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PART 4: China steady on the peg
By Henry C K Liu

PART I - Follies of fiddling with the yuan
PART 2 - Tequila trap beckons China
PART 3 - Futures imperfect for China

Chinese Prime Minister Wen Jiabao has criticized the US for not taking measures to halt the dollar's slide and made it clear that China would not revalue the yuan under pressure. "You must consider the impact on China's economy and society and also the impact on the region and the world," Wen said in Laos late Sunday on the sidelines of the Association of Southeast Asian Nations (ASEAN) meet when asked about pressures to change the yuan's decade-old peg to the dollar. Wen also signaled that speculation was too rife in the market at the moment to make such a change.

The announcement was timely as China stands at the crossroads of economic destiny, the direction of which will determine if it will be the latest victim of bankrupt neo-liberal ideology or the sole survivor that manages to develop an effective immunity from the deadly financial virus of dollar hegemony that regularly assaults all economies. On a strategic level, China, the most populous nation on Earth, cannot possibly expect to develop toward world-class living standards by exporting to a rich minority of the world's population. The poor economies' excessive dependence on export to the rich economies under dollar hegemony will perpetuate the maldistribution of wealth on a global scale and put China permanently on the lower end of that scale.

For a small, rich segment of the world's population to be the engine of growth for the entire global economy by consuming the products made by a poor majority is a formula of global financial imperialism. Financial imperialism is an advanced stage of old-time industrial imperialism. Nineteenth-century industrial imperialism of the British model at least produced industrialized products at the core out of raw material from undeveloped colonies. Twenty-first-century finance imperialism of the neo-liberal model uses financial manipulation to make industrialized colonies produce everything in exchange for fiat money in the form of dollars.

Imperialism, now and then
In contrast to industrial imperialism under which the imperialist economy exports value-added manufactured products for gold, with which to finance more new modern factories at home, the financial imperialist economy imports value-added products from the colonies and pays for them with fiat paper. The colonial economies now export real wealth in the form of value-added products and get paper in return. To make matters worse, under dollar hegemony, the fiat paper currency, in the form of dollars, can only be re-invested in the dollar economy, not non-dollar exporting economies. Exporting for dollars is merely shipping wealth out of the exporting economy to the dollar economy. The dollar economy has become the luxurious front office of the global economy.

Both forms of imperialism sustain favorable trade terms with the colonies through political coercion. A sustained trade deficit supported by currency hegemony is the essence of finance imperialism. Unlike producers in the industrialized core during industrial imperialism, producers in the colonies under finance imperialism do not get richer from producing. They are locked into a low-wage sweatshop production system so that global inflation can be contained to keep an ever-expanding supply of fiat dollars valuable. Credit is allotted through a central bank regime not to the entrepreneurs who can keep wages rising, but to those who can succeed in pushing wages down with government blessings. The more dollars the Federal Reserve releases, the lower world wages must fall to prevent global inflation. The more the dollar economy expands, the smaller the wage-to-price ratio in dollar terms. Those economies that defy this iron law of low wages under dollar hegemony are punished with financial crises that drain their dollar reserves.

Dollar hegemony renders domestic Keynesian demand management inoperative. It is no longer economically necessary to manage demand by raising wages even at the financial core, since consumption can be maintained by lowering prices of products produced at low-wage peripheries, paid for by the wealth effect of dollar assets buoyed by a rising tide of fiat dollars that the Fed can release without limits and with no penalty or reckoning. Thus under dollar hegemony, money takes on an additional function as a confiscatory tax on wages, apart from the conventional functions of store of value and medium of exchange. This confiscatory role of money on wages works across all national borders, spreading and perpetuating poverty on the working class all over the entire globe. Neo-liberal economists call it wage arbitrage natural to finance market fundamentalism. They put forward the argument that workers are not unjustly exploited by imperialists or capitalists. The dismal fate of workers under dollar hegemony, in a neo-Ricardian iron law of wages, is the logical outcome of a Hayackian amoral market scientism. The law of the financial jungle has become the ideal of the capitalist civilization.

Thus socialist China can move toward a "socialist market economy" without any sense of guilt of betraying its socialist revolution, all in the name of neo-liberal modernization. In the US, displaced workers blame low-wage workers overseas, rather than dollar hegemony, for the predictable fate for workers everywhere. Domestic class conflict is transformed into nationalistic feuds between workers in conflicting national economies. Dollar hegemony prevents non-dollar economies from developing their economies with sovereign credit denominated in local currencies to finance full employment and rising wages. Dollar hegemony, operating through unregulated foreign exchange markets, neutralizes the purchase power disparity between economies and makes it profitable to outsource high-paying jobs from the US.

China's move toward market economy along neo-liberal lines was originally intended to be a brief and temporary program to kick-start its economy off the stagnation caused by decades of hostile US containment and embargo, made worse by domestic ultra-radical excesses typical of a garrison state. But the temporary corrective expediency turned into a permanent revisionist policy that inevitably led to political instability. The pressure exploded in the Tiananmen incident in 1989, a decade after the launching of China's "temporary" economic reform. Misled by biased Western media with an agenda separate from the target, adverse international reaction on Tiananmen reverberated around the world, causing intense hostility toward socialist China, particularly from the Western anti-communist left, whose members denounced the Chinese government as being repressive of democracy, ignoring the fact that the real culprit was a policy drift toward market capitalism away from socialist planning. The historical fact was that Tiananmen began as a student mass movement to arrest the erosion of socialism in China.

Domestically, the real tragedy of Tiananmen was not the alleged abortion of latent bourgeois democracy, as the Western media tried to spin it. It was the ossification of a brief transitory strategy of market liberalization in order to build better socialism into a lasting policy of permanently postponing socialist construction. This policy is rationalized with all kind of revisionist ideological mumbo-jumbo, such as China must first go through a long capitalist stage before it can move onto a socialist stage, and let some people get rich first. The word "first" was then conveniently drop and the slogan became: let some people get rich, period. Yet there is solid evidence that China has successfully leapfrogged into the space age without repeating the costly experimentation of another century of the sub-orbital aviation. It is then a puzzle why socialism has to be postponed and wait for its gradual evolution from a restoration of capitalism.

There is no logic in insisting on repeating the mistakes of the capitalist West by copying a bankrupt market system bent on recurring self-destruction. Yet Margaret Thatcher's fanatic TINA (there is no alternative) mantra is accepted as the gospel of truth. Income disparity and wealth maldistribution natural to market economies are celebrated as necessary dynamos of prosperity. Economics, unlike truth-respecting physics from which it pilfered many theoretical concepts, tends to hang on to obsolete ideas long proved dysfunctional by events with ever more sophisticated rationalization. While Issac Newton is now a relic in the history of physics, Adam Smith is alive and well in the temples of economic thought more than two centuries after his time. China, after half a century of socialist revolutionary struggle, also swallowed the neo-liberal propaganda that only market capitalism can bring prosperity.

The Tiananmen tragedy
The tragedy of Tiananmen in 1989 is that it sounded the death knell of socialist revolution and heralded the restoration of capitalism in China. Tiananmen began as a backlash grassroots political reaction to wholesale official rejection of socialist principles and ideology. The students at the beginning of the Tiananmen incident protested against the ill effects of the introduction of market fundamentalism in the Chinese economy. They wanted to preserve full government financial support for education, particularly generous socialist benefits for students, and protested against high unemployment, income inequality and widespread corruption associated with the move toward market economy.

