Reserve Ratios Impotent in China

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Inflation concerns are brewing all around the world. Leaders of the developed world push their central banks to inflate, whole governments enact fiscal stimulus and bailouts, and commodities soar as the effects of negative real interest rates permeate through the world economy.

Cooling Bubbles in China

In China, there is a much larger concern. Inflation first found itself present in the real estate markets, and subsequently, the government nearly shut off speculative investment with a requirement for as much as 50% down on the purchase price. That bubble was thwarted.

Next, cash flew into gold and silver at the bequest of government, but that has yet to become a problem, since it is a world market. However, as time goes on, base metals and other structurally significant commodities are rising in price as wages stagnate and foreign investment flocks into China. To cool off the boom, the central bank has fought with its reserve ratios, rather than its target rate.

Since 2002, the reserve ratio has risen from 6% to a peak of just under 18% in 2008 before falling to below 16% and quickly rising to 18.5%, their highest ever. The most recent increase was the third such increase in less than one month. So far, efforts to curb the growth have done nothing with M2 money supply growing 19% in just one year.

Interest Rate Action

At some point, investors are going to demand interest rate action at the Chinese central bank, either by their voice or with their dollars. Chinese credit default swaps recently ran as high as 71.5 basis points, or .715% of the price of the bond. Investors worry that should China contract too quickly, the risk of default runs high, and through the markets, they're showing their cards as to how they believe the Chinese central bank should act.

Central bank action in China is very much different than you might find elsewhere around the world. While Keynesian economists globally tend to focus on the balance of payments, the Chinese are concerned with ownership and investment. Currently, one year deposits pay just 2.6% in light of 5.1% annual inflation, meaning the cost to borrow internally is effectively a negative 2.5%. That has allowed many within China to borrow, invest, and reap the proceeds of the current boom.

Investors are going to demand interest rate action at the Chinese central bank. To raise rates would essentially cut off domestic ownership of the economy, with foreigners still able to access developed world money for mere pennies on the dollar and bring it to China, stocking their cash in a currency that is not only inflating (allowing for real growth in equities), but also protecting against their own central bank action.

Investors are going to demand interest rate action at the Chinese central bank.

While there negative real rate opportunities in the developed world, there are few opportunities as beautiful as a near zero cost to borrow in a falling currency for investment in a growing economy with a rising currency.

China must soon act with interest rates which may bring about a temporary cooling. Expect, however, for foreign investment interest to front run any action by the Chinese central bank, since higher target rate means the Renminbi will only further gain against the currencies of the developed world.