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In October 2004, China's central bank, the People's Bank of China, raised interest rates for the first time since July 1995. This was against the backdrop of rising consumer and producer prices, and fear of a hard landing for the overheated economy. The benchmark lending rate was lifted from 5.31 per cent to 5.58 per cent. Overall, the gap between lending and deposit rates has been widened as a result. This announcement, together with more flexible rates introduced earlier in the year, are taken as signs that China is - gradually - embracing the market in its monetary policy.
The hike in interest rates by the central bank is significant on two fronts. In the short-term, it will have contractionary effects on the economy-higher borrowing rates are intended to put a brake on the overheated economy, albeit as most commentators would say, a tad too late since the effects of any interest rate adjustment take at least half a year to materialize. Inflation as measured by consumer prices (CPI) has been rising for a year or more, and hence real deposit and lending rates (after adjustment for inflation) have been virtually close to zero. Essentially, this means borrowing is virtually free, and saving brings little returns-creating no incentive for the people to save, and conversely plenty of inducement for them to borrow. A rate increase is therefore aimed to reverse this phenomenon.
A widening gap between lending and deposit rates, and greater flexibility for the financial institutions to adjust rates, mean more leeway for them to price their capital according to their costs. This will no doubt improve profit margins for the financial institutions, which have traditionally been a channel for reallocating capital to the state-owned sector.
In the long run, the introduction of market-oriented measures in monetary policy is a harbinger of financial sector liberalization. Traditionally, the central bank controls money supply by formulating credit plans: the plans determine the credit ceiling for each bank and each of its branches (from the capital Bejing all the way down to the provincial and sub-provincial levels) and the loans they extend within a particular year. Interest rates have been fixed and depressed to keep the cost of capital low so that the central government can reallocate financial resources to state-owned enterprises, as part of the communist government's strategy to promote heavy industry sector. Following China's growing integration with the world economy, Beijing has found it more and more difficult to maintain a 'planned economy', suggesting that interest rates-a market signal-may be increasingly used to allocate capital.
WATCHPOINT: Increasing the market orientation in monetary policy puts further pressure on the foreign exchange regime (the Chinese yuan is still pegged at 8.28 to the US dollar). For how long will Beijing be able to fend off speculation against a revaluation of the yuan?
About our company:
AFG Venture Group is an Asia and Australia based corporate advisory and consulting firm with over 20 years experience in creating alliances, relationships and transactions in Australia, South East Asia and India; including a 15 year history of corporate and equities advisory in Australia, undertaking merger, acquisition, divestment, fund raising and consulting for private and public companies.
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