Such demands at first received sympathetic hearings from the top leadership. Alas, wholesome student sentiments were quickly manipulated to turn intransigent by the US media at the scene to cover the state visit of president Mikhail Gorbachev of the USSR in its final stage of implosion, taking on the form of counter-revolutionary demands for political liberalization toward bourgeois democracy. While the students were actually demanding more government protection from the erosion of socialist rights and privileges gained for them by their heroic parents, the Western media distorted the student protests as demands for free markets and bourgeois democracy. Naive protesters were selectively featured by the US media on global television to recite Abraham Lincoln's Gettysburg Address in broken English, never mind that the speakers obviously had no understanding of US history and politics, let alone the statist and interventionist context of Lincoln's inspiring words.

The leadership in the Communist Party of China (CPC) at that historical moment was divided. While some remained sympathetic to a student movement to preserve socialism, others found it imperative to decisively crush a manipulated political revolt against a socialist government. In a fateful turn of tactics in the aftermath of the resultant tragic violence, the CPC leadership decided to preserve political control through further market liberalization, thus forfeiting its equalitarian socialist mandate in favor of authoritative institutional economics based on administrative intervention on free markets. A decade and a half after Tiananmen, the CPC is now forced to officially acknowledge the problem of the continued ability of the CPC to govern effectively. The phrase zhi zheng neng li ("governance capability") surfaced in mid-September 2004, when the CPC Central Committee was reported by The People's Daily as "discussing the cultivation of the ruling party's governing competence". The authoritative paper noted that it was the first time during the 55 years of history after the new China was founded that "the country's ruling elite considered how to improve the party's governance ability at an annual plenum of the central committee".

It is a conceptual oxymoron for a communist party to govern a market economy. Yet despite all the ideological, strategic and tactic errors of the past three decades, the CPC is far from being an irrelevant political institution as it remains the only political organization with the determination and ability to preserve the territorial integrity and independent sovereignty of China. The history of the Chinese economy shows that most periods of prosperity in four millennia had operated under the socialist principle of a commonwealth of Great Harmony (Da-tong) as opposed to the capitalist principle of petty bourgeoisie (Xiao-kang). The realities of Chinese society will soon turn the CPC back on its historic socialist track and wake up its leadership from the fantasy that only market capitalism can effectively mobilize the masses for national construction. Market fundamentalism will only lead China to fall again into its past dismal fate under the Kuomintang, whose socialist path had been diverted with the assassination on August 20, 1925, of leftist leader Liao Zhong-kai after the death of Sun Yat-sen, resulting in a bankrupt economy that provided the socio-economic backdrop for continuing semi-colonial exploitation by Western powers and the rise of the CPC as a liberating force for national revival.

But dollar hegemony injures not only the working class. Even the comprador class of finance imperialism is also periodically stripped of their ill-gained wealth by recurring financial crises caused by dollar hegemony. Still the multi-trillion dollar losses from the recurring financial crises and bubble bursts of past decades circling the globe did not all come from the rich. Some of it came from the hard work for low pay of the working poor, funneled to the rich through structural systemic economic injustice disguised as market forces. But most of it came from institutional depositories of worker pensions. Young workers are being forced to pay for the systemic losses of financial crises through the loss of jobs and reduction of benefits their parents once enjoyed. Retired workers are also forced to pay for the systemic losses through drastic shrinkage in the value of their retirement nest eggs. The enviable workers' benefits won through century-long struggles of labor organization in the industrialized core have been swept away by neo-liberalism in the name of competitiveness, while workers in the emerging economies are deprived of the minimum social progress their counterparts in the advanced economies already won a century ago.

Under neo-liberalism, even if and when the Chinese economy should finally catch up with the US economy, which under dollar hegemony is in theory equivalent to trying to catch up with one's own shadow in a setting sun, what Chinese workers have waiting for them at the end of the market fundamentalism rainbow is not a pot of gold, but the same dismal fate facing the US workers today, ie, to have their jobs outsourced to another still-lower-wage economy. China's industrial heartland will look like the rust belt in the US, where high-pay factory jobs have disappeared to low-wage economies and once-booming factories sold for scrap metal.

Race to the bottom
The result will be a global economy of more severe overcapacity, with wages too low and jobs too scarce to provide the purchasing power to buy the products workers produce. There was a time when a government printed money recklessly and hyperinflation would follow. Now, under dollar hegemony, when the US Federal Reserve prints dollars, inflation is kept under control by outsourcing high-wage jobs to low-wage economies while wealth becomes increasingly concentrated. Neo-liberal economists fail to understand that money is useless unless broadly distributed and spent. Neo-liberal monetary policies tend to inject liquidity only on the supply side as investment, an obviously wrong target in an overcapacity economy. Overcapacity is a direct outcome of excess return on capital from regressively low wage schemes. Liquidity should be injected to support demand management, by providing full employment with rising wages until overcapacity is eliminated. Unregulated credit markets inevitably become failed markets by directing credit where it is least constructive.

In China, the 1995 Central Bank Law granted the People's Bank of China (PBoC) central bank status, changing it from its historical role of a national bank in a planned economy. Central banking insulates monetary policy from national economic policy by prioritizing the preservation of the value of money over the monetary needs of a sound national economy. The ideological assumption asserts that a sound currency is the sine qua non of a sound economy. It is an assumption that is neither logically true nor empirically supported. A global international finance architecture based on an unregulated currency market with full convertibility at market rates in the context of universal central banking allows an increasingly volatile foreign exchange market to facilitate the instant cross-border ebb and flow of capital and debt. This instant cross-border flow of funds can be devastatingly destructive with little advance warning. Central banking thus relies on domestic fiscal austerity and monetary contraction imposed through high interest rates to achieve its institutional mandate of maintaining the exchange value of the local currency and to prevent destabilizing fund outflow.

In contrast, a national bank does not seek independence from the government policy. National banking views itself as in a supportive role of national economic policy. Independence of central banks is a euphemism for a shift from institutional loyalty to economic nationalism toward institutional loyalty to the smooth functioning of a globalized international financial architecture. The international finance architecture at this moment in history is dominated by dollar hegemony, which can be simply defined as a fiat dollar's unjustified status as a global reserve currency. National banking then seeks insulation and independence from the international finance architecture dominated by dollar hegemony.

The mandate of a national bank is to finance the sustainable development of the national economy, and its function aims to adjust the value of a nation's currency to a level best suited for achieving that purpose within a regime of exchange control. On the other hand, the mandate of a modern-day central bank is to safeguard the value of a nation's currency in a globalized financial market of no or minimal exchange control, by adjusting the national economy to sustain that narrow objective, through domestic fiscal austerity, economic recession and negative growth if necessary. International trade under central banking dominated by dollar hegemony becomes a race toward the bottom with beggar thy neighbor competition, rather than true comparative advantage.

In response to dollar hegemony, PBoC has adopted a monetary policy stance in 2004 designed to rein in excessive money and credit growth, avoid excessive interest rates volatility and accelerate interest rate liberalization. Such a policy stance deals with the symptoms but not the causes of economic trends deemed undesirable by policymakers. Moreover, these policy objectives are cross-neutralizing on one another.

