On June 7, the People’s Bank of China decided to raise the yuan reserve deposit ratio for financial institutions by 1 percentage point to 17.5 percent and thus freeze 422.2 billion yuan (US$61 billion) in funds in an attempt to reduce liquidity in the financial system and to curb inflation.
This upward adjustment of the deposit reserve ratio is the fifth this year and the 18 since 2006.
It has once again set a new high for the reserve deposit ratio.
Despite such frequent and drastic adjustments of the reserve deposit ratio, results from the Chinese government’s attempts to suppress the liquidity in the financial system seem extremely limited. For instance, in September 2003, China’s surplus reserve deposit ratio was 1.8 percent, which was lowered slightly to 1.3 percent by April this year.
This demonstrates that the central bank’s adjustments of the reserve deposit ratio had almost no limiting effects on the use of funds by financial institutions, as Chinese financial institutions still have surplus reserve deposits in the People’s Bank.
At the same time, China is facing pressure from the highest rates of inflation since 1996. Between January and April, commodity prices rose 8.2 percent.
Although the hike was mainly driven by a 22 percent rise in food prices, the potential for overall inflation is constantly growing. During the same period, the producer price index (PPI) rose 7.2 percent. This inflationary pressure will eventually affect the prices of general consumer products. This is the key motivation behind the Chinese government’s desire to suppress liquidity in the financial sector.
As a result, from January 2006 to last March, the central bank collected 2.12 trillion yuan through open-market operations and increased the required reserve deposit ratio to ensure a further 2.9 trillion yuan for a combined sum of 5.02 trillion yuan.
That means a total of 1.47 trillion yuan in outstanding funds for foreign exchange that the government was unable to write down, which accounts for 36.8 percent of the base currency issued by China.
The central bank is, in other words, unable to effectively write down huge outstanding funds for foreign exchange, which had caused an extreme surplus of capital.
Of course, the central bank can rely on its traditional interest rate policy to regulate the situation. The Chinese government is, however, concerned that raising interest rates will negatively impact the country’s economic growth rate and job market stability, which could lead to a less stable society.
Compared with past hikes in interest rates, it is clear that the Chinese government is loath to increase rates to control the currency problem. In 1993 alone the central bank increased one-year deposit account interest rates for financial institutions 3.42 percentage points. Between 1996 and 1998, the rate was lowered 7.2 percentage points. By contrast, since October 2004, the rate has risen only 2.16 percentage points.
The rapid increase in the country’s foreign reserves has resulted in a surplus of currency, which has steadily inflated the capital held by China’s financial institutions.
The rapid increase in China’s foreign reserves is, however, also linked to a lack of balance in exchange rates and the expectations that the yuan will appreciate.
Analysts predicted the yuan would appreciate 3.8 percent against the greenback in 2006. Last year the currency was expected to appreciate 5.7 percent against the US dollar and in the first quarter of this year it was projected to jump 9.1 percent.
The expectations of a stronger yuan have led to copious amounts of money flowing illegally into China. That money has largely gone into speculation. In 2006, US$6.9 billion in illegal money is estimated to have entered China. Last year this figure increased to US$125.1 billion.
For the first three months of the year, illegal funds smuggled from overseas jumped again to the astonishing figure of US$85.1 billion. Chinese authorities have made it clear that this money has already made it into the country’s stock and real estate markets.
Beijing is worried that this money will increase the risk of economic imbalance and create a bubble in the economy.
The excess of liquidity in China is inextricably linked to the unbalanced exchange rates and expectations that the yuan must appreciate sharply. Beijing knows this and is trying to avoid any reform of the yuan’s exchange rate system. But it is absolutely worthless for the central bank to repeatedly increase the reserve deposit ratio, which will not solve the problem. Combined with the serious matter of illegal funds flowing into China, the country is increasingly at risk of inflation.
Tung Chen-yuan is an associate professor at the Graduate Institute of Development Studies at National Chengchi University. Wang Guo-chen is a doctoral student at the institute.
TRANSLATED BY ANGELA HONG AND DREW CAMERON
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