China should beware of short-term monetary fixes
Editorial 2012-09-21 16:43
Renminbi banknotes at a bank in China. (Photo/Xinhua)
The US Federal Reserve has just launched the third round of quantitative easing policy after lengthy consideration amid the pressure of persistently high unemployment. At the same time, China's central bank last week bought 20 billion yuan (US$3.15 billion) in securities from selected banks with 28-day repurchase agreements even as the country faces a severe risk of economic downturn. The purpose was to cope with market capital demand for the upcoming "Golden Week" holiday period starting Oct. 1.
The People's Bank of China has no longer used short- and medium-term monetary policy tools to adjust market liquidity since the turn of the year, turning instead to extra-short repo measures. In the face of the threat from a weakening economy, Beijing has a greater need to use monetary policies to support the economy to smoothly coast through the difficulties.
But the central bank has not adopted more active monetary measures beyond these simple fixes. How could this help effectively defuse the crisis of an economic downturn? The central bank's repo operations in the open market certainly conforms to the principle of marketizing and liberalizing interest rates. But the tenure for the latest repos is too short. The policy can have only a brief effect on adjusting the capital amount and limited results with no price effect concerning anticipated changes in interest rates.
The 28-day reverse bond repurchase agreements with the banks carry a rate of 3.6%, lower than the Shanghai interbank offered rate (SHIBOR) of 3.94% and cannot be used as an indicator for the short-term rate.
For the consideration of capital cost, the People's Bank has already kept the one-year central bank bill rate under 2.5% in late 2011, lower by more than 1.1 percentage points compared with the interbank lending rate and dampening the interest of commercial banks. The central bank has had to use an executive order to allocate bill purchases by the banks.
It abandoned the issuance of central bank bills this year and adopted the tactic of extra-short repos not for a policy change but mainly because it is harder to force the banks by twisting their arm to purchase the low-rate bills.
Central banks of various nations issue short-term notes for the main purpose of readjusting excess reserves at banks in order to increase or reduce the lendable capital in the banking system. This is a key pillar in monetary policy. However, the timing and size of the central bank bills issued or retracted by the People's Bank in the past were only to stabilize or restrain the exchange rate of the renminbi against the US dollar rather than based on using monetary policies to support the economy.
The increasing complexity of economic development will enable Beijing to gradually realize that economic development cannot rely solely on economic policies and it has to be accompanied with proper and effective monetary policies.
Traditional economic policies have limited effects, especially during times of economic difficulties, while monetary policies can often attain unusual achievements. This is why central banks in different countries have now placed greater importance on monetary policy. When nations like the US, members of the European Union and Japan encounter economic downturn, their central banks often lower interest rates as a countermeasure. When the Fed initiated QE1, it aimed mainly to purchase long-term bank bonds to guide the long-term interest rate lower, induce enterprises to boost investments, increase hiring and lower the unemployment rate.
The newly launched QE3 meanwhile is to concentrate on buying mortgage-backed securities to achieve a lower mortgage rate and alleviate homebuyers' financial burden so as to stimulate house purchases and the dynamics of consumption.
In order to fend off the inflow of hot money during QE1, the People's Bank of China raised the required deposit reserve ratio at China's banks banks to 21.5% by the end of 2011. QE3 could lead hot money back to Asia again and make it more difficult for China's central bank to cut the reserve ratio.
It won't be that easy to stimulate the economy simply with statements like "having completed preparations with a fund of 1 trillion yuan to stabilize the economy" as made by Premier Wen Jiabao at the summer Davos world economic forum without opening up the lendable funds at banks.
For now, the People's Bank should restart issuing central bank bills in addition to the repo operations. Meanwhile, the central bank should defreeze the required deposit reserve ratio to let the banking system perform the function of enlivening market capital and at the same time mop up idle funds at the appropriate time with central bank bills.
China's economy will be caught in a complicated conundrum in the future as the authorities have to stave off economic decline but also at the same time fend off asset bubbles brought by inflows of hot money. The operation of extra short-term repos should be suspended because only long-term monetary policies can cope with such a complicated situation.