The PBoC expects to keep M1 (currency in circulation plus the checkable deposits in depository institutions) and M2 (M2 includes M1 plus retail non-transaction time deposits) growth rate at around 17% for 2004, still a destabilizingly high rate when GDP (gross domestic product) growth is targeted to be less than 7%. The outstanding yuan broad money, or M2, including money in circulation and all bank deposits, surged 19.1% year-on-year to 23.36 trillion yuan ($2.8 trillion) by the end of April 2004, albeit the increase was slightly less than that of March. This M2 level is extraordinarily high in relation to Chinese GDP of $1.4 trillion, amounting to 200%. The US M2 was $6.289 trillion in June 2004 against a GDP of $10.7 trillion, about 60%. And the US money supply is considered excessive. Much of China's large M2 is caused by recent massive foreign exchange transmission of hot money. At the end of July, M2 was up by 20.7% from the same period last year, higher than the central bank's planned growth of 17%.

Over the past two years, China's foreign-exchange reserves have grown rapidly, not from trade surpluses, but from the inflow of hot money. This has led to a substantial increase in yuan "base money" injection as a result of increased foreign exchange transmission. In line with its overall money and credit plan, the PBoC has attempted to prevent excessive growth of base money by withdrawing of yuan through open market operation. This has the effect of siphoning money from the domestic sectors to the export-related sectors where dollar hot money is concentrated.

Since April 22, the PBoC has intensified currency withdrawal from circulation through issuing central bank bills. In 2003, base money injection as a result of foreign exchange transmission added up to 1.15 trillion yuan, while open market operation withdrew 269.4 billion yuan base money, resulting in a net base money injection of 876.5 billion yuan. By the end of 2003, the PBoC had made 63 issues of central bank bills, amounting to 722.68 billion yuan, leaving an outstanding additional currency amount of 337.68 billion yuan. The money withdrawal came from the domestic sectors and the injection went mostly to export and export-related sectors, including speculative real estate markets. The bulk of the yuan withdrawal went to foreign reserves holdings. This monetary exercise was essentially borrowing from the yuan economy to finance the rise in China's foreign reserves, which lent mostly to the dollar economy in the form of US Treasuries.

The PBoC also aims to keep new bank lending for 2004 around 2.6 trillion yuan. Banks lent 835.1 billion yuan in new loans in the first quarter, representing 32% of the annual target and an increase of 24.7 billion yuan from a year ago. New loans by commercial banks between January and July soared to 1.9 trillion yuan, more than the 1.8 trillion yuan that they lent in all of 2002. But as banks are bypassed in the US by debt securitization in credit markets, Chinese banks are being bypassed by the age-old tradition of private loan syndication, which historically have been the financing of choice among overseas Chinese, when banks around the world routinely discriminated against immigrant Chinese borrowers and forced them to develop their own ethnic credit market.

Macro measures have little effect on this growing informal Chinese domestic credit market, where interest rates can be higher than sub-prime credit-card rates in the US. The real problem is the absence of an effective national credit allocation policy. Central bank interest-rate liberalization works against a national credit allocation policy and allows the market to do the allocation. In unregulated credit markets, credit flows to borrowers willing to pay the highest interest cost, which usually means the highest-risk speculative ventures, rather than to where the national economy needs credit most.

The PBoC claims that the ultimate objective of this monetary policy stance is to maintain balanced economic growth at a 7% rate target for 2004, holding consumer price index (CPI) around 3%. With "macroeconomic adjustment and regulatory measures", the hangover effect is expected to contribute 2.2% to CPI, with new inflation factors and price adjustment policies contributing 1%. The main monetary policy instruments are open market operation, bank reserve requirement, interest-rate policy, re-lending and re-discount, and credit policy.

The PBoC measures growth by GDP readings, as is common by international standards. Gross domestic product is a measure of national income. Dollar hegemony distorts GDP as a reliable index of growth for non-dollar economies since GDP includes foreign-reserves holdings when in effect such funds have left the local currency economy. Taking away annual rises in foreign-reserves holdings, real Chinese GDP is substantially lower than the $1.4 trillion figure. Take away also foreign-factor income in the form of returns on foreign capital, and real Chinese GDP may be half of what the misleading statistics show, since 54% of China's exports are traded by foreign investors. If one should ask to where has all the money gone given China's annual GDP growth of 9%, the answer is that most of it went to the dollar economy.

Moreover, this policy stance is in essence a neo-liberal supply-side approach. It is couched in typical policy jargon prevalent among central bankers, trapped by the flawed logic of the Washington Consensus and International Monetary Fund (IMF) snake-oil orthodoxy. The Chinese economy at this stage of its development does not need a tight monetary policy to fight overheating in some sectors any more than Chinese agriculture needs a drought to prevent soil-erosion from spring flood. What China needs is a new focused credit policy to shift from dependence on dollar-financed and -denominated export, and to institute full deployment of yuan sovereign credit insulated from dollar hegemony to finance the rapid development of its undeveloped domestic economy.

It needs to dampen the overheated export sectors with administrative means and stop letting an unregulated international financial market direct national economic policy. China needs to stop exporting real wealth by reducing export of goods produced by low wages for useless fiat dollars and refocus on real growth of its domestic economy. China needs to free its currency from dollar hegemony and to stop letting the international credit market dictate national development. Wealth denominated in dollars has very limited use in China. It only forces the PBoC to inject yuan money supply into China's export sector so that China can finance US national debt with its dollar trade surplus.

Financial comprador mentality is apparently dominating the policy establishment in the PBoC, which mistakes the size of its foreign reserves for national financial strength and confuses the health of the banking system under its regulatory supervision with the economic health of the nation. China's banks are basket cases only because China chooses to shift from a national banking regime to a central banking regime. Now the central bank wants to sacrifice the national economy to cure sick private commercial banks under its supervision, whose sickness ironically has been caused by a central banking regime.

Forex folly
Under dollar hegemony, an economy that holds or needs to hold large foreign-exchange reserves in the form of dollars is a financially weak economy. The need for foreign reserves is clear evidence that the rest of the world has no confidence in that country's currency and by extension, its domestic economy. The US, a global financial powerhouse, holds very little foreign currency. Japan and Germany, as defeated nations of World War II, have no option other than to be trapped in an international finance architecture dominated by dollar hegemony. It is a sign of serious poverty of insight, creativity and independent thought at the top that China's monetary establishment chooses voluntarily to play the same handicapped game as these two once-vanquished nations.

At the same time, the PBoC has provided liquidity to support the privatization of financial institutions through flexible market operation. This liquidity is not used to finance national economic expansion, but to finance initial public offerings (IPOs) of privatized banks. Banks in a national banking regime are social institutions, but in a central banking regime, banks are private institutions. Privatization of social institutions is a dubious neo-liberal undertaking that requires close government supervision and regulation to justify. Central-bank-provided liquidity for the purpose of facilitating the privatization of state-owned banks takes on the form of legalized theft from the public. It provides public subsidy in the form of interest-free loans to the favored buyers of the privatized banks.

