Since China is so much in the news, it seems useful to understand how the Peoples Bank of China (PBC) operates in the context of Chinese financial markets. The PBC of course has a web site, and this is what its balance sheet looks like. Note that the asset side of the balance sheet is dominated by foreign-currency-denominated assets. About 80% of assets is "foreign exchange," which I'm assuming is mostly US Treasury securities.
Another key feature, on the liabilities side is about 4.7 trillion Yuan (I think I have my units right) in "bond issue." These are PBC bills, which are interest-bearing securities issued by the central bank. The PBC uses PBC bills as part of its fixed-exchange rate strategy. To support an essentially fixed exchange rate with the US, the PBC has had to purchase foreign exchange, and it typically "sterilizes" (strange word - anyone know where this comes from?) this - by issuing PBC bills rather than outside money. Note that the stock of "claims against the government" on the asset side of the balance sheet of about 1.6 trillion Yuan. When operating under a fixed exchange rate, a central bank typically can't sterilize forever, as it runs out of interest-bearing domestic-currency-denominated assets to sell. However, the PBC is not constrained by that bound, as the central bank can issue its own interest-bearing liabilities (PBC bills), which are presumably less liquid than reserves. There are of course issues about sterilization. With well-integrated financial markets this has to be a losing battle, but with China there are enough internal and external financial restrictions that this could work. However, apparently it has not, as most monetary quantities in China are growing at rates in the neighborhood of 20% per annum, and the inflation rate is running at about 3% per year.
Now, as was widely reported yesterday, the PBC "increased interest rates." If you thought this was something equivalent to raising the fed funds rate target (in normal times), you would be wrong. The PBC increased the one-year "deposit rate" and one-year "lending rate," by 25 basis points each, to 2.25% and 5.56%, respectively. As this makes clear, there were related announcements about interest rates on deposits and loans of other maturities, where the rate increases were different. These deposit and loan rates are the interest rates of financial institutions. The banking system in China is dominated by a few state-owned banks, and these PBC-administered interest rates appear to effectively be deposit interest rate ceilings and loan interest rate floors. Interest rates in some financial markets in China are supposedly unregulated, but this piece makes it clear that, for example, interbank lending rates are driven primarily by rates administered by the PBC.
Was the PBC move yesterday a monetary tightening? This is complicated, as we are dealing here with a central bank that is not independent of the government, which also effectively runs much of the financial system. Part of the motivation for the interest rate increases seems to be a kind of disintermediation phenomenon, not unlike what occurred in the 1970s in the United States when there were deposit interest rate ceilings and high inflation. There are few vehicles for saving in China for private individuals, other than savings deposits and housing. Given higher rates of inflation, deposits are earning negative real rates of return, which makes investment in housing look very good. If all interest rates go up, what does this do? Deposits at banks become more attractive and, to the extent the loan interest rate floors are binding, borrowing becomes less attractive. Banks can of course park extra deposits in US Treasury securities. Apparently they do a lot of that already. Presumably the result is a net increase in the demand for outside money, which we would think of as a tightening effect of monetary policy. Currency becomes less attractive and the demand for reserves rises due to binding reserve requirements in China. Ultimately, though, we could think of this as involving no change in the PBC's policy stance, relative to a time when the inflation rate was lower. These changes in administered interest rates can be viewed purely as making the Irving-Fisher adjustments (though probably incompletely) that the market would be making if it were allowed to.