Renminbi internationalization may work against the Chinese central bank’s effort to tighten liquidity and curb rising inflation. Commercial banks will also have bigger leverage over the central bank as more interests and forces work in their favor.
Lately, China has experienced tightened liquidity. On 22 October, the 7-day repo rate reached 5.05%, the highest since June. The rates have been kept low and steady since the last peak at above 10% in June. Unlike last time, observers and financial institutions did not panic, and with good reason. China’s growth is picking up speed again: GDP growth was 7.8% in the third quarter with PMI at above 50. Better performance of the real economy indicates reduced risks of default or disruptions of capital chains. And, to state the obvious, 5% is very different from 10% for repo rates.
However, the People’s Bank of China (PBOC), China’s central bank, is under similar pressure, if not stronger, compared to June. Failure to navigate China’s economy out of these treacherous waters may lead to higher inflation or banking crises.
Over the past two weeks, PBOC has refrained from open market operations, which directly led to a tightening of credit. As more than USD 1.4bn repo was due during this period, the inaction from PBOC was equal to closing the tap on pumping liquidity into the Chinese economy for two weeks. The rationale behind this was to control rising inflation. The consumer price index (CPI) reached a 7-month high of 3.1% in September, not far from the full-year CPI target of 3.5%. Moreover, China’s housing prices in September rose 9.1% compared with one year earlier, the sharpest rise since January 2011, according to Reuters. The pressure of reining in potential inflation fell inevitably on the central bank.
The dilemma PBOC is facing derives from the causes of inflation in China. Foreign capital inflows were the main cause of the recent trend of price surges. In September, the funds outstanding for foreign exchange, an indicator of foreign capital inflows, increased by USD 20bn. This might have been caused by trade surplus or foreign investments. Another driver for inflation has been excessive credit. Chinese banks lent out USD 129bn new loans in September, surpassing the previous forecast of USD 100bn. The Chinese government’s micro-stimulus in late August encouraged more loans to support manufacturing and export sectors to meet the 7.5% GDP growth target for the year.
To inhibit inflation, which is part of the central bank’s duties, PBOC will have to get past renminbi (RMB) internationalists and export interests. Liberalizing the capital account and maintaining a stable currency at the same time means sacrificing PBOC’s policy utility. RMB internationalists favor capital account liberalization, while export interests support a devalued Chinese currency. China has made concrete steps towards RMB internationalization lately, opening offshore financial centers in London, Hong Kong and Singapore. This attracted capital inflows. The influx of investment and trade surplus have been the major causes of inflation in China. It is doubtful whether PBOC could win over the top leadership from the control of these two dominant groups.
One potential ramification of the dilemma is a greater difficulty in curbing shadow banking in China. Failure to raise interest rates and fight inflation due to political reasons gives shadow banking opportunities to grow without the credible threat of credit tightening. In fact, the credit crunch in June was designed by PBOC to teach banks a lesson and rein in shadow banking (see “China’s Tug of War Between Central and Commercial Banks”). The effort will be in vain if PBOC no longer has the final say over interest rates.
The Chinese economy is safe for now and its general outlook is still positive. Yet, it is always important to heed the development of the dynamics between the central bank and other domestic interests. Policy choices over RMB revaluation, export-led growth and RMB internationalization all have long-term impacts on PBOC’s power over inflation or shadow banking.