The recent increase in the benchmark rate by the People's Bank of China (PBOC) is a clear signal Beijing is worried about overheating. The dismal performance of China's stock exchanges is also a strong indicator of the failure of market socialism and the need for ownership reform. Without real owners of capital assets and competitive interest rates, the future of China's economic miracle is highly questionable.
The upsurge in inflation from zero to more than 5 percent in the last several months could further weaken the financial system. The PBOC has been using credit controls and moral suasion to slow the growth of bank credit, which expanded by more than 20 percent last year. As that growth slows, the non-performing loan problem could worsen.
The lack of free capital markets and competitive interest rates force China to resort to administrative measures, but those very measures are making the financial system less, not more, stable. If banks keep lending rates fixed at less than the rate of inflation, the demand for loans will continue to soar. If the PBOC accommodates that demand for money, inflation will accelerate.
The root of the problem is that politics, not markets, determine the magnitude and direction of investment in China's market socialist system. Nominal interest rates are set at below-market levels causing an excess demand for investment funds. Those funds are then directed primarily to state-owned enterprises through state-run banks. Corruption and inefficiency are inevitable in such a system.
The fact that inflation is now running at more than 5 percent means there is too much money chasing too few goods. Moral suasion is not enough to combat inflation, nor is credit rationing the answer; the PBOC must slow the growth of base money (ie, currency in circulation plus bank reserves) in a clear and credible manner.
Monetary control is complicated because when dollars flow into China the PBOC must buy those dollars with new base money to maintain the nominal peg at roughly 8.28 yuan per dollar, and then offset or "sterilize" those inflows by withdrawing the excess base money to prevent inflation. The larger the capital inflows, the more difficult it becomes to fully sterilize them. Moreover, if the PBOC increases interest rates, that action will stimulate further capital inflows and put upward pressure on the exchange rate.
The difficulty of offsetting capital inflows was evident in the second quarter when the central bank failed to sterilize most of the new base money created in the process of acquiring foreign exchange. The PBOC allowed a net increase of 211.6 billion yuan in the second quarter and base growth for the first half of the year was 19.2 percent. That growth must be returned to normal to achieve long-run price stability. Stop-go monetary policy can have destabilizing effects on financial markets.
The PBOC cannot afford to use administrative measures as a smoke screen to hide the real cause of inflation -- namely, excessive growth of base money brought about by failure to conduct an independent monetary policy designed to ensure long-run price stability. Credit allocation is a poor way to organize capital markets. If China wants to become a world-class financial center, market-led investment must replace state-led investment, and China must recognize the limits of monetary policy.