Policy considerations

Conquering The Coming Collapse

Conquering The Coming Collapse

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Policy outlooks could be very uncertain in an economic environment in which growth slows but inflation rises. Policymakers might become more hawkish when inflation becomes a prominent risk but might turn more dovish when there is significant pressure on growth. We need to have a good understanding of several critical questions in order to gauge the likely policy trend in the coming year.

First, is China's inflation a temporary price adjustment or more structural in nature? Policy actions should be more restrained if it's the former but can be more aggressive if it's the latter. The official documents so far still use the phrase 'structural price increases'. I am sympathetic to the view that this round of inflation was triggered initially by food prices, but almost every major episode of high inflation during the reform period began with rising food prices. With loose monetary conditions, the effects of increases in food prices could spread quickly to other sectors. Tightening of monetary policy should therefore continue in order to control inflation.

Second, is the Chinese economy overheating? Many economists attribute rising inflation to such a problem. Real GDP growth averaged more than 10 per cent during the past five years and reached 11.9 per cent in 2007. High growth does not, however, necessarily equate with overheating. Overheating occurs only when the economy grows at a pace faster than domestic resources can support. China recorded current account surpluses for 14 consecutive years. In 2007, the current account surplus reached 10.8 per cent of GDP. This means that China saved domestic resources for investment overseas; therefore, China's inflation risk probably stems mainly from the liquidity condition instead of the overheating problem.

Third, will the US slow-down drag down the Chinese economy significantly? In the case of a deep and protracted US recession, China's exports could suffer badly. This might not only slow economic growth, it could create serious overcapacity problems in China, which would, in turn, ease China's inflationary pressure. Although the US economy still faces significant uncertainty, its near-term outlook has improved compared with two months ago. This should help limit the downside risks for the Chinese economy.

Finally, will the Olympic Games be an obstacle to the tightening policy? Economists have come to agree that the boom and bust cycle associated with the Olympic Games, often observed in many countries, might not materialise in China. The games could, however, still serve as an important psychological factor for investors and policymakers. While it is unlikely to stop the tightening policies if inflation remains a major macroeconomic risk, policymakers will probably be cautious in determining the timing of such policies. Decisive policies are therefore more likely to be implemented after the games than before them.

China began its current round of tightening policy in early 2007, when the People's Bank of China (PBC) first raised its base policy rates by 27 basis points. In subsequent months, the PBC hiked its policy rates another five times (Figure 2.8). Meanwhile, the central bank also adopted a series of measures to directly manage the liquidity conditions, including reserve requirements, open market operations and credit control.

The focus of the tightening policies probably shifted recently. The PBC has not hiked its policy rate since the beginning of 2008; it has, however, stepped up efforts to control liquidity. By the end of June 2008, the commercial banks'

reserve requirement had reached 17.5 per cent. Direct credit control also began to affect commercial banks' loan growth (Figure 2.9). According to the PBC, the real average lending rate rose to more than 9 per cent in the second quarter of 2008, compared with about 8 per cent at the end of the year and the base lending rate of 7.47 per cent.

The effects of the tightening measures on broad liquidity conditions have been less than clear. The simple excess liquidity indicator—subtracting the growth of industrial production from the growth of broad money (M2)—suggests that the liquidity conditions probably loosened again from the beginning of 2008 (Figure 2.9). This probably confirms that the central bank is still lagging behind the market. More importantly, it likely reflects the burdens created by massive capital inflows.

Unfortunately, no one can satisfactorily explain the nature and composition of capital inflows. Between January and April 2008, foreign exchange reserves rose by US$228 billion, while the sum of the trade surplus and utilised foreign direct investment explained only US$93 billion (Figure 2.10). Some economists attribute the gap between the two to 'hot money'. Hot money is, however, probably not the proper term to describe recent increases in capital inflow,

Figure 2.8 Central bank benchmark lending rate and commercial bank base lending rate, January 1991-May 2008 (per cent)

Central bank benchmark lending rate

Bank base lending rate

Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07

Sources: CEIC Data Company and Citi.

Figure 2.9 Excess liquidity and bank credit, January 1998-May 2008

(per cent per year/year)

Excessliquidity (Left)

Bank credit (Right)

Jan-00

Jan-02

Jan-04

Jan-06

Excessliquidity (Left)

Bank credit (Right)

Jan-00

Jan-02

Jan-04

Jan-06

Jan-08

Jan-08

Sources: CEIC Data Company and Citi.

Figure 2.10 Monthly increase in foreign reserves, the trade surplus and utilised foreign direct investment, January 2007-May 2008

Increasein reserves

Tradesurplusplusutilised foreigndirectinvestment

Increasein reserves

Tradesurplusplusutilised foreigndirectinvestment

Jan-07

Apr-07

Jul-07

0ct-07

Jan-08

Apr-08

Jan-07

Apr-07

Jul-07

0ct-07

Jan-08

Apr-08

Sources: CEIC Data Company and Citi.

Figure 2.11 The renminbi's nominal effective exchange rate and bilateral exchange rate against the US dollar, October 2006-June 2008

1.10

1.05

1.00

0.95

0.90

RMBnominaleffective exchangerate(left) RMB/US$ (right)

Figure 2.11 The renminbi's nominal effective exchange rate and bilateral exchange rate against the US dollar, October 2006-June 2008

RMBnominaleffective exchangerate(left) RMB/US$ (right)

1.05

1.00

0.95

0.90

31-0ct-06 23-Jan-07 17-Apr-07 10-Jul-07 2-0ct-07 25-Dec-07 18-Mar-08 10-Jun-08

31-0ct-06 23-Jan-07 17-Apr-07 10-Jul-07 2-0ct-07 25-Dec-07 18-Mar-08 10-Jun-08

Sources: CEIC Data Company and Citi.

Figure 2.12 Shanghai A share stock-market: PE ratio and index, January 2001 - May 2008

Figure 2.12 Shanghai A share stock-market: PE ratio and index, January 2001 - May 2008

r 7,000

1-Jan-01

27-May-02 20-0ct-03 14-Mar-05 7-Aug-06 31-Dec-07

r 7,000

1-Jan-01

27-May-02 20-0ct-03 14-Mar-05 7-Aug-06 31-Dec-07

Sources: CEIC Data Company and Citi.

as much of it will likely stay within China for relatively long periods. There is, however, no denying that capital inflows surged in recent months.

There were probably many reasons why capital inflows increased dramatically during the past months. One reason could be the financial crisis in the United States. In a volatile international capital market, China becomes a safe heaven. Another reason might be the rapid appreciation of the renminbi, which encouraged expectations of more currency gains in the near future. During the first quarter of 2008, the annualised monthly pace of the renminbi's appreciation against the US dollar averaged 15-20 per cent—the fastest pace since the exchange rate policy reform in July 2005 (Figure 2.11). In April, this pace decelerated sharply to about zero, before picking up again to about 10 per cent in early June.

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