Download China Moves to Tighten the Money Supply

Chapter 14: Money, Interest Rates and Exchange Rates
China Moves to Tighten the Money Supply
By DAVID BARBOZA – January 6, 2007
China’s central bank said late Friday that it had raised the reserve requirement ratio
for banks, the fourth increase in six months, to further tighten the nation’s money
supply.
The modest move, which takes effect this month, increases the reserve ratio by half a
percentage point, to 9.5 percent. Analysts said it was the government’s latest warning
that too much money in the financial system could ignite inflation and perhaps fuel a
stock market bubble.
’’This is a warning shot,’’ said Dong Tao, the chief economist for non-Japan Asia at
Credit Suisse. ’’If the stock market continues to go up, we might see further
tightening.’’
Raising the amount of cash reserves that Chinese banks keep on hand with the central
bank effectively restricts the amount of money that banks can lend. While not being
very restrictive, the central bank aims to curb excessive lending to new factories, real
estate projects and road construction.
The move also comes as China’s stock market is booming after several years in the
doldrums. Last year, the country’s key index -- the Shanghai exchange -- rose 130
percent to close at 2,675, a record and the best performance of any major stock
exchange in the world in 2006.
The market reached a 16-year high in December, as millions of investors who had
been sitting on the sidelines in 2004 and 2005 jumped back into stocks.
Analysts say the government is determined to keep the economy expanding but is
concerned about growing so quickly that the economy might crash before 2008, when
Beijing is host to the Olympic Games, viewed as the ultimate coming-out party for
China.
Overinvestment in real estate and construction has been among the chief worries for
the government. And for much of the last two years there have been frequent
warnings and government measures to tame a wild property run.
The Central Bank said that last October, for the first time in five years, the bank
savings of Chinese citizens decreased from the month before, presumably as more
money went into the stock market. Credit Suisse estimated that more than $30 billion
in bank deposits have flowed into mutual funds or direct plays into the stock market
over the last six weeks.
Many analysts say now that the bull run will continue in 2007, prompting even more
money to flow into the market. One Chinese mutual fund raised $5 billion in a single
day recently before closing its doors to new investors, an astonishing achievement
here, according to some economists.
Industrial and Commercial Bank of China, which was publicly listed only last
October, here in Shanghai and in Hong Kong, has already gained over 70 percent.
This week, prices shot up again, before falling sharply Friday.
The run-up means companies in China can once again raise money in the Chinese
market rather than relying on the Hong Kong stock market. But huge risks remain in a
market that many analysts have long derided as a gambling den crowded with
companies with suspect accounting.
Several economists say that more increases are expected in the coming months, to
tame the economy and the stock market.
Hong Liang, a Hong Kong-based economist at Goldman Sachs, said that the
government had used the reserve ratio as a policy tool to help manage the economy
but that it had not been very effective in cooling things down. She did not ’’expect it
to have much impact on the real economy or the financial markets.’’
Large amounts of money flow into the country through foreign investments and
surplus dollars from trade. China also has a high savings rate. So many people are
looking to put that money to work -- in real estate, the stock market and even by
investing in art and antiques.
’’A lot of hot money has entered the market, legally and otherwise,’’ said Chang
Chun, a professor of finance at the China Europe International Business School in
Shanghai, speaking of the stock market.’’In the past few years people were
overpessimistic. Right now, they are overoptimistic and they’re bringing a lot of
money into the market.’’
1. The article states China's central bank has restricted the amount of money supply by requiring
that private sector banks hold more reserves (cash) on hand instead of investing them in loans or
other assets. If private sector banks are required to hold more cash in their vaults or in liquid
accounts, what should happen to their interest rates on loans and deposits? Is your answer
consistent with the model of the money market in chapter 14?
Answer: If private sector banks are required to hold more cash in their vaults and in liquid
accounts, then they will likely raise interest rates on the scarce money that they lend and raise
interest rates on deposits in order to attract more cash from their customers. After the change in
policy by the central bank, private sector banks would face a shortage of cash and to help
eliminate that shortage they could raise interest rates. This answer is consistent with the model
of the money market in chapter 14 because when the central bank reduces the money supply,
interest rates rise to prevent a shortage of cash. (The model normal shows a reduction in the
supply of money by the central bank, we could also increase the demand of liquid assets by private
sector banks, which would also cause a shortage of cash at current interest rates and cause interest
rates to rise thereafter.)
2. Given the central bank's actions, what should happen to the value of the Chinese currency, the
renminbi, if the Chinese central bank allows the value to fluctuate?
Answer: With higher interest rates on deposits and other assets, foreign investors should be
attracted to renminbi-denominated assets, so that the demand and value of the renminbi should
rise. The renminbi/dollar exchange rate should therefore fall.
3. Given the central bank's actions, what should happen to foreign investment in China?
Explain how the change in foreign investment compares with the change in domestic investment
expenditure. (The change in domestic investment expenditure is described in the article.)
Answer: With higher interest rates on renminbi-denominated assets, foreign investment should
increase. In contrast, domestic investment expenditure financed by borrowed funds or funds that
were previously saved should decrease because of the higher interest rates. Foreign investment
is saving by foreigners, so that higher interest rates increase its value. Domestic investment
expenditure is expenditure, so that higher interest rates decrease its value.