For much of the past year, China’s policymakers have been grappling with how to temper sharply rising asset and consumer prices and dampen the ill-effects of an unprecedented economic stimulus following the global financial crisis – without torpedoing strong economic growth.
China first set about reining in credit in April 2010, following a record RMB12.2 trillion surge in bank lending since the start of 2009. With M1 growth at 30%, M2 growth well above 20%, and a double-digit surge in urban house prices, authorities rolled out measures including: a clampdown on mortgage lending; a series of reserve requirement ratio (RRR) hikes; and orders to banks to slow credit to property developers and to sectors suffering from overcapacity.
The People’s Bank of China (PBoC) initially kept interest rates on hold. But a spike in consumer prices, driven largely by food prices, forced an increase in benchmark lending and deposit rates last October. The central bank has since raised rates three more times, most recently, at the time of writing, a 25 basis-point hike on April 6, and announced further increases to banks’ RRR, most recently to a record 20.5% on April 18.
Yet despite these measures, inflation concerns remain, prompting the government to stress that tackling inflation is now its No. 1 priority. The question vexing many analysts is whether China’s variegated approach to credit tightening and inflation fighting will succeed without sharply slowing growth.
TAKEN BY SURPRISE
Authorities appeared caught off guard by the sudden surge in inflation from late last summer. “The Chinese government were taken by surprise at the jump in CPI back in October and November – all of us were,” says Andy Rothman, chief China macro strategist at independent brokerage firm CLSA.
Poor harvests led to a spike in food prices in the second half of 2010. It was no coincidence that the central bank announced its first rate hike two days before September numbers were released, showing a sharp acceleration in the food component of CPI. Food price inflation hit double digits the following month, and continued to rise for the remainder of the year.
EFFECTIVE RESPONSE?
Authorities drew fire from many analysts at the end of last year for using RRR as the main policy tool, even though, at the time, inflationary pressures seemed largely concentrated in food. But as inflation expectations gathered pace, three rate hikes this year have blunted some of this criticism. While interest rates remain at roughly half the level of the previous 2007–8 inflationary peak, headline inflation rates are also around 50% below pre-crisis heights.
Rothman believes Chinese policymakers have responded “quickly and in a rational way”. While food prices have continued to rise, initial reports suggest substantial new planting acreage of key crops, which should help to lower food prices in coming months, Rothman notes. In addition, bank lending and money supply growth have slowed in the first quarter of this year. New bank lending fell 13% year-on-year in Q1, while M2 growth was 16.6% in March, down from almost 20% in 2010. Both have returned to pre-crisis growth levels.
'NOT A RATE-SENSITIVE ECONOMY'
The fact that Chinese tightening efforts appear to be having an effect while interest rates remain more than 100 basis points below the pre-crisis historical average has been taken by some as evidence that interest rates are not an effective policy tool in China.
“Raising rates is not that effective in influencing investment decisions in China, because interest rates remain lower than the opportunities for potential growth and returns,” says Wang Qinwei, China economist at Capital Economics.
Rothman says interest rates are only effective in China in managing inflation expectations, and the latest PBoC survey showed those expectations declining. The central bank’s Q1 inflation survey found that 47.1% of the public surveyed expected that prices would increase in the coming quarter, down from 61.4% at the end of Q4 10.
RELUCTANCE TO RAISE RATES
But some say China’s relative reluctance to use interest rates to tighten monetary policy stems from overriding concerns about currency appreciation and local government indebtedness.
On this view, raising rates would put unwanted upward pressure on the exchange rate while constraining the ability of already overstretched local governments to meet their debt obligations, which Northwestern University academic Victor Shih estimates at RMB1 trillion a year.
“On interest rates, the effort hasn’t been as great as you would expect given the level of inflation, and the reason is because the state is the largest debtor,” Shih says.
The chief result of this approach, he says, has been low deposit rates, and thus negative real interest rates, which have eroded household incomes and increased the appeal of speculative investments such as real estate, in turn undermining government attempts to cool property prices.
