For a government as famously wary of high inflation as China’s, the 5.1% rise in the consumer price index (CPI) in November – the highest rate in more than two years, and well above the full-year target of 3% – was an unwelcome development. Rising prices were mostly driven by higher food costs, but they nonetheless raised new questions about the appropriateness of Beijing’s loose monetary policy.
A response came at a meeting of the Politburo in December. The body announced that China would move from a “moderately loose” policy to a “prudent” one, and that economic planning would be “more targeted, flexible and effective” in the coming year.
The statement was made prior to the annual Central Economic Work Conference, chaired by President Hu Jintao, which outlined China’s economic policy goal for 2011 as one that will “maintain growth, restructure the economy, and tame inflation.”
As growth exceeds Beijing’s targets – third-quarter GDP growth hit 9.6% – pressure is rising on economic planners to curtail new loan issuance. The trick is to make the necessary adjustments to monetary policy to sustain economic expansion without causing overheating. There is some disagreement, however, over what this loan target should be.
“What we’re looking at is the impact on inflation and economic stability,” Moody’s Senior Vice President Tom Byrne told China Economic Review. “I don’t know exactly what quantum of loans is best, but anything at the lower range of loan growth would probably be best given the mass of credit expansion accumulated over the past two years.”
Initial estimates based on comments from the People’s Bank of China (PBoC) put the loan issuance target for 2011 at US$1.05-1.20 trillion. State media have reported figures around US$1.125 trillion, approximately the same level as 2010. These high estimates are causing some concern.
“The mainland press reported RMB7.5 trillion (US$1.125 trillion) in new loans – this is too high,” said Liu Ligang, head of China economic research at ANZ (ANZ.ASX) in Hong Kong. “If this were to be true, inflation will be a huge problem in 2011.”
But as Bank of America Merrill Lynch (BoAML; BAC.NYSE) economist Lu Ting noted in a recent report, while strong money supply growth is a driver of higher inflation, it is not necessarily the only factor. “Money supply is the bullet, but we still need triggers to deliver inflation,” Lu said.
He points to two significant factors that could be singled out as these triggers: a rapid rise in average wages, particularly those paid to migrant workers as the labor supply shrinks, and higher inflation expectations after the second round of quantitative easing in the US. “We don’t think growth overheating is a cause of the current level of inflation,” Lu said.
Neither, apparently, does Beijing.
While inflation is a cause for concern, officials realize that one of the core drivers over the second half was soaring food prices. Harsh weather conditions throughout 2010 caused a shortage in supply, which in turn triggered higher produce prices. Acccording to brokerage CLSA, rising food prices, particularly of fresh fruits and vegetables, accounted for 75% of the rise in CPI.
In the near-term, bad weather conditions over the winter are likely to continue to affect agricultural production, which could push inflationary expectations higher. To guard against this, Beijing has capped price growth, introduced toll exemptions for food transportation and released food from national reserves to raise supply levels.
Hikes in reserve requirements – the proportion of loans banks must keep in reserve – and interest rates will no doubt help slow the velocity of money growth. However, these moves may have a limited effect on taming inflationary expectations in the near term. Beijing will be hoping that their effectiveness is bolstered by its announced changes in monetary policy.
The government has said it will take a more “prudent” policy line in 2011, but exactly what this entails is so far unclear. Some suggest that the lack of clarity, particularly in setting out guidance on new loan issuance, shows less a laxity on Beijing’s part than a confidence in where the economy is headed.
“Maybe the apparent lack of urgency shows that behind the scenes Beijing knows the budget is under control, tax revenues are going up, they have a small fiscal deficit, and the current account is in surplus,” said Moody’s Byrne.
“They probably also remember that they won’t get that inflation spike like back in 2008 when oil prices went up to US$150 a barrel, so they can tolerate a little more inflation.’
While Beijing appears reluctant to curb loan growth altogether, it has pursued tightening in other ways. The People’s Bank of China lifted the reserve requirement ratio for most banks three times in December to around 19%, locking up an additional US$27 billion of cash and effectively limiting lending.
In late December, speculation was continuing to grow about further interest rate hikes to add to a 25-basis point hike in October, the first in nearly three years. However, that hike did little to stand in the way of a high CPI in November, and many economists have expressed doubts about the effectiveness of further rate hikes alone in addressing inflation.
Qiao Hong, chief China economist at Goldman Sachs (GS.NYSE) sees a combination of policy tools as the way forward to ease inflationary pressures.
“In our view, policy tightening will gradually kick in and likely include up to three interest rate hikes, intensified credit control, reserve requirement ratio hikes, and liquidity absorption through open market operations in the first half,” Qiao said. “If we take into account off-balance sheet borrowing, which will likely be restricted, credit tightening in 2011 will be even greater that the official loan growth suggests,” she said.
Greater, perhaps, but Beijing will not want to cut off cash flow if it is to maintain its 8% target for GDP growth.
“If the government doesn’t begin to tighten when inflation goes beyond 5%, then I think we’d become a little more concerned over whether macroeconomic stability can be assured,” said Moody’s Byrne.
“But they can’t go cold turkey on lending,” he added. “That would just make things worse.”