Monetary Policy, Tight Money, and Reserve Requirements

The Chinese central bank has put the brakes on bank lending and property speculation by using a tight money policy. The action comes in response to the apparent overheating of the Chinese economy, as viewed by top Chinese officials.

"Excessive growth in the supply of credit can initiate inflation or froth in property prices, which may eventually cause bad debts and increase financial risk," according to a statement from the Chinese central bank. The bank backed up its statement by increasing the reserve requirement that banks must hold on deposits. The policy is aimed at reducing the inflation that would naturally come with an economy that is growing to fast.

Investment spending in China has been increasing at nearly three times the rate of overall economic activity, while consumer spending has been lagging. These two observations lead many observers to conclude that China may be building new factories and apartment buildings faster than they can put them to use.

The increase in the reserve requirement makes less money available for banks to lend, and thus has the effect of reducing investment spending. The central bank expects its tight money policy to slow the investment in factories and housing alike, warding off any potential inflation.

Not all analysts expect the policy to be effective. Wang Xiaolu, the deputy director of the National Economic Research Institute, an independent policy group in Beijing, said that Chinese government agencies were uncertain about the seriousness of overheating, and that the latest increase in bank reserve requirements would do little to slow the economy. "It will reduce credit volume by a small amount - not much compared to the overall volume," he said. "The government is certainly concerned about overheating, and the central bank wants to adopt some contractionary measures, but the ones we've seen so far are fairly limited."

If the Chinese government's actions come too late and are inadequate to slow inflation, prices will increase on exported goods and could have an adverse effect on the Chinese economy. As Chinese prices increase due to inflation, the price of goods normally imported by the United States and Europe will also begin to rise. Thus, China could face a growing risk that a costly bust could follow its recent economic boom. This scenario is exactly what the Chinese central bank is hoping to avoid.

(Updated June, 2004)