SERIOUS MONEY:China is in a bind over inflation. Exchange rate policy means that conventional monetary policy is severely restricted
DENG XIAOPING, the late paramount leader of China, famously declared three decades ago that "to get rich is glorious" and his words seemed apt last year as phenomenal wealth seemed available to all via the Middle Kingdom's red-hot stock market.
The market's resilience last autumn in the face of the United States' growing credit crisis saw experts both here and elsewhere allege that China had come of age and was impervious to the crisis emerging in the West. The expert opinion, based as it was on just one single observation, proved decidedly naive as continued market turbulence coupled with a growing domestic inflation problem caused Chinese stocks to buckle. They have since more than halved from their all-time highs last October and continue to fall.
Inflation reached an 11-year high of almost 5 per cent in 2007 and data in the year-to-date has been less than encouraging. Consumer price inflation rose to 8 per cent in the first quarter, almost 1.5 percentage points higher than the fourth quarter of 2007, while more recent numbers remain uncomfortably high.
The bulls will undoubtedly point to surging food prices as the primary culprit behind the deteriorating inflation trend and this is true but only because a substantial element of non-food prices is under government control. The fact of the matter is that five years of above-trend growth has contributed to capacity pressures alongside rising unit labour costs. The inflation problem has become a very real cause for concern.
The Chinese authorities have declared that fighting inflation is their number one priority and the People's Bank of China (PBOC) has followed up such remarks with increasingly aggressive action. Reserve requirements were raised earlier this month for the fifth time this year to 17½ per cent, a rise of 10 percentage points in two years.
However, reserve requirements have been relatively ineffective in reining in money supply growth as the commercial banks have consistently held reserves in excess of that required by the central bank.
Excess reserves have fallen to an historic low at less than 2 per cent of deposits but the banks still have sufficient liquidity to grow their loan books in spite of the central bank's actions. Indeed, lending growth remains strong and the banks are set to exceed their full-year credit quota once again with little fear of credible punishment from the central bank. Foreign exchange lending continues to accelerate, adding fuel to the fire.
Reserve requirements have become the PBOC's primary policy tool due to the complications caused by exchange rate policy. China's quasi-fixed exchange rate vis-a-vis the dollar compromises monetary policy independence and the central bank's ability to slow the economy through conventional means. Interest rates cannot be raised significantly because the resulting capital inflows would place further upward pressure on the currency. That would require acceleration in the rate of reserve accumulation as well as substantial sterilisation operations to prevent a sharp increase in the money supply and consequent growing inflationary pressures.
China's exchange rate policy means that interest rates are determined more by the Federal Reserve in Washington than the PBOC in Beijing. Indeed, rate increases during the current tightening cycle have been far too small to raise the real price of capital to a meaningful level for an economy that is experiencing double-digit growth.
Aggressive easing in the US has complicated matters even further and, not surprisingly, the PBOC has been forced to keep interest rates on hold so as to keep the already attractive rate differentials in check. Unfortunately, real lending rates are now in negative territory while deposit rates have been negative for more than a year and reached four percentage points below zero in recent months. Negative lending rates are hardly an effective means in containing loan growth while theory instructs that negative deposit rates will lower the demand for money, which makes the PBOC's job even more difficult as money supply growth needs to be slowed even further.
Monetary policy has proved largely ineffective in dampening inflation pressures but administrative price controls have kept non-food price inflation in check. Unfortunately, this is largely superficial. History demonstrates convincingly that price controls typically fail to contain inflationary pressures and usually result in higher inflation expectations via reduced supply and buoyant demand. Price controls deter an effective supply response and motivate producers to keep product off the market rather than sell at artificially low prices while consumers are encouraged to accumulate inventories of cheap goods. The result is heightened inflation expectations as happened in the US in the early 1970s.
The Chinese authorities are in a bind when it comes to addressing inflation. Current policy tools are ineffective while exchange rate policy means that the use of conventional monetary policy is severely restricted.
Perhaps most worryingly, the authorities seem to have lost control of the money supply. The rate of foreign exchange reserve accumulation has jumped from $40 billion per month in 2007 to more than $70 billion through April, the bulk of which can no longer be explained by the current and capital account surpluses. Speculative flows are clearly finding their way into China and thwarting the PBOC's attempts to control the money supply. The PBOC needs to slow growth meaningfully below 10 per cent in order to contain inflation but it is running out of effective policy tools while hot money is aggravating its difficulties.
The only sensible tool left is the exchange rate and a once-off revaluation of sufficient size to deter further speculation. Unfortunately, it is hard to see the Chinese taking such action in the near term so inflation concerns will persist and consequently, the bull market's return is nowhere in sight.
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