Tuesday, December 28, 2010

China tightens

China raised interest rates on Christmas day with the benchmark lending rate raised 25bps to 5.81% and the deposit rate also raised 25bps to 2.75%.

We expect monetary conditions in China to tighten further over the course of 2011, with most of the work likely to occur in the first half of the year. The battle will be faught on three fronts -further increases in the required reserve ratio, further appreciation in the Yuan and further increases in benchmark interest rates. The benchmark lending rate is still 166bps below the rate that prevailed before the onset of the GFC, so there is plenty of upside relative to recent history.

This is the right course of action for China to take. As we have said on many occassions, we prefer the People's Bank of China to tackle inflation head-on. The consequence is lower growth, but we would prefer lower, stable growth to boom and bust. Growth indicators in China are still strong, so the inflation battle is being faught from a high-growth base.

The likely course of monetary policy next year in China highlights the differing challenges in 2011 between emerging and developed economies. In emerging economies the challenge will be to slow down overheating economies and keep inflation in check. The challenge in developed markets will continue to be the weakness of domestic demand, persistently high unemployment as economic growth remains insufficient to dent unemployment and inflation that remains too low for comfort.