• Mainland China is currently facing an unprecedented monetary challenge. Massive trade and capital flows are having a dramatic impact on domestic monetary conditions. The task now is for the People's Bank of China to combine various monetary policy tools together with exchange rates and other policy mixes to control liquidity growth and restore external balances. This is particularly challenging with the surging stock markets generating additional risks and uncertainties.

Less than a month since it announced a 0.5% increase in the reserve required ratio (RRR) to 11%, on 18 May the People's Bank of China (PBOC) surprised the market by announcing three new measures. By further raising the RRR to 11.5%, increasing interest rates and widening the daily RMB trading band from 0.3% to 0.5%, the PBOC seems determined to cool the economy and the surging stock markets through a tightening monetary policy.

It is just over a year since the mainland China authorities embarked on this most recent series of monetary-based tightening measures. The tightening policy began by addressing the excessive growth occurring in the area of fixed asset investment. Although this growth is showing signs of moderation - slowing markedly from 29.8% year-on-year in the first half of 2006 to 23.7% year-on-year in the first quarter of 2007 - the challenge remains since liquidity has continued to build up rapidly in the system. Total deposits have nearly doubled in the past four years to reach a staggering RMB35.9 trillion. This unwelcome development has fuelled asset price inflation and is the primary driver of the current A-share stock market frenzy. There are growing concerns that prices will continue to inflate if left unchecked and that the negative economic knock-on effects when prices finally plunge will be severe, as significant percentages of household wealth will evaporate. This is currently the Mainland's biggest economic challenge.

The PBOC attempts to manage the money supply through monetary policy tools designed to achieve specific goals such as constraining inflation, maintaining a stable exchange rate to keep external accounts in balance and achieving full employment or economic growth. Measures implemented may include changing interest rates (directly or indirectly through open market operations), setting reserve requirements, acting as a last-resort lender (i.e. engaging in discount window lending) or trading in foreign exchange markets. Nearly all such measures have now been deployed to deal with the current economic situation.

Reserve Requirement Playing Catch Up With Actual Reserve

Adjustment of the RRR has been the most actively used tool to cope with the liquidity challenge in the past 12 months. Five of the 10 increases in the RRR since September 2003 have been implemented in the past year, bringing the ratio to 11.5%. By raising the reserve requirements, the PBOC limits the ability of commercial banks to grant new loans and grow deposits. Higher reserve requirements should result in reduced money creation and, in turn, in reduced liquidity available to the public.

Between March 2006 and March 2007, the Mainland's external surplus translated into a USD327 billion increase in foreign reserves (foreign assets up an equivalent of RMB2,750 billion), as the PBOC sold renminbi to the market in exchange for its purchase of foreign currencies. Because the PBOC routinely reabsorbs part of any additional increase in renminbi liquidity by selling short-term bills (the so-called 'sterilisation process'), only RMB1,444 billion of new reserve money was created (Exhibit 1). This part of money supply is also called "high-powered money" because a small change in it can result in a large change in the overall money supply through the deposit creation process.

The reserve ratio is equal to the reserve divided by total deposits. In the 12 months to March 2007, deposits expanded by RMB4,337 billion, or 14.6%. However, the reserve jumped by RMB1,037 billion, or 26.6%, increasing the reserve ratio from 10.5% in Q1 2006 to 12.9% in Q1 2007.

This explains why the RRR has been raised more aggressively in the past 12 months in order to catch up with the actual reserve ratio. Assuming the current rates of growth last for another year, the actual reserve ratio will hit 13.8% by March 2008. This means that the RRR will have to be raised again to maintain its effectiveness - i.e., so that the rise in reserve money resulting from the build-up in foreign exchange reserves will not lead to excessive liquidity.

However, by raising the RRR, the PBOC is merely buying time. If the external surplus continues to surge --- and it most certainly will --- the PBOC will find itself endlessly playing the catch-up game.

