SERIOUS MONEY:STOCK MARKETS in the western world's advanced economies continue to record new cycle highs, primarily as a result of the policies implemented by the Federal Reserve, but equity values in the East's Middle Kingdom have dropped more than 10 per cent since the architects of state-directed capitalism launched an offensive on rising inflationary pressures late last year, writes CHARLIE FELL
The extremely accommodative monetary policy that commenced during the autumn of 2008 in response to the negative economic shock delivered by the global financial crisis is no longer considered appropriate, and the Politburo of the Communist Party recently ratified a transition in policy from “moderately loose” to “prudent”.
The Chinese authorities face an uphill task to reduce excess liquidity and ease inflationary pressures for the second time in three years. During the tightening campaign of 2007 and 2008, the People’s Bank of China lifted the banking sector’s reserve requirement ratio by eight percentage points to 17½ per cent and implemented a 135-basis point increase in benchmark lending rates. Yet, despite the aggressive measures, the central bank only narrowly succeeded in maintaining control of the money supply – and then only as a result of the global financial crisis. Fast forward to today and the People’s Bank of China may not get so lucky.
Inflationary pressures continue to intensify and consumer price inflation (CPI) has already jumped from less than 2 per cent year-on-year in late-2009 to more than 5 per cent last November, a 28-month high. Food price inflation already exceeds 10 per cent with little sign of retreat but unlike 2007 – when disruptions in the food supply chain, primarily blue-ear disease and the resulting surge in pork prices, were the primary culprit behind the acceleration in the inflation rate – the uptick this time round is also apparent in non-food prices.
The primary factor behind the rise in inflation during the current episode is a surge in the money supply. M1 growth accelerated from 9 per cent year-on-year in December 2008 to 32 per cent a year later and peaked at 39 per cent last January. In spite of a series of measures, including a 3½ percentage point increase in the required reserve ratio to a record 19 per cent alongside a half percentage point hike in benchmark interest rates, M1 growth is still running close to 20 per cent year-on-year. This is several percentage points above the rate consistent with high single-digit growth in real output.
Year-on-year growth in M1 exhibits a strong correlation with CPI, with a six to 12-month lag, and the relationship suggests monthly CPI could peak at 7 per cent year-on-year during the first half of 2011. This observation is corroborated by the People’s Bank of China’s most recent survey of depositors, which indicates their expectations are consistent with consumer price inflation of more than 6 per cent next year. The government acknowledged it is unlikely to meet its official inflation target of 3 per cent for 2010 and, in recognition that average prices will continue to trend higher, the Chinese authorities have been forced to raise the inflation target for this year to 4 per cent. However, given CPI could easily average more than 5 per cent during the first half of the current calendar year, it is clear the bank has much work to do to meet next year’s target. However its efforts will be constrained by its exchange rate policy and complicated even further by the Federal Reserve’s quantitative easing.
China’s quasi-fixed exchange rate vis-à-vis the US 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, which would then require acceleration in the rate of reserve accumulation and substantial sterilisation operations to prevent a sharp increase in the money supply and growing inflationary pressures thereof.
China’s exchange rate policy means interest rates are determined more by the Federal Reserve in Washington than the People’s Bank of China in Beijing. This means the banking sector’s reserve requirement ratio has become the primary policy tool to mop up speculative capital inflows and reduce excess liquidity. Indeed, the negligible increase in interest rates so far is nowhere near sufficient to ease price pressures, as both deposit and lending rates are below expectations of future inflation and thus negative in real terms.
Speculative capital inflows are already thwarting the People’s Bank of China’s efforts to control the money supply and quantitative easing in the US has added fuel to the fire. The rate of foreign exchange reserve accumulation remained relatively constant at $65-$66 billion per month during last year’s third and fourth quarters, but it is of some concern speculative inflows jumped from less than $16 billion per month in the autumn to more than $60 billion per month during the final three months of the year.
The Chinese authorities face a difficult task in 2011, as inflationary pressures threaten to undermine social cohesion, while the available policy actions are restricted by current exchange rate policy. It is quite clear the tightening cycle in the Middle Kingdom deserves close scrutiny in the year ahead.
charliefell.com
