Currently, the global economy is at a sweet spot. Price inflation seems under control even though copious amount of money is printed in bailouts and stimulus. Asset prices are rising again and there’s hope that the global economy is returning back to growth soon. Just 6 months ago, the markets were staring into the abyss of a Greater Depression. Today, it’s blue skies and green shoots ahead.

In China, though Chinese stocks had deflated somewhat, Chinese property are still rising rapidly, thanks to their bubble blowing policies (see How big is the credit bubble in China?). The Chinese government are well-aware that there’s a property bubble in their economy. And they are also aware that it was the low interest rates and easy money from the Greenspan era that precipitated the GFC by artificially inflating asset prices with debt. They acknowledged that it was a mistake to use interest rates to ‘control’ price inflation and let asset prices run away into an almighty bubble. This acknowledgement is hardly new. As we wrote before in How are central bankers going to deal with asset bubbles?, central bankers have repudiated Greenspan’s doctrine (and that explains why Greenspan is silent nowadays). But the PBOC has a problem- they cannot raise interest rates easily.

Why?

It’s thanks to their managed exchange rates. To understand why, imagine you are a hedge fund manager. What will happen if China raise interest rates? Given that short-term interest rates are effectively zero in the US, this makes a very ideal carry trade- borrow almost for free in the US, send the money to China and put it into a Chinese bank, collect interest payment and repatriate the profits back into the US. If you are aggressive for higher returns, you may want to put the money into riskier assets (e.g. bubbly property). Since the exchange rate is more or less fixed and controlled, there is no fear for an adverse currency movement to turn this carry trade into a loss-making business.

In essence, if China raises interest rates, it will attract hot money into the country, which risks further inflation of asset price bubbles. China can’t raise interest rates unless the US does. Since we don’t see the US raising their interest rates any time soon (see Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber?s view), we doubt China will be raising theirs soon too.