China’s reliance on administrative credit controls and reserve requirements, rather than interest rate adjustments, in setting its monetary policy is becoming increasingly unsustainable.

In 1st half of 2010, the open-market operations of the People’s Bank of China (PBoC) exhibited wild swings, and quirks of the domestic financial system and shifts in global capital flows—not macroeconomic fundamentals—were to blame.

With these trends likely to continue in the medium term, the PBoC’s monetary policy will remain stuck in the traffic caused by pileups in international currency markets and the domestic interbank market. The longer the central bank alternates between hitting the brakes and the gas, the less likely it will be to raise interest rates, which continue to ease in real terms.

After a massive liquidity injection over the past two months, the central bank is set to resume withdrawing liquidity from the interbank market and then, no doubt, put all that liquidity back shortly thereafter.

If this prevents the PBoC from hiking interest rates, inflation and asset prices will be difficult to contain once some administrative measures are loosened in 4th Quarter of 2010.

Bringing The Pieces Together