At the end of August 2003, the IPO of Huaxia Bank led to substantial liquidity shortage in commercial banks. Under such a circumstance, the PBoC, on August 26 and September 2, 2003, twice reduced the issuance scale of three-month central bank bills and injected liquidity to commercial banks through seven-day reverse repo transactions. At the time of the Changjiang Power IPO on November 11, 2003, the PBC again conducted seven-day reserve repo transactions. Under the guidance of open market operation, the seven-day repo rate and typical inter-bank interest rates remained stable at around 2.15% despite liquidity volatility resulting from IPOs, which indicated that open market operation reached expected targets. Free money was handed over by the central bank to favored private borrowers to buy privatized state-owned assets.

Given sufficient liquidity of financial institutions and falling trend of money market rates during the first quarter of 2004, the PBoC intensified sterilization operation, using open market operations to counteract the effects of exchange market intervention on the country's monetary base. In this period, the cumulative amount of central bill issuance reached 435.2 billion yuan and outstanding amount stood at 615.45 billion yuan. Base money injection as a result of foreign exchange purchase amounted to 291.6 billion yuan, and open market operation withdrew 281 billion yuan, resulting in a net base money injection of 10.6 billion yuan and basically offsetting the foreign exchange position of base money.

With fixed exchange rates, when excess foreign currency seeks to exchange into the home currency, as in the case of China in the past two years, the monetary authority must supply additional home currencies to keep the exchange rate fixed, even with controlled convertibility. The monetary authority buys up the excess foreign currency with local currency and increases its foreign exchange reserves. This operation increases the supply of home currency in private circulation. When a central bank intervenes to keep a fixed exchange rate, it needs to sterilize its foreign exchange intervention by taking separate actions to prevent the home money supply from rising or falling due to foreign exchange intervention. In the case of sterilization, the authorities will simultaneously buy or sell foreign currency and sell or buy interest-bearing domestic debt or assets to remove the excess or add depleted home currency, offsetting any effect on the home money supply.

However, if the money supply stays unchanged, then according to the laws of open interest-rate parity, the monetary authority can keep the exchange rate fixed only by lowering domestic interest rates. Any excess supply of foreign currency that existed before will remain. It disappears only from the domestic money supply, and now reappears in the form of foreign-exchange reserves. The home interest rate will have to fall to offset pressure on the exchange rate to rise. Otherwise, inflow of hot money will continue.

Thus the recent rise of the one-year benchmark interest rate by 27 basis points to 5.58%, effective from October 29, 2004 - the first such hike in nine years - with the rise of one-year deposit rate to 2.25% from 1.98%, is a counterproductive move in the context of managing hot-money inflow. The central bank also moved a step toward the goal of interest-rate liberalization, scrapping the upper limits on yuan lending rates. Banks can now charge as much as they want for yuan loans. The last time the PBoC raised lending rates was in July 1995, and the rates were last changed in February 2002, when they were lowered to boost a sluggish economy.

These measures will only attract more inflow of hot dollars that had been caused by the gap between dollar interest rates and yuan interest rates to begin with. According to the principle of open interest-rate parity, if a monetary authority sterilizes, its ability to keep the exchange rate fixed depends on the market's aversion to exchange risk - an aversion ironically exacerbated by a fixed exchange rate not supported by a corresponding interest rate policy. Thus it is irrational for the PBoC to raise interest rates to cool the economy while the overheating was created by an inflow in hot foreign money due to high yuan interest rates. Those who advise the PBoC to raise yuan interest rates lack adequate understanding of the relationship between interest rates and foreign-exchange rates and the impact of hot foreign money on domestic money supply in a fixed exchange-rate regime.

A central bank wanting to hold the exchange rate of its currency fixed against upward market pressure supplies domestic currency to the market, creating pressure for the nominal interest rate of the home currency to fall. This causes bonds prices to rise. A fall in the nominal interest rate spurs aggregate demand, which causes GDP and the price level of the economy to rise. This expansion of the economy - in particular, the rise in consumption and investment - may have been a completely unintended side effect of the central bank's actions.

A foreign-exchange intervention is said to be unsterilized if its effects are allowed to pass through to domestic inflation and domestic GDP, and is said to be sterilized if its effects are not allowed to pass through. A central bank sterilizes its foreign-exchange interventions with open-market operation following foreign-exchange intervention. The central bank's desire to fix the domestic currency below market pressure leads to an expansion of domestic money supply, causing nominal interest rates to fall, which then spurs aggregate demand. If the central bank does not want to affect aggregate demand, then an open-market operation to maintain the nominal interest rate at its pre-intervention level is normally required. But there are alternative regulatory options, such as lifting bank reserve requirements, if the central bank does not want to change interest rates, albeit such alternatives are not without economic cost. The PBoC had elected to employ such alternatives until it succumbed to raising yuan interest rates in October.

In order to rein in the obviously excessive credit growth, the PBoC had raised the required reserve ratio by 1% to 7% on September 21, 2003. The central bank raised the reserve requirement for commercial banks by half a percentage point to 7.5% effective April 25, 2004, and has called for banks, enterprises and local governments to help curb investments and cool down the economy. The new requirement applies to the country's big four state-owned banks, 11 joint-stock banks and more than 100 urban and rural commercial banks. However, thousands of rural and urban credit cooperatives will maintain the existing 6% reserve requirement.

Bank reserves are a percentage of total deposits that commercial banks must maintain for risk management. Only deposits over the minimum set by the central bank may be used for lending. The higher reserve will freeze approximately an additional 110 billion yuan (US$13.3 billion) in commercial banks' liquidity. The 0.5-percentage-point reserve hike is largely to prevent runaway growth of money and credit and keep the national economy expanding on a steady, fast and healthy track. Excessive credit growth could cause inflation, asset price bubbles, new non-performing loans at commercial banks and systemic financial risks. Financial institutions' reserves at the central bank now exceed 2 trillion yuan. The China Banking Regulatory Commission (CBRC) has ordered banks to stop lending to steel, aluminum, cement, real estate and automobile industries.

Calling on the reserve
Conventional money and banking theories regard required reserve ratio hiked as a relatively drastic measure compared with changes in interest rates. Nevertheless, the PBoC interpreted it as a mild and preferred move. The reason is that the PBoC has to withdraw a large amount of excess liquidity because of fast growth of foreign-exchange reserves. To do so, if the central bank only issues CB bills without any other measure, it has to raise the interest rates on CB bills to a very high level given strong expansion momentum in the export sector and the commercial banks' wide interest-rate differentials over the returns on CB bills. However, a high interest rate would have significant adverse implications on the whole economy. Moreover, it would exacerbate the inflow of hot foreign money. In contrast, the 1.5% rise of required reserve ratio enabled the central bank to reduce at a lower economic cost the commercial banks' excess reserve by about 260 billion yuan, accounting for only 9% of their holdings of Treasury bills, financial bonds and CB bills.

Therefore, the new required reserve ratio hike was considered a comparatively mild policy measure. The operative word is "comparatively", for the measure was far from mild. Still, the policy was announced one month in advance, giving time for financial institutions to manage their liquidity. The PBoC also provided timely support to those financial institutions with short-term liquidity difficulties so as to maintain the overall stable development of financial operation and money market interest rates. Still, with each additional percentage point of reserve requirement tying down 260 billion yuan in excess reserves, a 7.5% reserve ratio translates into a reduction of more than 1 trillion yuan of bank loans, which may help achieve the new lending target for 2004 to around 2.6 trillion yuan, but it would not provide much help to the economy, particularly the depressed sectors. Since the overheating is concentrated mostly in export and export-related sectors of the economy, there is no compelling logic to reduce aggregate demand for the whole economy with a nationwide bank reserve ratio.

