It is a well-known fact in monetary economics that the Central Bank can control either the exchange rate or the interest rate but not both. China has been administering a fixed exchange rate policy for many years which has encouraged significant capital inflow and the buildup of reserves. As much as they would have liked to have control over domestic interest rates, they have been content to absorb the buildup of liquidity by issuing bonds.
In recent weeks, however, domestic liquidity pressures have forced interest rates to rise. The popular press point to deteriorating credit portfolios in the major banks as the cause. The real culprit, however, is the exchange rate. While, strictly speaking, exchange controls prohibit the export of capital from China, recent liberalisation permits capital outflow in certain circumstances. The domestic banking system, however, requires liquidity to finance these outflows. In the absence of a liquidity injection from the Central Bank, the system needs to find this liquidity itself which in extreme circumstances requires significantly higher interest rates domestically.
So accustomed to capital inflow under the fixed exchange rate regime, the PBOC was caught flat-footed in response to the sudden liquidity demand domestically that they failed to respond by buying bonds. In recent days, they have learned from this error, and stand ready to smooth liquidity conditions in the domestic market as the need arises. Nevertheless, the debate in China must now be strongly focusing on the exchange rate. For years China has resisted international pressure to free up the Renminbi, but now with domestic interest rates becoming volatile the issue is having domestic political and business ramifications.
Faced with the potential for domestic unrest China is quick to respond. The Yuan will be floating freely very soon.