“Wealthy Chinese don’t have the option of putting money in the bank as they will lose purchasing power over time, so they are constantly looking for ways to beat inflation,” Shih says. “In the short term, many have looked to real estate, first in Beijing and Shanghai, then in second-tier, third-tier and smaller cities, driving up prices.”
PROPERTY CONCERNS
In fact, while most economists believe that headline inflation is now largely under control, authorities are having a harder time keeping the lid on property prices.
“The idea that you can keep real interest rates low and use bank regulations to stop house prices going up is a curious response,” says Michael Spencer, chief Asia economist at Deutsche Bank. “Property prices are still too high, and even where we’ve seen price falls, they’ve been miniscule.”
Residential property prices in most major cities have stabilized or in some cases fallen over the past 12 months following numerous restrictions, while transaction volumes have fallen significantly. But given negative real interest rates and continued strong demand, the fear is that property prices could again surge if restrictions are relaxed in any way. “The government is putting a lot of effort into containing house prices in a market where the fundamental drivers are likely to continue to increase house prices over the medium term,” says Louis Kuijs, senior economist at the World Bank’s China office.
“There is a danger that central banks lose control of managing inflation expectations through their housing policies, or that at some point the central bank will have to start hiking rates aggressively to curb house prices,” says Spencer.
But the link between house prices and inflation expectations is less clear: Rothman, for one, says that house prices have no real impact on broad inflation expectations in China because relatively few people can afford new houses.
Nevertheless, high house prices and the drop in home sales over the past year following new restrictions have driven up rents, which factors directly into China’s consumer inflation basket; and to that end property policies do factor into inflation.
Average rents in a number of major cities have shown double-digit growth over the past year according to both official and unofficial data, which drove the housing component of CPI up 6.6% year-on-year in March 2011.
According to Shih, if the government introduces further administrative measures and drives down property prices, it could prompt significant capital outflows from wealthy Chinese, who would find all inflation-beating investment channels closed off domestically. “There is a genuine risk of large outflows,” he says.
Kuijs, meanwhile, warns that a slowdown in sales, housing starts and construction could lead to a significant slowdown in economic activity, given the importance of property to the overall economy. “Property is the area in the macro sphere in which I see the largest risks,” he adds.
OUTLOOK
Most economists expect that, barring further unforeseen food price shocks, headline CPI inflation should start to moderate in the coming months as food prices abate and non-food inflation stays muted. Non-food inflation in China has to date shown little sign of picking up – despite rising rents, it stood at 2.5% in Q1.
As a result, an increasing number of analysts think further tightening – and a hard landing for the economy – is unlikely. “Pressure for monetary tightening should taper off in the coming few months,” Jun Ma, a Hong Kong-based economist at Deutsche Bank, wrote in a recent research note. “The risk of an economic hard landing as a result of policy over-tightening will decline.”
ING, Standard Chartered, Deutsche Bank and HSBC predict just one further 25 basis-point rate hike this year, while Capital Economics does not expect any further rate rises.
“We’re basically at the end of the tightening process, but it’s a misnomer to call it a tightening process because it’s more a process of monetary policy normalization, and policymakers don’t need to tighten beyond normalization,” says Rothman.
Others warn that while headline inflation should begin to moderate, credit and liquidity growth remain strong and will necessitate further administrative tightening by the authorities.
Jonathan Anderson, an economist at UBS, noted in a recent research note that although the issuing of formal bank loans has slowed, many banks have found alternative ways to lend, latterly through bank acceptances and corporate notes and bonds. With each administrative measure that the PBoC and China Banking Regulatory Commission take, banks look to find alternative means, meaning that credit growth continues to be higher than the authorities would wish, and necessitating a clampdown on these alternative means of financing by the authorities.
In addition, with a large volume of central bank notes due to mature in the coming months, and continued evidence of capital inflows, Capital Economics’ Wang believes that the central bank will need to continue hiking the RRR to absorb the excess.
Significant liquidity, credit and asset-price risks persist, and the policy course in the coming months is likely to remain treacherous. But, to date, policymakers appear to be keeping their balance.