China should always be prudent when implementing a low, or even negative, interest rate, if it is to bring money and credit growth to a reasonable level. It should avoid rushing to a decision by only taking into account the cooling of its consumer price index (CPI).

China should always be prudent when implementing a low, or even negative, interest rate, if it is to bring money and credit growth to a reasonable level. It should avoid rushing to a decision by only taking into account the cooling of its consumer price index (CPI).?[ycwb.com]

There has been a rising domestic demand for the central bank to lower its interest rate, since the growth of the country's CPI, a main inflation indicator, fell to 3.2 percent in February, which put an end to the era of negative deposit rate that began in February 2010. The inflation rate finally fell below the current benchmark rate of 3.5 percent for one-year fixed deposits.

This assertion has gained further ground as the growth of funds outstanding for foreign exchange is slowing down, the expectation of the RMB's appreciation turned weak, and some commercial banks are adjusting their mortgage interest rate for first-time home buyers.

However, the central bank should be cautious about changes in the CPI, as there actually is no easing of inflationary pressures at home. Though the CPI growth cooled from 4.5 percent in January to the lowest level in 20 months, there are still many factors which may increase economic uncertainties and complexity and lead to high inflation this year. Such factors include excessive monetary growth, rising labor costs, and a housing price that is still too high. Prices may also be pushed up due to the price surges in bulk commodities brought by the international capital flows and economic recovery. The political-business cycle arising from elections in major global powers in 2012 will also become another factor for price hike.

Most importantly, a great number of problems in China's economic development are closely related to the policies on excessive low interest rate or negative interest rate implemented in the past decade. Some of these problems are as follows: the national GDP growth relying more on investment than consumption, a bubbling real estate market, severe inequality in social wealth distribution, and a foreign exchange reserve that grows too fast. These issues may become even more severe if the government fails to properly adjust policies and speed up the marketization of the current banking regime with its rigid interest rates.

Negative real interest rate reigned in China for 58 months out of the 99 months between November 2003 and January 2012, accounting for 60 percent of the total. In February 2008, it reached a record high of 4.56 percent. It also lasted for two years in a row from February 2010 to this January, with a monthly level above 1.6 percent. The calculations based on Chinese residents' current deposits of 35 trillion yuan (US$5.6 trillion) show that 560 billion yuan (US$88.9 billion) evaporated under this policy each year. Such a high rate has exerted a series of serious negative effects on China's economic growth.

First, the high negative interest rate produces a crowding-out effect on consumption by slowing the increase of people's income. It's hard for China to expand domestic demands without changing this situation.

Second, the high negative interest rate has evolved into a mechanism which leads to the rich's plundering of wealth from the relatively poor. High negative interest rate, as an outcome of the government's stringent policies, led to the transfer of interest from the savers (creditors) to the bank (debtors) who may make use of this mechanism to help those in power or the otherwise privileged to grab and increase their wealth.

Third, the high negative interest rate resulted in acute speculations in the real estate market. Many savers, who found it hard to get satisfactory returns from the bank, chose to invest their money in other sectors, especially the real estate market. Many speculators aiming for profit tried their best to get more loans from the bank, which in turn led to the excessive credit expansion and an even higher demand for bank credit. In addition, difficulties to get financing by small and medium-sized enterprises, as well as rampant high-rate loans, are also linked to the high negative interest rate.

To level out these issues, the central bank needs to act cautiously to figure out where the country's interest rate should be by taking into consideration various factors beyond changes in the country's CPI. By having control over local banks' direct credit interest rate and determining credit risks for commercial banks, the central bank easily causes distortion or invalidity of the pricing mechanism in the domestic financial market. If this is to happen, it would amplify difficulties for China to realize sound economic development.

Therefore, there is an urgency for China to change its policies on low interest rate or negative real interest rate in the course of advancing its interest rate marketization, through methods such as gradually increasing the deposit rate, allowing the banks to determine credit risk pricing on their own, and streamlining the pricing mechanism in the domestic financial market. China must avoid falling into the vicious circle of continuing long-term negative real interest rate by blindly expanding its credit market.

The author is a researcher with the Institute of Finance and Banking under the Chinese Academy of Social Sciences.

(This post was published in Chinese and translated by Zhang Junmian.)

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