Chinese money, Chinese interest rates

Late on Friday, the Chinese central bank raised interest rates a quarter point to help cool the economy and slow the recent surge in consumer prices. It was the third rate hike this year and will bring the one-year deposit rate up to 3.33 percent and the one-year lending rate to 6.84 percent.

This follows last week's announcement that GDP grew by 11.9 percent from a year earlier in the second quarter and consumer prices rose by 4.4 percent in June, the sharpest increase since late-2004, exceeding the central bank's 3 percent inflation target for the fourth consecutive month.

Of course the yuan gained slightly against the dollar, but not too much. China has limited the rise in their currency, the yuan, by buying U.S. dollars, the source of soaring foreign-exchange reserves that have now topped $1.3 trillion, adding to the consternation of U.S. lawmakers who desperately want the yuan to rise faster to help narrow the trade gap.

The rising price of food is an increasing problem in China. Food prices account for about one-third of their inflation index and with the cost of pork rising almost 60 percent and egg prices up almost 40 percent, this could lead to some major unrest, something that the Chinese government desperately wants to avoid, particularly before next year's coming out party at the Beijing Olympics.

[One possible solution here is to get on board with the U.S. style 30+ percent weighting for rent (combined "real" rent prices and owners' equivalent rent) and deemphasize food which accounts for only 15 percent of the U.S. inflation index. Clearly, the Chinese central bank needs to spend more time managing not only rising prices, but "inflation expectations".]

So, why are prices rising so rapidly? Paul Kasriel at Northern Trust explains:

Because Chinese government policy is to manage the Chinese exchange rate, especially with respect to the U.S. dollar, and because the U.S. dollar “wants” to fall in the global foreign exchange market, the PBOC (People's Bank of China) is forced to buy dollars in order to keep the Chinese yuan from rising faster relative to the dollar.

The PBOC pays for the dollars it purchases -- those dollars or the dollar-denominated investment instruments purchased with these newly-acquired dollars – showing up as foreign assets on its balance sheet – with Chinese yuan.

And where does the PBOC get these yuan? The same place all modern central banks get their currencies – they create them with a stroke of a key. (One difference between central bankers and counterfeiters is that counterfeiters actually have to put a little work into creating currency – engraving and physical printing.)

Sounds like a swell system, sure to stand the test of time, but this is what passes for contemporary monetary policy and mainstream economic thought in a global economy that increasing appears to be coming unhinged.

Evidence of the "less hinged" nature of money and credit in China came earlier today when regulators announced that, henceforth, credit creation would be limited to 15 percent annual growth, rather than the 17 percent growth seen in the first half of the year.

How did financial markets react to all this news of monetary tightening?

Contrary to what central bankers expected, the stock market responded by pushing ahead to a one-month high, signs of a major recovery in investor confidence, or so they say.


Someday, this is all probably going to end badly.