In recent years, driven by a rapid expansion of the money supply or "liquidity" accompanying a sharp rise in foreign exchange reserves, China has shown signs liquidity exchange rate regime an emerging asset bubble, with real estate and share prices climbing rapidly.
The inflation rate has also continued to rise. The Chinese liquidity exchange rate regime has been taking steps to tighten monetary policy in order to halt the surge in liquidity, but constrained by the exchange rate policy that seeks to achieve currency stability liquidity exchange rate regime the U. China liquidity exchange rate regime generated a surplus in its current account - primarily in its trade balance - as well as in its capital account, which reflects the flow of funds.
These twin surpluses have exerted upward pressure on the renminbi RMB. The growth in base money has boosted broad money supply M2 by means of the credit multiplier. Consequently, China's M2 at the end of reached Liquidity exchange rate regime growing liquidity has pushed up consumer prices as well as asset prices, namely prices of real estate and shares.
The sharp spike in real estate prices started in Shanghai and other coastal urban areas around and has now spread to inland cities. Liquidity exchange rate regime upward trend in stock prices was triggered by the reform of non-tradable shares launched in The benchmark Shanghai Composite Index has multiplied almost six times over the past two and a half years.
Inflation is also accelerating, with the year-on-year rate of CPI increase reaching 6. To hold down the surge in liquidity resulting from its growing external surplus, the PBOC has introduced the following three major measures, which are liquidity exchange rate regime to tighten monetary policy or achieve sterilization in a broad sense.
However, the scale of intervention has become so large that sterilization operations have led to a rapid rise in interest rates, which in turn is attracting further capital inflow, liquidity exchange rate regime liquidity control increasingly difficult. The Liquidity exchange rate regime aims to control the credit multiplier and the money supply by raising the deposit reserve ratio that applies to banks. It has revised this ratio upwards 11 times sincefor an aggregate increase of 5.
This year alone, eight revisions have been made, hiking the ratio 4. These revisions adversely affect bank profitability as the interest rates the banks can earn from the reserves deposited with PBOC are much lower than the interest rates they charge their borrowers.
The objective of interest rate hikes is to discourage demand for investment, shares, real estate, and other non-deposit financial assets by increasing borrowing costs, thereby easing the upward pressure on consumer and asset prices.
Since October liquidity exchange rate regime, lending rates have already been increased eight times, with the benchmark one-year lending rate rising 1. Meanwhile, to bolster the appeal of deposits and stop the outflow of funds to the stock market, the PBOC has also raised interest rates on deposits by seven times since Octoberwith the benchmark one-year deposit rate rising a total of 1.
Even these aggressive hikes have failed to keep pace with runaway inflation. As a result, real interest rates have followed a downward trend since the beginning ofwith real deposit rates falling below zero.
Thus monetary tightening so far has been insufficient to prevent further rises in consumer and asset prices. The ineffectiveness of monetary policy in China is consistent with the principle of impossible trinity, that no country can simultaneously achieve three goals: China had, for a long time, pursued independent monetary policy while retaining a de facto dollar-pegged exchange rate and by restricting capital mobility giving up free movements of capital.
With capital movements gathering momentum following China's accession to the World Trade Organization WTOhowever, the effectiveness of its monetary policies is declining as noted above.
While China shifted to a managed floating exchange rate regime in Julythe focus of its foreign exchange policy is still on "management" rather than on "floating.
In fact, China's external surplus is the direct result of the PBOC's intervention in the foreign exchange market in a bid to ease the upward pressure on the foreign exchange rate. This pressure arises from circumstances under which the supply of a foreign currency, namely U. In the absence of intervention by the central bank, as under a freely-floating exchange rate regime, any imbalance between demand and supply in the foreign exchange market is corrected by fluctuations in the exchange rate.
A current account surplus, for example, would inevitably be offset by a deficit in the capital account, or a net capital outflow. As a result, liquidity growth is blocked at the source. Thus shifting to a freely-floating exchange rate system is the most effective solution for curbing liquidity growth. Indeed, it was the rapid growth in foreign exchange reserves and in the money supply starting that prompted Japan to adopt a floating exchange rate system in February Likewise, shifting to a freely-floating exchange rate system is now the only remaining option China can adopt today to curb its liquidity surge.
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