CATO JOURNAL objective, forward-looking assessment of the borrowers creditworthy ness. This objective is not well served by a substantially undervalued RMB An undervalued RMB induces both speculative capital inflows (chasing expected exchange rate appreciation)and a large trade sur- plus. It therefore leads, as has been amply demonstrated over the past three years, to a large accumulation of international reserves. This reserve accumulation in turn--if not countered by specific policy measurescan spill over into an excessively rapid expansion of bank credit (and of the monetary aggregates). And when bank credit ex- pands too fast, the quality of loan decisions almost always suffers, with serious fiscal consequences. China experienced just such a bank credit"blowout"in 2003 and the first part of 2004, when bank credit growth expanded at a 20 percent plus clip and when the ratio of the increase in bank credit to gDP hit a historic high. b while the main driver of that excessive credit expansion may well have been domestic rather than external factors. the external imbalance undeniably made the task of financial policy much more difficult The Chinese authorities were able to regain control over the growth rate of bank credit in 2004-2005--and bank lending growth returned to a more sustainable pre-blowout pace(about 13 percent) But the final tab for the lending excesses of 2003-2004 is likely to b large. Moreover, it was only through the use of both strong admin- istrative controls(on bank lending, investment projects, and land use) and of large-scale sterilization operations that runaway credit growth was contained. Each of these measures carries its own costs. Bank managers and loan officers do not learn much about how to make better credit decisions if the central government steps in to direct the credit allocation process. Moreover, the controls are not well suited to responding in a timely way to changing financing and cyclical condi tions.Indeed, in the first quarter of 2006(after the controls had been eased), the growth of bank credit surged again, with that quarter's increase accounting for approximately half the targeted increase in bank len nding for 2006 as a whole. In a similar vein, although the interest rate on sterilization bonds is relatively low and although the stock of reserves is high relative to the stock of sterilization liabilities ed (since it accelerated in 2005 i In a sign that the People's Bank of China(PBC)has begun to worry again about excessive redit growth, the PBC raised based lending rates by 27 basis points in late April (2006), hile leaving deposit interest rates unchanged.objective, forward-looking assessment of the borrower’s creditworthi￾ness. This objective is not well served by a substantially undervalued RMB. An undervalued RMB induces both speculative capital inflows (chasing expected exchange rate appreciation) and a large trade sur￾plus. It therefore leads, as has been amply demonstrated over the past three years, to a large accumulation of international reserves. This reserve accumulation in turn—if not countered by specific policy measures—can spill over into an excessively rapid expansion of bank credit (and of the monetary aggregates). And when bank credit ex￾pands too fast, the quality of loan decisions almost always suffers, with serious fiscal consequences. China experienced just such a bank credit “blowout” in 2003 and the first part of 2004, when bank credit growth expanded at a 20 percent plus clip and when the ratio of the increase in bank credit to GDP hit a historic high.16 While the main driver of that excessive credit expansion may well have been domestic rather than external factors, the external imbalance undeniably made the task of financial policy much more difficult. The Chinese authorities were able to regain control over the growth rate of bank credit in 2004–2005—and bank lending growth returned to a more sustainable pre-blowout pace (about 13 percent). But the final tab for the lending excesses of 2003–2004 is likely to be large. Moreover, it was only through the use of both strong admin￾istrative controls (on bank lending, investment projects, and land use) and of large-scale sterilization operations that runaway credit growth was contained. Each of these measures carries its own costs. Bank managers and loan officers do not learn much about how to make better credit decisions if the central government steps in to direct the credit allocation process. Moreover, the controls are not well suited to responding in a timely way to changing financing and cyclical condi￾tions. Indeed, in the first quarter of 2006 (after the controls had been eased), the growth of bank credit surged again, with that quarter’s increase accounting for approximately half the targeted increase in bank lending for 2006 as a whole.17 In a similar vein, although the interest rate on sterilization bonds is relatively low and although the stock of reserves is high relative to the stock of sterilization liabilities, 16Simultaneously, inflation rates (for consumer and producer prices) also soared. Those too have since come down significantly. The decline in the growth rate of broad money has been less marked (since it accelerated in 2005). 17In a sign that the People’s Bank of China (PBC) has begun to worry again about excessive credit growth, the PBC raised based lending rates by 27 basis points in late April (2006), while leaving deposit interest rates unchanged. CATO JOURNAL 260