Minimum bank reserves are up (again)

michael pettis

Many analysts expect that if inflation numbers remain high the PBoC will be forced to raise interest rates again.  I think this will probably happen, but I also think there are many constraints on the PBoC’s ability to keep raising them, and these are going to get worse, not better. Apparently a number of state-owned enterprises (SOEs) have started complaining that with rates having jumped 117 basis points this year, financing costs are up roughly 20%, and these SOEs may be putting pressure on the NDRC to ease up on interest rate hikes (the PBoC cannot set interest rates independently but must get approval from the State Council). 

Although it is true that rising inflation undermines the real cost of the rate increase over the full life of the loans, increasing interest rates will nonetheless have the same cashflow effect as accelerating principle payments, and rising rates are straining cashflow for some of the less healthy SOEs. 

I also heard this weekend from traders that concerns are rising that increasing interest rates are putting a lot of pressure on mortgage borrowers.  I haven’t seen figures, and anyway the accounting is notoriously unreliable – it is widely believed that information provided on loan documents is “exaggerated” —but apparently one of the consequences of rising real estate prices may have been that in the past Chinese home-buyers have taken out mortgages whose servicing costs are as much as twice as high as a share of household income than is normally deemed prudent (roughly 25%).   This may not be as a bad thing as it sounds because Chinese do save at very high levels, but most, if not all, of the mortgages in China are adjustable-rate mortgages, and so increasing interest rates by 20% this year must have been painful, and may be squeezing a lot of homeowners.  This is not a new story, by the way, but perhaps the sub-prime crisis in the US has made people more sensitive to problems in the Chinese mortgage market. 

As an aside, two weeks ago one of my Peking University students told me that in another finance class a student had asked the professor if China has sub-prime mortgages, and the professor replied the in China all mortgages are sub-prime.  He got a big laugh.  He is exaggerating, of course, but it is not hard to hear some pretty hair-raising stories.

The PBoC has not said anything explicitly about their own constraints in raising interest rates, but from what people are saying in the market these issues are, at the very least, being discussed intensely.  As I mention in an entry on my own blog, short-term interest rates in the repo market and in the bills market China have reached unprecedented levels and one theory making the rounds is that the PBoC is allowing short-term rates to run up as a “backdoor” way of constraining liquidity.   That may be because they think the standard tools of monetary policy – interest hikes, sterilization, reserve hikes, administrative measures – have not seemed to have had much effect.  

It is interesting that in their half-year report, released a few weeks ago, SAFE (the State Administration of Foreign Exchange – the PBoC’s trading and reserve-management arm) admitted in the roundabout way beloved of central bankers that monetary policy isn’t working:

“The PBOC conducted a combination of open market operations and reserve requirement hikes in the first half of this year. The PBOC has raised reserve requirements six times by a total of 300 bps, increased the benchmark RMB lending and deposit rates three times and also raised the benchmark deposit rate for foreign currencies. These measures eased the surging money and credit supply. However, the excess liquidity situation hasn't been changed fundamentally." 

The RMB continues to appreciate at a much faster pace than usual – this week it was up by a record 0.6% (not counting the one-off July 2005 revaluation when the RMB was de-pegged), which means over the last two weeks it has gone up by nearly 1.2% (it is up about 12% since July, 2005). 

Most traders and academics that I talk to are still unsure of whether this represents a real change in policy or just posturing before the various European meetings later this month.  My guess is that the meetings may have increased pressure but in the end it is the weakness of the dollar and the increasing perception that monetary policy tools are not working that are driving the faster pace of appreciation, and that this will continue even after Sarkozy’s visit on November 25.    

The weak dollar has certainly made it easier (and maybe politically necessary, vis a vis Europe) for China to revalue.  I suppose the authorities will experiment with a faster revaluation and see if it does set off a massive inflow of speculative capital.  I believe that it will, in which case the authorities may backtrack and slow down the rate of appreciation, but I think the authorities will eventually be forced to move to Plan B – a one-off maxi-revaluation.   

More and more Chinese economists (although still a small minority) believe that this is where we are headed.  The idea was unthinkable six months ago but a recent poll showed that 5% of Chinese economists now favor a one-off maxi-revaluation and there are strong rumors that the idea was even proposed at the State Council level (and soundly rejected). Don’t forget that on Tuesday we are supposed to get October CPI inflation numbers.