But a larger question about the monetary effectiveness of bank reserve requirements needs to be addressed. Reserve requirements, a tool of monetary policy, are computed as percentages of deposits that banks must hold as vault cash or on deposit at a central bank. Reserve requirements represent a cost to the banking system. Bank reserves are used in the day-to-day implementation of monetary policy by the central bank.

As of June, the reserve requirement for US banks was 10% on transaction deposits (checking and other accounts from which transfers can be made to third parties), and there were zero reserves required for time deposits. The US Monetary Control Act (MCA) of 1980 authorizes the Fed's Board of Governors to impose a reserve requirement of from 8% to 14% on transaction deposits and of up to 9% on non-personal time deposits (those not held by an individual or sole proprietorship). The Fed may also impose a reserve requirement of any size on the amount depository institutions in the US owe, on a net basis, to their foreign affiliates or to other foreign banks. Under the MCA, the Fed may not impose reserve requirements against personal time deposits except in extraordinary circumstances, after consultation with Congress, and by the affirmative vote of at least five of the seven members of the Board of Governors.

In order to lighten the reserve requirements on small banks, the MCA provided that the requirement in 1980 would be only 3% for the first $25 million of a bank's transaction accounts, and that the figure would be adjusted annually by a factor equal to 80% of the percentage change in total transaction accounts in the US. An adjustment late in 2003 put the amount at $45.4 million. Similarly, the Garn-St Germain Act of 1982 provided for a 0% reserve requirement for the first $2 million of a bank's deposits. This level, too, rises each year as deposits grow, but it is not adjusted for declines in deposits. For 2004, that level is $6.6 million. The transactions-account reserve requirement is applied to deposits over a two-week period: a bank's average reserves over the period ending every other Wednesday must equal the required percentage of its average deposits in the two-week period ending the Monday sixteen days earlier. Banks receive credit in one two-week period for small amounts of excess reserves they hold in the previous period. Similarly, a small deficiency in one period may be made up with excess reserves in the following period. Banks that fail to meet their reserve requirements can be subject to financial penalties.

Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money. In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500. Thus, higher reserve requirements should result in reduced money creation by banks and, in turn, in reduced economic activity.
In practice, the connection between reserve requirements and money creation is not nearly as strong as the exercise above would suggest. Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels. Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market so long as they are willing to pay the prevailing price (the federal funds rate) for borrowed reserves. Consequently, reserve requirements currently play a relatively limited role in money creation in the US.

Reserve requirements, the discount rate (the interest rate that Federal Reserve Banks charge depository institutions for short-term loans), and open market operations (buying and selling of government securities) are the Fed's three main tools of monetary policy. There is a continual flow of reserves among banks, representing the ever-changing supply and demand for these reserves at individual banks. When the Fed engages in open market operations, it adds to or subtracts from the supply of reserves. The effectiveness of the Fed's actions results from the reasonably predictable demand for reserves that is created by reserve requirements.

The Fed changes reserve requirements for monetary policy purposes only infrequently. Reserve requirements impose a cost on the banks equal to the foregone interest on the amount by which required reserves exceed the reserves that banks would voluntarily hold in order to conduct their business, and the Fed has been hesitant to make changes that would increase that cost. There have been only a handful of policy-related reserve requirement changes since the MCA was passed in 1980. In March 1983, the Fed eliminated the reserve requirement on non-personal time deposits with maturities of 30 months or more, and in September 1983, it reduced that minimum maturity to 18 months. Then, in December 1990, the Fed cut the requirement on non-personal time deposits and on net Eurocurrency liabilities from 3% to 0%. In April 1992, it cut the requirement on transaction deposits from 12% to 10%. In announcing its December 1990 move, the Fed noted that the cut would reduce banks' costs, "providing added incentive to lend to creditworthy borrowers". Similarly, in announcing its April 1992 cut in reserve requirements, the Fed observed that the reduction would put banks "in a better position to extend credit".

Current reserve requirements are low by historical standards. From 1937 to 1958, the rate on demand deposits was always at least 20% for banks in New York and Chicago, which were "central reserve cities" - a term now obsolete. Before the passage of the MCA in 1980, only banks that were members of the Federal Reserve System had to meet the Fed's reserve requirements. State-chartered banks that were not Federal Reserve members had to meet their state's reserve requirements, which typically were lower. As a result, many banks dropped their Federal Reserve membership and member bank transaction deposits fell from nearly 85% of total US transaction deposits in the late 1950s to 65% two decades later, weakening the Fed's ability to influence the money supply.

The MCA sought to solve this problem by authorizing the Fed to set reserve requirements for all depository institutions, regardless of Fed membership status. The Fed has long advocated the payment of interest on the reserves that banks maintain at Federal Reserve Banks. Such a step would have to be approved by Congress, which traditionally has been opposed to this because of the revenue loss that would result to the US Treasury. Each year the Treasury receives the Fed's revenue that is in excess of its expenses. The payment of interest on reserves would be an additional expense to the Fed.

Capital adequacy
Apart from bank reserve requirement that is designed to insure liquidity, a private bank's capital - also known as equity - is the margin by which creditors are covered if the bank's assets were liquidated. A measure of a bank's financial health is its capital/asset ratio, which is required to be above a prescribed minimum international standard set by the Bank of International Settlement (BIS), whose rules set requirements on two categories of capital, Tier 1 capital and Total capital. Tier 1 capital is the book value of its stock plus retained earnings. Tier 2 capital is loan-loss reserves plus subordinated debt. Total capital is the sum of Tier 1 and Tier 2 capital. Tier 1 capital must be at least 4% of total risk-weighted assets. Total capital must be at least 8% of total risk-weighted assets. When a bank creates a deposit to fund a loan, its assets and liabilities increase equally, with no increase in equity. That causes its capital ratio to drop. Thus the capital requirement limits the total amount of credit that a bank may issue. It is important to note that the capital requirement applies to assets while the bank reserve requirement applies to liabilities.

The China Banking Regulatory Commission (CBRC) announced new regulations on capital adequacy on February 27 in a bid to enhance risk management of the banking sector in line with the BIS Basel Accord. After injecting $45 billion equity into two big state banks, China's foreign exchange reserves stood at $403.25 billion at the end of 2003. Under the stricter regulations, which took effect on March 1, capital adequacy ratios of Chinese commercial banks fell further below requirements. To give commercial banks more time to replenish their capital base, the CBRC has set the deadline for meeting the new requirements at January 1, 2007. Most of China's commercial banks fail to meet the 8% minimum requirement for capital adequacy even under the older rules, which has stood as a major obstacle hindering bank reform efforts.

Chinese commercial banks are required to set aside part of their profits as bad loan provisions, but few of them have been able to meet that requirement. The vast amount of non-performing loans means, in some cases, that some banks have to set aside more money than the net profit they make. Under the new rules, the capital adequacy ratio - capital divided by risk-weighted assets - is calculated after a full deduction of bad loan provisions. Banks are required to fully set aside reserves only after 2005. The new rules end some favorable treatment in assigning risk weights to loans given to key state-owned enterprises and some types of mortgage loans. The rules allow the CBRC to give differentiated regulatory treatments to banks with different capital adequacy levels. The CBRC has the authority to take over or urge for restructuring of banks with "seriously low" capital adequacy ratios.

