China In Focus: Bifurcated Impact Of Rising Rates On Chinese Economy

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In the United States, increases in interest rates result in increases in national savings rates as rates move broadly with changes in inflation. In contrast, in China interest rates are controlled by government intervention and do not reflect changes in inflation. According to Michael Pettis, Professor of Finance, Guanghua School of Management, Peking University, author and writer on China Financial Markets blog, increases in interest rates decrease Chinese national savings rates. China has chosen to control its currency regime and maintain an undervalued currency.

The People’s Bank of China seeks to control current account trade-related flows and currency values by injecting money into the economy through surpluses in current accounts and investments. However, money inflows and outflows to the country increasingly occur outside of the central bank’s control, and these outflows are increasingly speculative. Credit expanded both inside and outside the banking system resulting in bubble-like conditions for real estate values and looser credit standards. Stock market and producer prices soared.

Global commodity prices also increased in value. Production capacity increased and manufacturing of goods surged. These conditions show that central bank’s efforts, such as selling central bank bills, transacting in the repo market and aggressively increasing bank reserve requirements did not totally neutralize effects of an undervalued currency and its associated money supply expansion.

China’s slower growth in domestic demand

On the other hand, Chinese domestic demand shrank as wages did not increase for consumers. In turn, disposable income growth remained subdued and consequently consumption grew at a slower pace relative to Chinese GDP. Domestic demand as a share of GDP has plummeted in China, particularly on the decade ending in 2010-11. Higher interest rates also encouraged savings among consumers given that investment options are more limited relative to an open economy like the United States. Consumer inflation has also remained at moderate levels despite monetary expansion in other sectors of the economy.

Savers versus borrowers

In a system where financial controls exist, like China, expansive monetary policy impacts sectors of the economy differently. Net borrowers are corporations, governments, real estate investors, and producers of goods and infrastructure. Net savers are households. Furthermore, the majority of savings in the Chinese economy are bank deposits and the bulk of lending comes from bank lending or other forms of bank financing.

When interest rates are lowered arbitrarily by the government, net savers experience a drop in their purchasing power as the real value of their deposit declines. This drop, along with savings in interest expense (lower income to consumers), is passed on to net borrowers. Hence, net borrowers benefit more from expansionary monetary policy than net savers on a real basis.

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