Source: www.asiaecon.org |

Monetary policy is important because it has an immense impact on financing conditions in the economy. It influences prices, the availability of credit, bank’s willingness to assume risk, inflationary expectations and ultimately consumption and investment.

The People’s Bank of China, China’s central bank, has committed to the “moderately loose” monetary policy that has helped the economy recover from the global economic slump. Over the next two quarters, the central bank will pay attention to the increase in domestic asset prices and inflation expectation by fine-tuning its monetary policy, according to a recent article by Zhang Xiaohui, the director or the PBOC’s monetary policy.

In its quarterly monetary policy report, the PBOC said, “In the period ahead, the People’s Bank of China (PBOC) will unswervingly implement the appropriately loose monetary policy while fine-tuning policy with market-oriented tools in line with economic changes at home and abroad.” Liu Yuhui, the director of the Center for Chinese Economic Evaluation at the Chinese Academy of Social Sciences told China Daily that the bank has already initiated some micro-tightening measures like open market operations. In addition, China’s top banking regulator urged lenders to limit lending and focus on strengthening the credit markets instead.

When the central government wants to tighten monetary policy it tries to absorb excessive liquidity. The bank is currently selling more bills to mop up cash, since M2, the broadest measure of money supply rose a record 28.5 percent in June 2009 compared to a year earlier. Furthermore, the central bank has kept interest rates and reserve requirements for banks unchanged this year after cutting them at the end of 2008 to combat the global credit crisis. These actions hint that stricter monetary policy is on its way, causing investors to worry. The expectation of higher borrowing costs will result in lower investment activity and lower purchase of consumer durables.

The Effect on Consumers and Investment:

Tighter monetary policy means that the cost of borrowing will increase. Recently, China’s central bank decided to keep its interest rate at the same level after slashing interest rates at the end of 2008. China cut its interest rate from 6.66% in October 2008 to 5.31% in December 2008. Since then it has remained at the same level. The bank’s decision to keep interest rates at 5.31% for the time being is a way the central bank is moderating its loose monetary policy and transitioning to a tighter monetary policy to support the economy as it recovers.

Investors and consumers are worried about the effect a tighter monetary policy will have on the economic recovery. Interest rates may affect consumer spending. When interest rates are higher, consumers will spend less and save more, weakening demand in the short run. They will want to spend less on illiquid assets when their financial situation worsens and thus invest less in consumer durables, such as cars, business equipment, etc. Weak demand is a threat to any recovering economy.

A contraction in the money supply by the central bank is achieved through an increase in short-term market rates through interest rates. As a result, the real interest rate and capital costs increase, which decrease investment.

Tight monetary policy will reduce banks’ assets either directly or indirectly, by limiting credit creation when tighter reserve requirements are imposed. This will lead to reduction in loans, thus in investment. Consumers are worried that central banks will increase the reserve ratio, according to Wang Zheng, a fund manager at Jingxi Investment Management Co. The increase in reserve ratio will influence commercial banks’ refinancing cots. If finance costs increase (as they will with higher interest rates) banks will pass on the costs to consumers and investors (borrowers) which will discourage many from borrowing and thus decrease investment and consumer spending.

Also, an increase in interest rates may increase the risk that some borrowers cannot pay back their loans. Banks might become reluctant to give out more loans to those borrowers (consumers or investors) and they will be forced to cut back on planned expenditures.

“In the first half, we had excessively loose monetary policy and now, in the second half, we’re moving into appropriately loose monetary policy,” Zuo Xiaolei, Galaxy Securities Co. chief economist said Xiaolei added “The central bank is doing the right thing,” Xiaolei said, without specifying how it may tighten policy. “China needs stable economic growth. China doesn’t need big ups and downs.” The PBOC has already begun absorbing excessive liquidity through open market operations in order to ease inflationary threats. By withdrawing money from circulation and raising the cost of financing. In Wednesday, August 5th, the central bank released a report where they promised to “use market oriented methods to carry out dynamic fine-tuning taking into consideration domestic and international economic conditions and price changes”.

“As the recovery becomes more solid in the third quarter, we expect an orderly winding down of stimulus policies beginning in the fourth quarter or early next year. The key move will be the first hike in the reserve requirement,” said a report from Standard Chartered Bank.

While investors and consumers worry, others, like strategist Jerry Lou, from Hong Kong thinks the government may not go in for a tight monetary policy yet. “We assume there would be two rate increases in the second half of 2010,” he said.