By Yi Xianrong (China Daily)
Updated: 2007-06-01 16:57

On May 18, the People's Bank of China, the central bank, announced it would raise the deposit reserve requirement, lift the interest rate and widen the floating band of renminbi against the US dollar.

Dubbed a "multiple punch", the simultaneous use of three policy tools by the authorities is targeted at enhancing the management of liquidity within the financial sector, maintaining sound growth in bank credit as well as investment, and keeping inflation under control.

However, the move had only minor influence on the capital market, especially the stock market. The indifference originated from two facts: the rate hikes were not significant enough to impose shocks and the market had been expecting the adjustment.

In this situation, the central bank should resort to interest rates, the most effective, convenient and frequently used policy tool in any market economy.

The interest rate lies at the core of a market economy. A market-orientated interest rate can help allocate resources effectively.

China has been working on marketization of interest rates since 2000 and great progress has been made. Yet the benchmark interest rate, the rate for one-year deposits, is still under State control.

As a market price for capital, the interest rate should be decided by multiple factors. At the very least, it should agree with the basic rule of the market.

The economic soundness of a country can be judged from the growth of its gross domestic product (GDP). If the economy prospers, the revenue from all productive factors increases: salary, business profit, interest rate and rent for land.

While the United States sees an annul GDP growth of about 3 percent, its federal funds rate, the US benchmark rate, stands at 5.25 percent.

China has enjoyed nearly 10 percent annual growth for more than two decades, but its benchmark interest rate is only 3 percent. The huge gap cannot be explained under any theoretical economic framework.

The low-interest rate policy is the very origin of many distorted economic activities, including the overheated investment in fixed assets, the white-hot real estate market and the stock market.

When the interest rate is kept at an unreasonably low level, people find it rewarding to invest with borrowed money since loans are cheap.

Consequently, the economy sees over-heated investments, not only in fixed assets but also in all available investment tools.

As more money flows into the investment market, the price of investment tools, including financial products and the property, rises. This in turn attracts more money.

Much of this money comes from bank loans. With the relatively big gap between interest rates on deposits and loans, banks are more than glad to lend money, the simplest way to make a profit.

Actually, the banks do have strong lending impulses. The roaring property market is a result of the real estate speculation on borrowed money since housing mortgages are viewed as a safe and convenient form of loan.

The low interest rate can have another effect: Capital, one of the factors in productivity, is substituted for other factors because of its low cost. After making a cost comparison, businesses would probably prefer more capital over labor.

Since 1994, business investment has been growing at six times the rate of employment, which indicates that Chinese businesses are relying more on capital than on labor.

If capital takes the position of labor in material production at a higher than normal speed, it would dampen China's comparative advantage as a country with rich labor resources. Employment will be hurt, which in turn hurts consumer spending.

As a result, the low interest policy actually encourages social wealth to flow into capital-intensive sectors, like real estate. When ordinary people have to spend a large portion of their income on real estate, they do not have enough money to spend on other items.

Despite the potential damage to the economy, the low interest rate is maintained under strict control.

The authorities are doing so out of various concerns. When the interest rate is raised, businesses may face higher costs, global speculators may be encouraged to enter China, and consumers will decrease their spending. All these possibilities increase the risk of a hard landing for the economy.

However, the interest rate, as the essential factor in the financial market, should be given more room to play its role in allocating financial resources. The authorities must make an all-out effort to overcome the obstacles and recover the due function of the interest rate as an important policy tool.

The difference between interest rates on deposits and loans should also be narrowed so that the banks will have less incentive to lend. Thus, the overheating of the Chinese economy as well as the capital market could be slowed.

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