Monday, February 14, 2011

China interest rates: more to come?

Last week’s interest rate rise was the third since October and it is likely there will be more. Inflation, and the control thereof, is the key theme for emerging markets this year.

Recall our post GFC story: growth would be strongest in emerging markets and it would be productive sector led. That would put upward pressure on commodity prices and, given their share in emerging market CPI baskets, inflation. Any lack of commitment on the part of monetary authorities to control inflation would be negative for the economic stability and prosperity in those countries.

China has become the poster child for the emerging market inflation fight, although the battle is being fought on a number of fronts. India tightened monetary conditions six times last year and still posted a China-like 8.9% growth rate for the year to September 2010.

The first tightening in China in October was met with disappointment by global equity markets. At that point the fear was that the US was going into a double-dip (not our view) and that China was providing about the only source of true private sector led demand. Now that US growth is looking more assured, we can take a more medium-term view of China monetary policy: that keeping inflation in check is a good thing and will lead to stable, albeit lower, growth than might have otherwise been the case.

Further interest rate hikes seem inevitable. The borrowing rate has been raised to 6.06%. The pre-GFC high was 7.47% so there is scope to move. The lending rate is 3.0%. With inflation at 5%, that’s a negative real rate, telling people they’re better off spending than saving.

Increases in bank Required Reserve Ratio’s has been an important part of the equation to stem excesses in asset (housing) markets. The RRR has been raised progressively in recent months, with a higher level for larger banks. Late last week China announced new reserve requirements for various city-level commercial banks, but did not announce the specific ratios. This could signal the beginning of a more targeted approach to setting the RRR.

There is a third tool at the disposal of the authorities that they are not yet using enough – an appreciating exchange rate. An appreciation in the CNY lowers the cost of imports. It takes the heat out of inflation and encourages households to buy more imports. It also encourages the necessary shift of resources from the tradeable to non-tradeable sectors. That’s good for China consumers, the China economy and the global economy.