The PBoC announced on March 25 that the required reserve ratio for financial institutions with capital adequacy ratio below a specific level would rise 0.5% to 7.5%, while the ratio for other financial institutions remained unchanged. State-owned commercial banks, urban and rural credit cooperatives were exempt from the differentiated required reserve ratio policy. On April 11, the PBoC announced again that the required reserve ratio for all financial institutions except from urban and rural credit cooperatives (RCC) would rise 0.5% effective April 25. The differentiated required reserve ratio scheme was explained as both a transitional policy in line with China's current financial system and an innovation based on the original purpose of required reserve ratio policy, i.e. to ensure payment and settlement of commercial banks, and to prevent over-lending by financial institutions attracted to profitable loan terms which may undermine their liquidity and payment capacity. A period of one month is hardly a reasonable transition period for bank policy changes.

The required reserve ratio policy then gradually evolved into a monetary policy instrument and the deposit insurance regime combined with supervision on capital adequacy ratio started to replace it as policy tools to impose prompt corrective actions on financial institutions based on different risk profiles. Given the fact that China has yet to establish a deposit insurance system and quite a number of financial institutions failed to reach the 8% capital adequacy ratio, the differentiated required reserve ratio scheme is conducive to curb excessive credit expansion of financial institutions with low capital adequacy ratio and poor asset quality, and to prevent the one-size-fits-all approach in macro financial adjustment and regulation. Yet a one-size-fits-all approach is basic to central banking standardization, an institutional flaw that central banks seek to correct with complex exceptions.

At the same time, the PBoC aims to strengthen credit management by rigorously curbing loans to over-invested industries, and keeping the proportion of medium- and long-term loans at reasonable level. The PBoC will also endeavor to adjust loan structure, urge financial institutions to implement credit policy, promote financial ecological development, enhance re-lending and rediscount management, continue to improve and prioritize financial service to the rural economy, and further promote inter-bank market development. These are positive moves in support of national development, but hardly profit-driven market strategies for private banks.

The priority of China's current interest rate policy is to enhance institutional reform so as to facilitate monetary policy transmission mechanism. This is a questionable priority unless institutional reform supports national economic development. A legitimate question centers on the validity of the assumption that a move toward market fundamentalism enhances national economic goals. The goal of all financial markets is to maximize private profit and in an unregulated market, private profit maximization often runs counter to national economic interests.

Since September 2003, the year-on-year consumer price index (CPI) level has grown rapidly to 3.2% at the end of December, implying increasing inflation pressure. From January to March 2004, the CPI rose 3.2%, 2.1%, and 3.1% respectively and month-to-month rose 1.1%, fell 0.2% and rose 0.3% respectively. The CPI in the first half of this year may continue to rise, but current one-year loan rate is 5.58%, rising 27 basis points from 5.31% after nine years. If real loan rates should fall negative at some point in time, the behavior of market participants will be distorted.

Already, firms can make profits simply by borrowing to acquire and hold inventory in certain overheated sectors, thus aggravating raw material shortage, pushing price level further up and leading funds to circulate in retailing rather than be invested in manufacturing. Therefore, the price level is one indicator the central bank must closely monitor when considering interest rate policy. Yet the Chinese economy is still highly disaggregated. Wide disparities in CPI readings are registered in different regions and economic sectors. This leads to the question about the validity of a unified national interest rate policy. Even in the US, where the economy is highly aggregated, the Federal Reserve System is comprised of 12 regional Federal Reserve Banks with 24 branches to monitor local economic conditions.

In addition, the central bank is forced to take into account the destabilizing force of speculative foreign exchange arbitrage. Over the past two years, capital inflows have led to a substantial rise in China's foreign-exchange position. The amount of capital inflow is directly linked to domestic and foreign interest rate differentials. To deal with the problem, the PBoC adopted a floating re-lending rate regime. Re-lending refers to the loans central bank grants to financial institutions. Floating re-lending rate regime means the PBoC, according to macroeconomic and financial situations, can set and announce the extent by which the re-lending rates move above benchmark rates within the fluctuation band authorized by the State Council.

Effective from March 25, the rates on one-year-or-less liquidity re-lending rose by 0.63 percentage point from existing benchmark level. In order to support agricultural development, floating re-lending rate regime for rural credit cooperatives (RCCs) will be implemented gradually over a period of three years, and three years later the rate increments for RCCs will be half of those for other financial institutions. The PBoC considers the adoption of a floating re-lending rate regime as another important step toward interest rate liberalization. It claims to help not only improve the interest-rate formation mechanism and the central bank's capability of guiding market rates, but also upgrade the effectiveness and transparency of re-lending management. Such claims stretch monetary logic and policy credibility.

Loan rate resetting
Since January 1, the ways of resetting loan (excluding household mortgages) rates are being determined by borrowers and lenders through negotiation. The frequency of resetting rates on medium- and long-term yuan loans, previously once a year and now determined by borrowers and lenders, can be monthly, quarterly, annual, or fixed. This policy move has corrected the asymmetry between fixed deposit rates and annually changed loan rates. Consequently, commercial banks can determine the way of resetting loan rates according to customer's credit rating, and flexibly design loan products. Also, shortened resetting intervals help commercial banks spot borrower solvency problems earlier. In addition, when the central bank changes benchmark rates, commercial banks can more promptly adjust loan rates based on lending agreements, thus mitigating interest rate risk, facilitating the transmission of monetary policy to manufacturing and consumption.

The change of loan rates resetting policy forced commercial banks to establish offer system, to factor in credit risk and interest risk when estimating profits, and to set up internal transfer pricing mechanism. Yet often commercial banks fall into liquidity difficulties when the central bank abruptly and unexpectedly reverses interest rate trends. Since economic trends generally develop slowly, it would be reasonable to expect the central bank to make its interest rate calls with minimum element of surprise and with ample lead time. Yet central banks tend to play cat and mouse with the market on its monetary policy moves, making them major market-destabilizing agents.

With the control of lending scale and deposit/lending rates, the commercial banks' asset and liability management (ALM) only focuses on the ratio of deposit to lending. Interest rate liberalization, nevertheless, requires commercial banks to focus on interest rate risk and capital adequacy ratio. Loan rate floor management calls for commercial banks to adjust asset structure with risk pricing. According to a survey in 2002, less than half of outstanding commercial bank lending is at fixed rate, while in publicly traded commercial banks, the percentage of fixed rate loans is only 36. Since the 0.9-1.7-percentage-point floating range has basically liberalized lending rates, commercial banks now must learn to price risk. This is because China and Asia generally do not have a well-developed sovereign credit market providing long-term sovereign debt instruments as benchmark for bank loans and mortgages.

Bank loan pricing then must take into account such complex factors as short-term fund cost, direct and indirect costs, loan taxation cost, loan maturity, loan risk and profit targets. Fund cost rate refers to the cost for commercial banks to obtain fund in the market with similar maturity and cash flows as the loan extended to clients, i.e. the internal transfer price of the loan. Direct costs, including all costs related to loan product and client services, can be derived from direct cost rate using activity-based-cost (ABC) or average-cost method. Indirect costs, generated from operations other than loan activities, can be calculated using the average-cost method. Because the calculation of direct and indirect costs both use historical data, the data must be updated regularly so as to ensure its effectiveness and applicability.

