Here's Why China's Central Bank Is Letting Interest Rates Run Wild

Reuters

China's financial system experienced a liquidity squeeze in June with short-term interest rates spiking to frightening levels before cooling off.

From October 19 to October 30, China's interbank rates jumped again, this time surging by about 220 basis points.

Adding to the investor anxiety was speculation that China's central bank might tighten monetary policy thanks to stabilizing economic growth and rising inflation.

But the central bank has stood on the sidelines.

Bank of America's Ting Lu explains that it is in part because it thinks this could enforce some discipline. It's also because it's ability to gauge liquidity demand is limited.

Here are Lu's reasons verbatim:

1. The PBoC does not think it has the full responsibility to deliver very stable interbank market rates. The PBoC even believes that a small volatility could impose some discipline.
2. The PBoC's capacity in predicting of liquidity demand and supply is limited.
3. The PBoC might be too insensitive to market sentiments when it put off reverse repo 17 October.
4. The PBoC might not be willing to inject liquidity immediately to arrest a sudden rise in interbank rates as by doing so it's equivalent to a strong commitment to Shibor stability and a failure in prediction.

The Chinese central bank clearly needs to be clearer on the role of key interbank rates and needs to improve it communication with the markets to ease anxiety.