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Understanding China's Monetary Policies

China's economy is growing at an impressive rate, but the People's Bank of China must carefully tune its monetary policies to stop the economy from overheating, writes RUBY ZHU

As China travels down the road towards a market economy, the way it manages its monetary policy has a direct bearing on its economic growth, and that of Hong Kong.

According to figures compiled by the People's Bank of China, between January and October 2003, M2 supply in the Mainland increased at an average monthly rate of 20 percent, far higher than the 16.8 percent in 2002. In the second half of 2003, the number of loans approved grew by 23 percent, far higher than the same periods between 1998 and 2002 (15.5 percent, 8.33 percent, 6.01 percent, 13 percent and 16.9 percent respectively). Growing demand for loans has also pushed prices higher, with China's Consumer Price Index (CPI) rising for a consecutive 10 months in 2003, after falling for 14 months in a row previously.

For any monetary policy to work, central bankers must keep the rising supply of money within a limited deviation from the sum of GDP growth and inflation rates. For instance, after WWII, the German economy grew at an impressive 9 percent annually for several years, with its M2 supply basically being kept around 13 percent. During the same period, Japan's economy grew even faster at 15 percent annually, while the increase in M2 supply was around 20 percent. By comparison, China's M2 supply has been growing at 20 percent, while its GDP has been at 8 percent. Obviously, China's M2 supply has been growing too quickly, which can partly be attributed to the influx of hot money from speculators. 

To prevent the economy from overheating, the Central Bank raised the deposit reserve rate for local banks in the country by 1 percentage point (from 6 percent to 7 percent) in August 2003 to tighten banks' lending. Following the tightening of  lending to property projects, the above measure further shows that China is aiming for a stable and healthy monetary policy, as opposed to an active fiscal policy in the past.

Interest rates

The rise in China's CPI has also increased speculation that interest rates for renminbi loans will also go up. If low interest rates around the world start to rise, China should have enough room to also raise its rates as a result of inflationary pressure. On the other hand, if low interest rates remain unchanged, interest and exchange rates for the RMB are also expected to remain the same.

The higher deposit reserve rate has already led to a decline in the amount of funds available among banks and pushed up the inter-bank lending rate. Given this scenario, RMB interest rates are unlikely to change in the first half of 2004. Whether they will be adjusted in the second half of this year depends on inflation in China and interest rates abroad. With the chances of the RMB interest rates being low, Hong Kong enterprises are expected to take advantage of the current low interest rates for RMB deposits and loans, which stand at 1.98 percent and 5.31 percent respectively for a one-year term.

Exchange rates

China will most likely keep its RMB exchange rate stable for the foreseeable future, and any conflicts to this strategy will probably be trade-related. With China's external trade becoming increasingly balanced, revaluation of the yuan will not only aggravate unemployment in the country, but also cause a current account deficit, which will in turn discourage foreign investment. Nonetheless, the United States Federal Reserve's efforts to weaken the US dollar will inevitably intensify pressure to revalue the RMB. To limit any instability, there are signs that China is going to adjust its forex portfolio this year and peg the yuan to a basket of currencies, rather than just the US dollar.

State-owned banks

Much of the growth in loans in China last year can be attributed to Mainland banks granting more loans to small- and medium-sized enterprises. According to the People's Bank of China's credit registration consulting system, 51.7 percent of bank loans given in the first half of 2003 were to SMEs, up 0.7 percent compared with the same period of 2002. In the third quarter of 2003, however, the number of loans granted to private enterprises soared 82 percent -- a clear indication that financing bottlenecks that Mainland SMEs kept running into are finally been alleviated. The banks' efforts to widen their lending base will also help improve their non-performing loan (NPL) ratios.

The big four state-owned banks will list on the stock exchange one by one, and when they do China's Central Bank is expected to inject money into them to make sure their NPL ratios meet listing requirements. This will most likely be done by selling off non-performing assets worth 1.4 trillion yuan to the four largest state asset management companies through the issue of bonds and/or other tools. As a result, more foreign investment bankers are expected to be interested in the trading and handling of these assets.

Foreign-owned banks

The advantages that CEPA brings Hong Kong banks will be expanded once the Mainland China Banking Regulatory Commission broadens of the scope of business that foreign banks can engage in. From December 2003, foreign banks are allowed to set up operations in 13 cities (originally nine). More importantly, they are also allowed to provide RMB banking services for Mainland firms.

China's sound and stable monetary policy is aimed at preventing inflation and at keeping the economy from overheating. Any changes in interest rates, exchange rates and banking policies will have significant implications that Hong Kong companies with close ties to the Mainland cannot afford to ignore.

Ruby Zhu is the Chamber's China Economist. She can be reached at, ruby@chamber.org.hk