Taming Inflation: Interest Rates or Exchange Rates?
Last night I was on Chinese TV talking about — you guessed it — inflation. The focus this time was on what measures the Chinese government can use to tame rising prices. My fellow guest was Prof. Xiao Geng, director of the Columbia Global Center in Beijing. You can watch the show here.
One thing Prof. Xiao and I agreed on is that price controls imposed by the NDRC (China’s central planning bureau) are not the solution, and have the potential to make things worse. But we disagreed over what tool would prove most effective in getting at the root of the problem. Prof. Xiao argued that China should raise interest rates substantially; I argued that allowing currency appreciation was the key, in order to rein in the expansion of China’s money supply.
In many ways, these two strategies are just two sides of the same coin. Raising interest rates chokes of demand for money, by making borrowing more expensive. Allowing the RMB to appreciate, by reducing or even eliminating the need to support the currency peg by buying dollars in exchange for RMB, helps choke off the ready supply of money that’s been flooding the economy. Either way, the money supply should tighten, cooling inflation.
I respect Prof. Xiao’s argument, and agree that interest rates are part of the equation. But I would still maintain that reining in the supply of money, by allowing RMB appreciation, is the real prerequisite of any lasting solution, for the following reason.
In the U.S., we talk about the Fed “setting” interest rates — or at least the short-term Federal Funds rate that underlies all other interest rates. But actually, unlike in China, where bank deposit and minimum lending rate are directly fixed by the central bank, the Fed indirectly determines interest rates by manipulating the amount of money is available to banks as reserves, which they need in order to lend. By buying government securities, the Fed increases the amount of money in the economy and effectively lowers interest rates. By selling those same securities, it reduces the amount of cash outstanding and raising rates. By manipulating the quantity of money, the Fed determines its price.
In China, this situation is complicated by the central bank’s policy of maintaining a fixed exchange rate for the RMB to the dollar. China sells more than it buys abroad, running a trade surplus. It also brings in more capital for investment than it sends abroad. Normally, these two flows — the current and the capital account — are supposed to balance each other out, but China is a net importer of foreign currency on both sides of the equation. All those dollars (and euros, etc.) flowing into China would normally pile up, and the value of those excess dollars would decline (relative to the local currency) until they were attractive enough for people to use to buy goods or investments, canceling out one side or the other of the surplus. But in order to maintain the exchange rate — and the surpluses in trade and capital flows — China’s central bank steps in and buys all those excess dollars at a fixed rate, and accumulates them as official reserves. In exchange, it issues Renminbi, expanding the domestic money supply. For every dollar of the $3 trillion official reserves China holds, the PBOC has injected the equivalent amount of Renminbi into the Chinese economy.
Normally all that new RMB would fuel inflation — with more money chasing the same amount of goods, prices go up. In order to prevent that, the PBOC has to “sterilize” its foreign exchange (FX) purchases by taking that same amount of RMB back out of the economy, usually by forcing banks to hold higher reserves or by selling them special government bonds. In effect, the PBOC has to use its tightening tools — much like the Fed would do — just to counteract the loosening effect of its FX purchases, and keep the money supply from exploding. It has to run just to stay in place.
Assume the PBOC influences market interest rates the same way as the Fed — it doesn’t, but just assume it does. When it buys dollars with RMB, it expands the money supply, which would lower interest rates. To begin with, it has to sell bonds or raise reserve requirements just to cancel that effect, and keep interest rates from falling. If it actually wants to raise interest rates, it has to exceed that breakeven threshold by selling even more bonds or hiking reserve ratios even higher. Maintaining the currency peg raises the bar for what actually constitutes monetary tightening — anything below full sterilization falls short, and even though it may look like tightening, is actually net loosening.
