Higher interest rates not the only option
By Robert Blohm (China Daily)
Updated: 2006-08-04 08:39 Many economists and financial
market players wrongly blame the relatively fixed RMB exchange rate for China's
"runaway" economic growth and for attracting "hot money" in anticipation of what
they think is inevitable RMB appreciation. That's because they think the only
way for China to control economic growth is by tightening credit, reflected in
higher interest rates. They assume higher interest rates mean greater
foreign-exchange demand for RMB for investment and thus the impossibility of a
fixed RMB. This view was expressed recently by Nicholas Lardy, senior fellow at
Washington's Institute for International Economics and a leading US expert on
China's economy, in an appearance on CCTV9's Dialogue programme just over a
month ago. This thinking may stem from three misconceptions.
The first may be the danger of identifying the real economy with the
financial or monetary economy, or of looking at monetary policy as the be-all
and end-all anchor of all economic policy. Money and credit are a commodity like
others, not a proxy for the entire economy which uses money as a medium for
valuation and exchange. Interest rates are the price for credit but it's the
level of all prices (reflecting their rate of change), not just of credit, that
drives the economy.
Rising price levels in China reduce foreign-exchange demand for RMB for
investment because they lower the "purchasing power" of the RMB in terms of the
amount of goods one unit of the currency can buy. Higher interest rates are the
exception but higher goods prices neutralize the ability of interest rates to
cause appreciation of the RMB. Think of the negative effect of higher prices on
the ability to export, resulting in less foreign demand for RMB.
A second reason for the erroneous thinking relates to China's economic rise's
still being in its early stages. In this period, the contribution to economic
growth by construction of infrastructure and buildings is disproportionately
high compared to the contribution made by the use of those facilities. This
attracts real-estate investment fed by credit availability, and that is
investment which seeks to profit from price appreciation, not from income from
use. So, higher real-estate prices, like high interest rates and the price of
other investments, wind up serving to appreciate the RMB rather than acting as
goods prices.
But there are a lot of other prices driving China's economy, and their rise
has the effect of depreciating the RMB. Furthermore a price rise by a company
makes it more profitable and this serves to attract market investment away from
real estate into other sectors of the economy where it is not financed by the
mortgage credit that would otherwise be made more available by ever higher
real-estate prices, or away from other "fixed-asset" over-investment that has
been driven by artificially-low input prices.
Foremost among those prices are the prices of energy, the economy's most
important single input. If any industrial policy needs to be consistent with the
rest of economic policy, it's energy policy. But few economists understand
energy because of its nature as a bulk-market commodity and many get distracted
by its nature as an essential commodity. Economists typically understand best
the retail markets they deal with in their everyday lives.
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