On Friday, the People's Bank of China and the State Council launched a coordinated move to pull the blistering economy on to a sound track of development.

 

The central bank raised the benchmark one-year deposit and lending rates of commercial banks by 0.27 percentage points, effective from Saturday, and the State Council decided to cut the income tax from bank deposit interests from 20 percent to 5 percent since August 15.

 

The two major policy moves are aimed at realizing a reasonable growth in bank credits and investment, easing the inflation pressure and maintaining a stable price level for the country.

 

The market has long been expecting the policy adjustment.

 

According to the official statistics on the economic performance from April to June, GDP grew by 11.9 percent, investment in estate development rose by 28.5 percent, while the CPI was up by 4.4 percent in June. All these figures indicate probable economic overheating.

 

The dual adjustments regarding interest came after the authorities had a better vision on the role of interest rates in the financial market.

 

The Monetary Policy Committee under the central bank, after its second quarterly meeting held early this month, said "the sound monetary policy featuring a steady and moderate tightening should be continued" according to the current situation of the economy.

 

Meanwhile, it also stressed that "development of the money market benchmark interest rate system should be accelerated to further increase the role of price in macro financial management".

 

Central bank officials were also heard expressing their concern openly that a negative actual interest rate might threaten the sustainable economic growth and the government has the responsibility to lift the actual interest rate above zero.

 

Realizing the urgency of the issue, legislators authorized the State Council to make a decision on the rate of interest tax last month.

 

Given all these happenings, it is natural for the public and the market to expect an interest rate hike and a drop or suspension of interest tax when the official economic indicators were released last weekend.

 

Compared with previous interest hikes, the latest one has been launched amid public anticipation, which gives it extra strength to achieve its policy goals.

 

There had been fierce disputes about the necessity and effectiveness of interest hikes in recent months. The public doubt about it directly weakened its power over the economy.

 

The latest rise also indicates the central bank's incrementing reliance on the interest rate.

 

Widely applied as a tool in macro control by central banks around the world, the interest rate is at the heart of the financial market, hence a fundamental policy tool in the market economy.

 

Although China's market is to be further developed, it is not hard to see that a flexible and effective scheme of forging prices for the financial resources is a sign of the maturity of the financial market.

 

When the Monetary Policy Committee said it would attach more importance to the benchmark interest rate and use it as leverage in financial macro management, it is not hard to see that the central bank and the committee have had a substantial transformation in their ideas about the financial market, which will definitely have a long-reaching bearing on the economic policy of the country.

 

However, the interest rate hike and the reduction of interest tax are presented later than they should have been to achieve their policy goals. The interest rate should also have a bigger increase than the newly announced figure.

 

The CPI picked up by percent in a single in June. Before the interest rate was raised, 3.06 percent was the most interest achievable from a one-year bank deposit. With tax included, the net rate of interest was actually minus 1.952 percent.

 

Once the interest rate is hoisted and the tax reduced, people will get a net minus 1.2365 percent on a one-year deposit, assuming the monthly CPI growth stays at 4.4 percent.

 

Simple mathematics show the latest moves do not help the fact that the actual interest is less than zero.

 

Therefore, it is necessary for the central bank to lift the interest rate by larger margins and more frequently.

 

Of course, the interest hike and the interest tax cut will influence the economy in a way that cannot be underestimated.

 

The two policy moves will change the market expectation because they will install the impression that the interest rate is a regular tool at the central bank's avail whenever the economy needs to be manipulated.

 

The players must predict the market response to the interest hike and the countermeasure of the central bank toward this response before they make their decisions. The policymakers will also have to look further into the future before changing policies.

 

The chain of expectations, speculations and actual revision of policies and investment decisions from the market and the authorities will form a pattern of decision-making of strategic significance to China's financial market and the national economy.

 

The two changes also show the central government has established a new concept of economic management by preferring market-orientated tools to administrative orders.

 

It is clear the government is trying to review the pattern of economic growth in a bid to achieve it in a way that is more sustainable and friendlier to the public welfare.

 

The author is a researcher with the Institute of Finance and Banking under the Chinese Academy of Social Sciences

 

(China Daily July 25, 2007)