China is to raise the banks' required reserve ratio for the third time this year, indicating that interest rates may be about to go up. Or should the yuan exchange rate be allowed to rise first?

The economic situation in China is characterized by excess liquidity and the so-called "tidal bore" phenomenon first identified by Vice-Governor of the World Bank, Lin Yifu.

Lin used the term to describe the process of industrial upgrading in developing countries. Investment is directed into industries with mature technology and markets, integrated into global supply chains. There is a tendency for excessive investment to be directed towards particular industries. When this results in overcapacity, investors move on to another "hot" industry, and so on.

The tidal bore flowed into the Chinese IT industry in the 1990s. Now speculative funds are mainly flowing into real estate and the stock market, but also new sectors such as new energy, new materials, new medicines, logistics, tourism, and consumer goods.

The tidal bore phenomenon leads to irrational exuberance among Chinese investors. But excessive investment doesn't bring in good returns.

According to the Development Research Center of the State Council, the sources of liquidity are about to experience a significant structural change. The proportion of domestic funds, made up mainly of new loans, will decline, in favor of foreign exchange earned through a combination of yuan appreciation and the recovery of foreign trade.

The problems of excess liquidity and the tidal bore phenomenon will not be solved by adjusting the required reserve ratio.

China is still in the throes of industrialization and urbanization, and its high savings rate, high investment, and high growth mean excess liquidity will continue to be a problem. Just adjusting interest rates will not solve the problem. Currency policy has to go hand in hand with fiscal policy.

Raising interest rates may deter investment in new projects but will not stop money pouring into existing projects because cancellation costs outweigh the cost of higher interest rates.

Furthermore, raising interest rates will lead to an inflow of hot money which in turn will increase pressure to raise the exchange rate.

Therefore, it makes more sense to let the yuan float before raising interest rates.

(This blog was first published in Chinese and translated by Chen Chen.)