Interest Rates Are Not Rising Enough

Compared to increases in the RRR, interest rate rises have been far more moderate. There have been just two interest rate hikes this year and only four since November 2004. The deposit rate increase implemented on 18 May --- 27 basis points for one-year time deposits - was greater than the 18-basis- point rise in the one-year lending rate. Rates were pushed even higher on longer term deposits in response to more households withdrawing their savings and investing in stocks. The benchmark one-year deposit rate now stands at 3.06%, just ahead of CPI inflation which is currently 3%. However, when the 20% tax on interest income is taken into account the rate in real terms remains in negative territory (Exhibit 2).

Increasing the lending rate will have a more pervasive and stronger impact not only on the stock market but also on economic activity more generally. However, it appears that the PBOC is still not ready to push the lending rate to a more restrictive level, reflecting the current lack of consensus among policymakers as to whether the real economy is genuinely overheating. Since the release of first-quarter GDP figures for this year the government has only expressed the view that the economy is "reaccelerating", a term that falls well shy of the concept of overheating. Although inflation readings have been on the rise, the PBOC has yet to single out this risk in its overall economic assessment, especially when applying monetary policy measures.

Nevertheless, the cost of capital (the one-year benchmark lending rate is currently 6.57%) remains too low compared to the inflation rate (3%) and the nominal rate of GDP growth (15.9%). Given that interest rates are far too low in real terms, considerable room exists to raise them much further. Deposit rates should also be significantly increased. Higher lending rates would help curb the loan growth that plays such an important role in liquidity expansion within the banking system.

Restoring External Balances Is The Key

As long as the external surplus continues to surge, establishing and maintaining adequate control over liquidity growth will remain difficult. There are two major ways in which the Mainland can tackle the challenge of rapidly accumulating foreign reserves: reduce the accumulation of these reserves; and/or create more capital outflows through regulatory changes.

The broadening of the daily trading band from 0.3% to 0.5% on either side of central parity technically sets the stage for a faster rate of currency appreciation, which could theoretically help reduce the speed of foreign reserves accumulation. Indeed, the Mainland's currency has appreciated at an annualised rate of 9.7% during May 2007, compared with an annualised rate of 4.2% in the previous nine months (Exhibit 3). However, it remains to be seen whether this acceleration will continue and if it will produce the desired results. Beginning with and including the one-off appreciation that occurred on 21 July 2005, the value of the renminbi has so far strengthened by 7.4%. But the Mainland's trade surplus has continued to hit record highs.

The development and implementation of the Qualified Domestic Institutional Investors (QDII) scheme - which allows local investors to buy overseas stocks - represents a major step in creating more channels for the outflow of capital. However, even if all existing QDII quotas are fully utilised, the USD7.25 billion in total projected outflow is nowhere near large enough to have a significant effect - at least not in the short term.

Further, the private sector remains lukewarm about investing abroad. The domestic stock markets remain highly attractive and overseas investment returns must make up for losses incurred due to the steady appreciation of the renminbi. The newly established State Foreign Exchange Investment Company will also create more channels for capital outflows, although the exact arrangement of this company remains uncertain at this stage.

Restoring external balances involves many structural changes which require time to take full effect. In the short term, therefore, the authorities will continue to rely on measures that can control liquidity growth.

Conclusion

The current monetary challenge is unprecedented in the Mainland's economic history. The massive trade and capital flows that have arisen since the Mainland's accession to the World Trade Organization several years ago are having a dramatic impact on domestic monetary conditions - particularly in the context of ongoing liberalisation in the financial sector. The task now is for the PBOC to combine various monetary policy tools together with exchange rates and other policy mixes on capital controls to restore external balances and help keep the economy on a growth path. This is no small order, particularly when the surging stock markets continue to add further risks and uncertainties. However, the government should not be distracted by this - monetary policy should focus on influencing the macro-economy.

MAJOR ECONOMIC INDICATORS