In China, taxation cost rate is the operating tax rate plus added cost per loan. Credit risk premium is used to cover expected loan loss and the expected loan loss rate equals default rate multiplied by loan loss rate. To estimate loan loss, commercial banks must set up internal rating modes. The longer the loan's maturity, the higher should be the lending rate. The logic behind is that longer maturity means longer financing period, consequently higher financing cost and greater possibility of changing cost. Therefore, the loan rates should rise accordingly. Profit targets can be estimated using return on capital and the ratio of capital to lending.

At present, loan pricing is one weakness of China's commercial banks because of a history of interest rate control. In the process of interest rate liberalization in coming years, commercial banks need to step up efforts in pricing products, accumulate experience and develop basic data analysis to strengthen international competitiveness. But interest rate liberalization comes with an economic cost. The IMF has been rightly criticized for prioritizing the soundness of lending institutions over the health of borrowing economies by allowing interest payments to overwhelm the budget of many borrower governments. It is not a rational policy to destroy a national economy to save its adventuresome banking system, much less so a foreign adventuresome banking system.

Deposit rate ceiling management requires commercial banks to actively adjust their liability scale and structure, and adapt themselves to capital adequacy ratio management. Commercial banking management theories have evolved from asset management, to liability management, finally to asset and liability management (ALM). Liability management for banks originated at the end of the 1960s, when high inflation and sharp and unexpected interest rate hike combined with rigorous interest rate control in many countries and led to disintermediation and fund shortage in commercial banks, forcing them to adopt liability management and to attract fund back into commercial banks through innovation.

Bank liability management in China emerged from a very different history. The underdevelopment of capital markets and securitization of debt in credit markets have left banks as main intermediaries of credit in Asia generally and China in particular. In China, funds and risks are over-concentrated in banks while capital adequacy ratio of most commercial banks is low. To meet capital adequacy ratio requirements, commercial banks must reduce either asset or liability. With a deposit rate ceiling policy, commercial banks can tailor deposit price to specific situation. Commercial banks with low capital adequacy ratio can reduce deposit by lowering deposit rates so as to mitigate the pressure of excessively expanding loans to avoid loss due to large liability. Therefore, deposit rate ceiling policy not only helps rein in excessive credit growth and mitigate inflation pressure and non-performing loan risks, but also guide funds into capital market to promote capital market development and securitization. Yet savings do not disappear merely because bank deposit rates are low; savings only seek other vehicles to achieve higher returns. With the underdevelopment of credit markets, an informal credit market emerges outside of control of the central banks.

Both financial institutions and their customers need instruments to hedge interest rate risks in a liberalized interest rate regime. Option-pricing theory states that financial institutions, even without derivatives, can use basic instruments to create transactions with the same nature as derivatives to hedge risks. Derivative hedging is cost-effective and convenient. But its advantages to the hedging parties are derived from transfers of unit risk to systemic risk. The nature of derivative transaction requires high leverage, a risk reflected in the meltdown of major hedge funds such as LTCM. In this regard, China needs to enhance fundamentally the internal control of financial institutions before pushing toward derivative transactions to provide commercial banks and customers with hedging instruments.

The era of $50 oil will greatly impact the global economy. Asia will be directly affected. With the Chinese economy overheated, rising oil price will exacerbate inflation pressures. Conventional wisdom suggests that this adds greater pressure on interest rate rise. China is the second largest oil consumer in the world after the US. Yet half the Chinese demand can be met with domestic oil products. The increased demand for imported oil comes from the expanding Chinese export sector. High oil prices cast a shadow over global growth prospects, which could dampen Chinese export growth and thus reduce Chinese demand for imported oil. But since a higher price of oil increases the income of oil producers and the expenditure of oil consumers for the same amount of oil, high oil price increases world GDP without expanding the world economy. High oil prices are inflationary on a global scale.

Chinese export growth can transform into market share growth even as the global economy slows down. As China's global market share in export expands, the value-adding performance of its trade will correspondingly be upgraded even if global economic growth slows. High oil price has limited direct impact on Chinese domestic consumption since domestic consumption is supplied mostly by domestic production. So far, domestic inflation pressure has mainly come from food and farm produce prices. But oil prices are global. Chinese domestic oil will seek export markets if domestic prices stay below world market levels, unless price control is instituted. Rising prices in imported oil and oil products and other basic commodities affect mostly capital industries and the real estate sector. The manufacturing sector registered no inflation for lack of pricing power due to overcapacity, even though energy cost has increased. Cost-pushed inflation in the export sector has been largely neutralized by reduced profit margins and productivity increases from worker reduction and salary decreases.

Oil and yuan
The high oil price has refocused the debate on the yuan exchange rate. An upward revaluation of the yuan may temporarily reduce the nominal cost of imported oil, but the resultant fall in the dollar will lead oil producers to further raise oil prices. The US has adopted a "benign neglect" posture on the falling dollar for devious reasons. And the chairman of the Fed actually began to "talk down" the dollar. The European Central Bank is caught in a dilemma. Since oil is denominated in dollars, a high euro will help the eurozone on energy cost and help contain euro inflation and keep euro interest rates low. As it is, all central banks are trying to keep short-term interest rate below neutrality because of high unemployment everywhere. A falling dollar will also reduce windfall profits for the Organization of Petroleum Exporting Countries. The US will keep oil around $50, which is good for oil-producing states such as Texas; keep the Europeans quiet about a falling dollar, increase US exports to keep the labor unions under control, defuse mounting isolationism in Congress and make it cheaper to foreigners to invest in dollar assets, keeping dollar asset prices up. There is no incentive for Washington to alleviate international tension if that will bring the dollar up. Thus the monetary argument for multilateralism is also disarmed.

China has an unbalanced, overheated economy, with some serious over-investment in some sectors and regions while other sectors and regions are caught in protracted stagnation and credit crunch. The key to the Chinese economy lies in rebalancing export with domestic development and shifting investment from overheated regions to depressed underdeveloped regions. This shift requires policy planning to rein in unregulated markets and to apply national banking principles to domestic development. Doctrinaire central banking in support of capital markets for maximum return on capital at the expense of national development must be curbed. Improved risk-management systems alone will not cure the problem of excess liquidity pouring into unauthorized steel mills, aluminum smelters and real-estate projects, causing an inflationary investment bubble. Planned credit allocation needs to be strengthened in keeping with the Five-Year Plan, which has been largely ignored by blind faith in market fundamentalism. China had 139,400 building projects under construction in the first seven months of 2004, with total investment rising 38% to 11.2 trillion yuan, most of which were located in over-saturated markets in overheated regions. No amount of bank risk management can withstand such massive scale of credit-market failure.

Give credit where due
Credit allocation is not related to the level of interest rates in a planned economy. In the US, credit allocation is handled with tax deductibility of interest payment in government-encouraged sectors. Much of the credit misallocation in China has been created by its state privatization policy to rely on a market economy for economic growth. This unleashes massive off-budget spending financed with loans from newly privatized banks based on unrealistic revenue projections. Such privatization activities have contributed to the concentrated surge in domestic loan demand in saturated markets. When economic growth slows, these loans will turn non-performing. The overheating in the Chinese economy is concentrated along the coastal region, with the rest of the nation left underdeveloped for lack of credit. It is also concentrated in proliferation of copycat projects of earlier entrepreneurial successes.

