Guan Tao, a former official with the country’s foreign exchange administration who is now a researcher with a Beijing-based private think tank, said domestic factors will determine China’s stance on monetary policy.
“We don’t see the need to completely tighten monetary policy,” Guan said. “The economy is still finding the bottom. Inflation is low. Authorities need to improve the effectiveness of monetary policy.”