China's central bank may have to raise interest rates on deposits and loans should a hike in deposit reserves fail to bridle the rapid increases in money supply and soothe worries about overheating.

The People's Bank of China has decided to increase the required reserves of total deposits that financial institutions' must maintain by September 21 to 7 percent. Currently, such institutions must maintain 6 percent of deposits in reserve. [newsphoto.com.cn]

But financial analysts and official sources say the move appears unlikely this year.

The People's Bank of China (PBOC) announced on August 23 a decision to raise financial institutions' required reserves to 7 per cent of their total deposits, from 6 per cent currently.

Financial institutions lent 1.88 trillion yuan (US$226 billion) in renminbi loans in the first seven months of this year, already topping the total for loans rolled out in 2002.

"Excessive growth in loans will fuel low-level expansion of the economy and will undermine the sustainable healthy development of the economy," the PBOC said in the announcement.

Although the required reserves increase is still two weeks away (the move takes effect on September 21), it has exerted immense liquidity pressure on the money market, with commercial banks, especially smaller ones, scrambling for short-term loans to replenish their reserves.

"Liquidity is really tight right now... tighter than anything," said Ma Junsheng, a senior manager at the Industrial and Commercial Bank of China. "The impact on the entire market is tremendous."

The impact of the reserves hike on individual banks largely varies by their liquidity management abilities, he added.

Interest rates have soared following the announcement. The rate on benchmark seven-day repurchase agreements jumped to above 2.8 per cent, even higher than the 2.66 per cent coupon on a seven-year Treasury bond issue earlier this year.

Two weeks have now passed since the central bank's announcement, but liquidity remains tight. "That means the excess reserves some banks set aside were just a bit too low," said an analyst who asked not to be named.

But it is too early to conclude to what extent the hike may slow lendings, Ma said. "(The reserve rise) should have an impact on loans, but not so soon. We need to wait for the numbers at the end of this month."

The PBOC estimated that the 1 percentage point hike in required reserves will freeze 150 billion yuan (US$18 billion) in base money, a term that includes cash in circulation and all reserves at commercial banks.

It is widely estimated that that number, multiplied with a so-called "currency multiplier" which stands at a little above 4 currently, may result in a potential total contraction in money supply of as much as 600 billion yuan (US$72 billion).

But Wang Yuanhong, a senior analyst with the State Information Centre, said the ultimate impact depends on how banks adjust their excess reserves, or the amount of reserves they keep apart from the required reserves, on a voluntary basis to meet payment needs.

The aggregate excess reserve ratio of Chinese commercial banks maintained a downward trend this year as they boosted lendings to meet growing business funding needs. It fell to 3.8 per cent at the end of June, down 2.59 percentage points from the end of last year.

"If (commercial banks) continue to reduce excess reserves (to offset the pressure on their lending capacity), (the required reserve rise) will not have a significant contractive effect on loans," Wang said.

If that turns out to be the case, the consumer price index (CPI) - the key inflation barometer - rises above 1 per cent, and the economy keeps growing faster than 8 per cent, the central bank may finally resort to a hike on lending rates.

That, he said, would do a better job of solving the structural problem than having the reserve rise by raising borrowing costs in funds-intensive industries like real estate, auto and steel that some fear are overheated.

But that scenario looks unlikely in the near term, given the liquidity pressures in the money market. The PBOC has already reversed a contractive stance it maintained for the past eight months in open market operations, releasing 35 billion yuan (US$4.2 billion) of currency in repurchase agreements last week.

And the possibility of the CPI rising above 1 per cent is dim, said Yuan Gangming, a senior economist with the Chinese Academy of Social Sciences.

The auto and real estate sectors, where prices are growing the fastest, are currently not factored in China's CPI, he noted. And the ex-factory prices for consumer goods, which largely dictate CPI trends, have been on the decline this year and are unlikely to reverse course any time soon.

"For the entire year, the CPI will absolutely stay below 1 per cent, or even below 0.5 per cent," Yuan said.

China's CPI growth, after months of being in negative territory, started to rise in October last year. The index's growth hit 1 per cent in April, but subsided afterwards. It registered 0.5 per cent last month.

Yuan dismissed inflationary worries, insisting that the unabated investment enthusiasm will not overheat the economy. The growing investments are partly the result of years of low investment, fuelled by heavy initial investments in such sectors as automobiles, and may be offset by the sluggishness in spending, he said.

PBOC Governor Zhou Xiaochuan said last week the central bank may consider further moves to offset rises in money supply as a result of its purchases of excess US dollars aimed at stabilizing the exchange rate of the renminbi.

That refuelled speculation about a possible interest rate hike, with the discount rate - another major monetary policy instrument - at a fairly high level currently and rarely used in recent years.

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