The Chinese Ministry of Finance had announced that starting October 1, 1999, interest payment to bank depositors would be taxed at an annual rate of 20% nationwide. This action ended four decades of tax-free interest income. It defies common sense for Xinqiang to have the same interest tax rate as Shanghai if the government promotes a policy to shift investment to the interior west.

China's total tax revenue is less than 12% of GDP, one of the lowest in the world. This is the residual legacy of a socialist economy in which tax revenue is not crucial for financing public expenditure. The use of sovereign credit for domestic development is conditioned on the principle of the State Theory of Money, which asserts that the value of a fiat currency rests on government authority to tax. In shifting to a "socialist market economy", China is under-taxed for the full application of sovereign credit for domestic development. This fact limits the ability of the central government to plan for balanced national development. And the Chinese economy is still highly disaggregated by location. Unlike the US, where the states enjoy substantial power to set local tax policies to compete for growth, Chinese provinces are allotted very limited autonomous authority in this regard. Thus the depressed, low-growth regions constantly find themselves at a disadvantaged competitive position compared to the coastal, developed ones.

Higher interest rates across the whole economy affect not only overheated sectors and regions, but also underperforming sectors and regions. China's agriculture and service industries have received less investment compared with natural resource sectors closely related to the export sector and the real estate sector in coastal cities. While fixed-asset investments grew 40%, year-on-year during the year's first quarter, investments in the nation's agriculture sector rose a scanty 0.4%.

China's service sector has not shown any sign of overheating. In fact, education and health services have experienced declining investment for more than two decades. Since private investments are expected by policy to gradually replace government spending as the economy's main driving force, high interest rates will cause credit crunches on fund-strapped sectors while having little influence on already-overheated sectors. China's policymakers have been unduly and unwisely influenced by Hong Kong capitalists whose experience has been limited to real estate and light manufacturing and have not the slightest clue on national economic development policy.

By the end of June, bank loans to the real-estate sector reached 2.1 trillion yuan, up 36.1% year-on-year. New investments in land developments increased 28.7%. A recent field survey by the National Bureau of Statistics indicated the average property price in 35 of China's cities increased 10.4% in the year's second quarter compared with a year ago. In Shanghai, the growth figure reached an astonishing 20%. In industries supporting real estate construction such as steel, cement and building supplies, fixed investment is as high as 172% (iron and steel). Official government estimates say that when all steel projects currently under construction come to full production, they will turn out more steel in 2005 than the country will be able to use until 2010.

Despite the central government tightening regulations in the steel, cement and aluminum sectors, the real estate sector drove steel prices up 2.1% in July from June, and 18% from a year ago. The price of cement rose 4.7% from June, and 11.6% year-on-year. The PBoC noted in its 2004 third-quarterly report on monetary policy that its credit-tightening measures have prevented new investments in the real-estate sector, but failed to influence the demand side. As investments and new projects in land development continue to decline, demand will consequently exceed supply. This will push property prices up. But the demand side in the real estate sector can be managed in ways besides interest rate hikes, such as increasing down payment ratio for residential mortgages to effectively bring down property prices.

But the real factor behind price inflation in real estate is not construction cost, but rising land cost, a factor over which the central bank commands no direct control. Investments in real estate grew by more than 40% in the first quarter year-on-year. This is the fastest growth in China's modern history - almost three times the 25-year average of 15%. What this means is that investors are pouring money into real estate, which is jacking up prices and creating an artificial bubble just waiting to pop. Figures from the end of 2003 estimate that real-estate vacancies stand at 26%, quadruple the US figure, eight times Hong Kong's and two and a half times the international norm. The inventory cannot possibly be absorbed by domestic consumers whose income cannot support such speculative prices. These prices are sustained by speculative momentum.

Yet the recent interest rate hikes in the US are unlikely to cause an outflow of speculative funds, or hot money, from China. Martin Feldstein, president of the National Bureau of Economic Research and Harvard professor of economics, has calculated that a 0.25% or even a 1% increase in dollar interest rate will not make hot money leave China. This is because China's rigid currency regime and tight control over capital accounts means speculative funds will, over the short term, have trouble finding a way to benefit from the abrupt rate rises in the US. A short-term rate change would not affect foreign direct investments (FDI) going into China as FDI is generally for the long term. On the other hand, a widely expected US long-term policy of a measured pace of interest rate hikes will force interest rates in other currencies to rise.

China's GDP still grew 9.8% in the first quarter of 2004. Fixed asset investment reached 879.9 billion yuan, up 43% year-on-year. The April consumer price index (CPI) also jumped to 3.8%, compared with 2.8% for the first quarter. Money supply in the first quarter grew 17% and new loans reached 2.6 trillion yuan, the second highest in history. Yet amid these bullish growth data, unemployment keeps rising. Also in April, construction of a major steel smelting facility in Jiangsu province was brought to a screeching halt for alleged illegal land expropriation and improper borrowing. The move was widely viewed as part of the effort to halt undesirable construction in an overheated sector. The State Development and Reform Commission also conducted a nationwide price inspection. Local governments were instructed to halt utility price hikes if inflation in their areas exceeded national norms.

Financial institutions lent 1.88 trillion yuan in the first seven months of 2004, already topping the total for loans in 2002. Interest rates have soared after the release of these data. The rate on benchmark seven-day repurchase agreements jumped to above 2.8%, even higher than the 2.66% coupon on a seven-year sovereign bond issue earlier in 2004. The problem is that these loans have been made in the wrong sectors and to the wrong borrowers.

PBoC has already reversed a contractive stance it maintained for the first eight months of 2004 in open market operations, releasing 35 billion yuan of currency in repurchase agreements in September. The CPI is expected to rise less than 1%. The auto and real estate sectors, where prices have been growing the fastest, are currently not factored in China's CPI. Both sectors appear to be heading for abrupt slowdowns due to dwindling purchasing power. And the ex-factory prices for consumer goods, which largely dictate CPI trends, have been on the decline in 2004. The CPI, after months of decline, started to rise in October 2003, hitting 1% in April, but subsided afterwards. It registered 0.5% rise in August 2004. Little noticed is that fact the CPI declines often comes from declining corporate profits.

The growing investments are partly the result of years of low investment, fueled by heavy initial investments in such sectors as automobiles, and may be offset by the sluggishness in spending. Since August, China's macroeconomic policy makers have faced a dilemma: either fail in cooling down the economy or risk causing economic depression. The official jobless rate is 4.3% that does not reflect the real situation since it does not include laid-off workers from state-owned industries or migrant workers. Even though Chinese workers earn on average $0.61 an hour, China is losing manufacturing jobs because of technological advances as employers try to boost productivity by laying off redundant workers, given that wages cannot fall below zero. Unskilled workers can become cost-ineffective against the cost of automation. Evidence is mounting that job shrinkage can also occur on low wage levels in a booming economy.

Fixed-asset investment in China rose 26.3% year-on-year in August 2004, down from 31.1% in July and far below the 47.8% in the first quarter. Other key data shows a similar trend. Industrial output rose 15.9% year-on-year, slightly above a 15.5% rise the month before but well below the 19.4% fi