China: Pausing for a breather (page 3 of 3)

From the financial market's perspective, the central bank will need to proceed with caution. It must remain mindful of the interest rate differential between the US and China and the impact on the CNY's revaluation pressure. Hence it would be reluctant to raise domestic rates more aggressively than the US.

Higher rates could also set back banking reform
Furthermore, the PBOC is also watching the reaction from local equity and bond markets. The adverse impact on stocks and bonds from expectations of higher interest rates represents a serious threat to the financial strength of state-owned enterprises and financial institutions, as many hold substantial portfolios of government bonds and/or other financial assets. Managing market expectations would be critical to avoiding significant volatility.

Already, the slowing economy will pressure some businesses that are on life support. The risk of default amongst these weaker companies will likely rise. The Big Four state-owned commercial banks have reduced their non-performing loan ratio by 4.8 percentage points between the end of 2003 and mid 2004. But further improvement will be increasingly difficult without the injection of fresh capital from the authorities. Higher debt servicing costs, approximately 14bn yuan per month for each percentage point increase in the lending rate, could exacerbate the situation further.

Benchmark rate to stay put in 2004
In sum, the central bank is facing a policy dilemma where it is uncertain about the effectiveness of rate hikes, yet the adverse impact on financial markets is already apparent. The good news is that the latest release of softening economic data is reducing central bank urgency to tighten monetary policy. Hence various administrative measures, such as requesting greater bank prudence in new lending, restrictions on new investment or projects and capital requirement, are expected to remain as primary tools to guide the economy to a more sustainable growth rate. Despite upside risks to interest rates, the PBOC is not expected to raise benchmark rates in 2004. Moreover, the central bank will be careful not to tighten other monetary levers, such as reserve requirements, too aggressively.