Interest Rate Hikes — Really a Good Medicine?

Author: [Mu Zi]
Source: [Fund Analysis]
Article type: Regular article
Published: 2007-5-25 18:31:14
Column: Expert Perspectives

The interest rate hike has arrived as expected. The PBOC's few standard tricks need no prediction — anyone watching can see them. Almost everyone is now lost in debates about whether the PBOC's Cheng Yaojin-style three axe-blows are appropriate and effective. But regardless of whether the PBOC's three axe-blows are appropriate or effective, they cannot mask this fact: the current financial system structure must be fundamentally reformed.

Under the current domestic financial structure, how meaningful the interest rate tool — widely employed in the West — actually is here is very much worth questioning. And whether the massive issuance of bills and the raising of reserve requirements can have much effect on so-called excess liquidity is equally questionable. But one most direct effect is beyond doubt: these textbook-Western-style regulatory measures have already made and continue to make the PBOC's balance sheet increasingly ugly. Historically, many difficulties have been caused by blind regulation carried out by those who fancy themselves God. Of course, the PBOC won't be delisted, but even the PBOC obviously cannot keep swinging Cheng Yaojin's three axe-blows with no regard for results just because it can never be delisted. Policy resources are also limited. Swing the three axes too often, and at best they lose their effectiveness; at worst, they become self-inflicted wounds. This risk must not be ignored.

In theory, this textbook-style regulation is premised on linear continuity, but China's current financial structure contains structural singularities. These structural singularities exist because China's financial structure is composed of components with extremely large differences. It's as if you want to apply Euclidean geometry to solve a problem — you first need to confirm that the object of study satisfies the fifth postulate. Otherwise you're shooting at the wrong target. And for monetary tools to function properly, the most basic prerequisite is to establish a financial system structure that allows those monetary tools to work. Obviously, this is a far more fundamental, far more urgent matter than fiddling with interest rates, reserve requirements, and RMB fluctuation limits.

Even if that systemic prerequisite were already established, how long could the current Cheng Yaojin game of rate hikes and the like continue? The fundamental interest rate differential between the RMB and the USD means the space for rate hikes has boundaries. And once the USD's rate-hiking cycle ends, the pressure and risk therein — don't these demand vigilance? The current RMB problem, at root, is caused by America's need to transfer its accumulated economic risk to other economies through dollar depreciation. If we don't discuss the RMB problem from the perspective of currency warfare, we're forever scratching an itch through our boots. And the current overall structure of China's foreign exchange reserves dictates that, unless this problem is fundamentally resolved, it remains an enormous Achilles' heel. If directly reducing the massively overweight USD share in foreign reserves is already somewhat unrealistic, then using dilution to bring that ratio down quickly is the truly urgent priority.

As for pegging monetary policy adjustment targets directly to asset prices — that's probably the most pointless exercise on this planet. In truth, if you really want to bring the stock market down, the simplest and only effective method is to take the economy down. Every other method is, in essence, ineffective. Every factor in the market is merely one of the market's many variables. The market is the resultant of all forces, all operating on the same economic foundation. Unless you directly destroy that foundation — thereby causing all market forces to shift in the same dimension — everything will continue its natural course through divergence. A historical fact worth revisiting: after the much-invoked "Twelve Gold Medals" of 1996, the Shenzhen Component Index, five months later, rose from 2792 all the way to 6102, only naturally topping under the technical pressure of its 1/2 line — with no policy suppression whatsoever.

It can be asserted: unless the financial system structure undergoes a root-level overhaul — as the share-structure reform was for the stock market — the financial structural difficulties we now face are impossible to solve through measures like interest rate hikes, which amount to rubbing athlete's foot medicine on a headache. Interest rate hikes: what China's economy cannot bear so lightly. For an economic system with structural singularities, blindly prescribing Western textbook medicine without thorough financial structural reform will not only cause resistance to accumulate until the relevant policies completely lose effectiveness, but also carries the risk of ultimately triggering a policy-induced crisis. In plain terms: what was originally just a cold could end up being medicated into cancer. Such things are not fairy tales.

Western regulatory tools are like Western medicine — they certainly have their effectiveness, but they also have their drawbacks. If learned but not mastered, applied by the book without adaptation, the harm is even greater. An economic system is like a human body — it's worth looking at problems from a Chinese medicine perspective too. For economic regulators, three Chinese medical maxims are essential knowledge: "All medicine is one-third poison"; "The superior physician treats what is not yet sick"; and "Study must be broad to comprehend the variations, thought must be refined to illuminate the subtleties — learn from the ancients but don't be bound by them." Of course, that last maxim should more appropriately be changed to "learn from the West but don't be bound by the West."

(Special Senior Advisor to this publication, Mu Zi)