China and Australia’s Central Banks: Same, Same But Different

It is well established in monetary economics that the Central Bank can control either the interest rate or the exchange rate but not both.

In China, the People’s Bank is struggling to defend the fixed exchange rate regime that is the root cause of the extreme volatility in their domestic short-term interest rate markets. Historically, capital inflow could be relied upon to keep interest rates and domestic liquidity conditions in check. However recently, daily flows have been unpredictable which at times has caused liquidity shortfalls and spiking interest rates. The fixed exchange rate policy may well be abandoned in the coming months if the government decides that stable domestic interest rates are preferred to the evil of a volatile exchange rate.

Meanwhile, in Australia, the Reserve Bank is struggling to defend their short-term interest rate while at the same time encouraging a weaker dollar. Even though short-term interest rates are at historical lows, they are still more than two percentage points higher than in the United States or Europe. Recent weakness in the Australian dollar has also made it attractive to foreign property investors as well as raw material consumers. Upward pressure on the Australian dollar is brewing, but the RBA can only jawbone it down. Cutting interest rates is out of the question since this may well fuel a bubbling property market.

China and Australia’s central banks have different problems stemming from the same basic fact: that is, capital flows to the point of highest return. Like it or not, policymakers cannot fight the market.