Keep in mind that when the PBOC sells bonds or raises bank reserve requirements, it has to pay interest on those balances. Essentially, if the PBOC doesn’t want to print money to buy dollar reserves, it has to borrow it, and has to bear the cost of carry. In most countries, the more the central bank “borrows” in this way, the higher interest rate it has to pay to attract the funds, which at some point begins to exceed the return its getting from investing its dollar reserves (usually in U.S. Treasuries). The central bank starts losing money, which is why many countries ultimately are forced to abandon sterilization — much less a tightening policy on top of sterilization. Of course, China can evade this constraint by essentially forcing state-run banks to “lend” the PBOC funds at below-market or even zero interest rates. All that does, though, is shift the carrying losses from the central bank onto the banking system. Either way, you can see the stresses that just keeping market interest rates from falling, much less raising them, places on China’s banking system as long as the PBOC keeps accumulating dollars reserves to stop the RMB from rising.
Of course, interest rates in China aren’t based on the market supply and demand for money, they’re set by the central bank. So why can’t the PBOC just raise regulated rates, regardless how much money it’s pumping into the economy? If it raised rates high enough, presumably that would choke off demand for borrowing. If fresh new RMB deposits were flowing into the banking system as a result of the PBOC’s FX purchases, the decline in loan demand would leave Chinese banks holding lots of unused cash. The end result is basically the same as sterilization: banks stuck with a bunch of money they can’t loan out, and must either hold as bonds or reserves. Either the PBOC pays market rates on those holdings and bears a huge cost of carry, or it pays below-market rates and the banks take the hit. Either way, the continuous injection of new RMB from the PBOC buying up dollars places a big burden on the banking system that makes a tight monetary policy very difficult to sustain.
I agree with Prof. Xiao that China should be looking to raise interest rates. I agree with him that, if you consider what rates Chinese borrowers are willing to pay in the informal “shadow” lending market — upwards of 20% per annum — the rate hike would need to be rather steep to have any appreciable impact. But in my view, trying to tighten in this way, while maintaining the currency peg, is like sailing directly into the wind, or swimming against a powerful current. By allowing the RMB to appreciate — either by raising the peg and issuing fewer RMB per dollar, or by not stepping in to buy any more dollars at all, and letting the RMB find its own level — China would significantly lower the hurdle it faces — and the burden it bears — in running an effective tightening policy.
The PBOC apparently agrees. Just today, I read a report from China Securities Journal, courtesy of the analyst team at Bank of America-Merrill Lynch, which said that Mr. Guan Tao, a senior SAFE official, stated that “China must lower FX reserve growth to fight inflation.” “If FX reserve growth continues at the current speed,” he indicated, “it will significantly impede the inflation and property price control, and liquidity will flow to other areas even if property prices drop.” This is the rationale behind calls for the PBOC to “cap” its foreign reserves at $1.3 trillion — although the day when it could have stopped at that level came and went a while ago. The fact is, China doesn’t have to (and never had to) accumulate any more foreign reserves than it wants — all it has to do is decide to stop buying dollars and let the RMB find a market price based on the respective supply and demand for each currency.
I also agree with Prof. Xiao’s point that a slow, drawn-out appreciation of the RMB attracts inflows of “hot money” speculating on further appreciation, exacerbating the external surpluses that put pressure on the exchange rate in the first place. The problem, however, isn’t due to the RMB appreciating, it’s due to China falling behind the curve on appreciation by trying to keep the RMB down. The solution is to get out ahead of the curve, either with a dramatic, one-time revaluation (say, 20-30%) which would head of speculation, or by just letting the exchange rate float. The artificial suppression of the RMB is what brings in “hot money” betting that China’s currency dike will either spring a leak or collapse.
I’ve often stated before that RMB appreciation is not a “silver bullet” for solving China’s trade imbalances with the United States. That’s true, and I stand by the argument. But China’s intervention to prevent the RMB from finding its natural price relative to the dollar is a key factor fueling domestic inflation, and makes it extremely difficult for China to take effective steps to rein in runaway prices.