China s Interest Rate Challenge

The Real Interest Rate Risk

Surplus Chinese savings made possible America s credit expansion between 2003 2005, when the federal funds rate (the overnight rate at which US banks lend to one another) was held at 1 .

If credit expands too rapidly, the Fed can raise the interest rate that it pays on deposits. Sufficiently high rates will induce commercial banks to prefer the Fed s combination of liquidity, safety, and yield to expanding the quantity of private lending.

America s Interest Rate Puzzle

Lower interest rates are not a solution to this dilemma.

If the interest rate is raised too little, banks will use more reserves to support lending, leading to higher inflation. If the interest rate is raised too much, economic activity will be constrained and growth could fizzle.

And it is the real interest rate not the money rate that counts for economic growth.

At present, the interest rate is less than 0.5 .

Because the inflation rate is also about 2 , this implies a negative real interest rate, which is confirmed by the interest rate of 0.6 on ten year Treasury Inflation Protected Securities (TIPS), which adjust interest and principal payments for inflation.

The Fed could, in principle, limit inflationary lending by raising the interest rate on excess reserves or by using open market operations to increase the short term federal funds interest rate.

Recently, the PBC raised the one year lending rate and the one year deposit to 6.56 and 3.5 , respectively.

However, this is no longer applied since the central bank started changing rates by 0.25 percentage points on October 19, 2010 (which was a rate increase).

But when prices are falling, the real interest rate exceeds the nominal rate.

In Japan, the ten year rate has drifted to below 0.8 .

And, due to rising consumer prices, the nominal interest rate will continue to rise.

In May 2006, the fairly free domestic interbank rate was just 1.62 , while the US Federal Funds rate was 5 .

According to the followers of Knut Wicksell, the central bank must keep the market rate of interest near the natural rate of interest.

But the interest rate that Greece must pay buyers of its government bonds has shot up to a record high level of nearly 9 5.9 percentage points above the benchmark rate paid by Germany.

The second adverse effect of deflation is to raise the real interest rate, that is, the difference between the nominal interest rate and the rate of inflation.

Since the interest rate set by the ECB is now less than 1 , there is little difference between its current monetary policy and what the Bank of Spain would do if it could set its own interest rate. But when the euro zone starts to recover, the ECB might choose to raise the interest rate before a higher rate would be appropriate for Spain, which could exacerbate Spanish unemployment.

As a result, the interest rate for 12 month fixed deposits has reached 3.9 .

All the above assumes that the interest rate remains constant throughout the whole period.

Until recently, an exchange rate peg dominated China s monetary policy, with interest rates unchanged for nine years until October 2004, as the government attempted to manage lending through administrative guidance and credit controls.

But such an insignificant rate hike will do little to relieve long term pressures, because investors will expect more rate hikes and move money into China, increasing upward pressure on the yuan s exchange rate.

Domestic deflation means that the real interest rate on Japanese bonds is higher than the nominal rate.

Foreign investors then sent their money to New York to take advantage of the higher rates.

The first, the Secular Stagnation Hypothesis, has been proposed by Larry Summers. Its key premise is that the equilibrium interest rate at which demand would balance supply is currently below the actual interest rate.

With its benchmark lending rate at the zero bound, the Fed has embraced a fundamentally different approach in attempting to guide the US economy.

A direct effect of the higher interest rate would be to increase the budget deficit and the rate of growth of government debt.

Past experience implies that the real rate will rise to at least 2 , taking the total nominal interest rate to more than 4 , even if expected inflation remains at just 2 .

And that is important, because a rise in the federal funds rate will cause other, somewhat longer interest rates to increase as well.

Monetary policy is now drawing on a more comprehensive toolkit, such as the policy rate, the interest rate corridor, required reserve ratios, and the reserve option mechanism.

At 6.5 , the one year lending rate is now 0.3 above August s headline inflation rate.

Although it is difficult to anticipate how high long term interest rates will eventually rise, the large budget deficit and the rising level of the national debt suggest that the real rate will be higher than 2 . A higher rate of expected inflation would also cause the total nominal rate to be greater than 5 .

Under these conditions, the Fed will want to raise the interest rate to prevent an acceleration of inflation.

Deflation increases the real (inflation adjusted) debt burden, as well as the real interest rate.

That way, limited interest rate spreads could do the work of its missing exchange rate mechanism.

When interest rates go up, these payments will (when the rate is variable) also go up, possibly becoming unsustainable.

These countries existing foreign debt, by contrast, carried an average interest rate of 1.6 with an average maturity of 28.7 years.

A higher rate of expected inflation would also cause the total nominal rate to be greater than 5 .

The picture is especially grim for the UK, with the official interest rate at 0.5 and inflation at 3.3 .

After the advent of the euro, the eurozone s Mediterranean members enjoyed a lending boom while piggybacking on Germany s low interest rates.

Thus, the market can establish the necessary interest differential only if interest rates on yuan assets fall below their dollar equivalents.

So, if the PBOC sets the interest rate on one year deposits at 3 , commercial banks can offer depositors a rate as high as 3.3 .