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BEIJING.
Inflation is proving a tougher foe than the Chinese government imagined and, as that realisation sinks in, risks are tilting towards more aggressive monetary tightening than investors expected.
So far, markets have been little perturbed by Tuesday’s interest rate increase, Beijing’s third since October, seeing it as just another small step in an incremental campaign aimed at reining in prices without unduly harming growth.
They are in danger of underplaying both the build-up of price pressures in China and the determination of officials, sensitive to inflation’s historic role as a cause of political unrest in the country, to regain control.
“It’s begun to sink in for policymakers how serious inflation and the property bubble are. Over the last month or two, there has been a lot of soul searching about how to normalise policies as quickly as possible,” said Isaac Meng, economist with BNP Paribas in Beijing.
A glance at the forecasting record of China-focused economists shows how investors have consistently under-estimated the severity of tightening, a pattern that appears to be repeating itself.
At the start of last October, the consensus prediction of analysts was that China would wait until the second quarter this year to raise benchmark rates. But just a few weeks later, it surprised with an increase.
At the start of December, the dominant view was that China would lift rates by a total of 75 basis points by the end of 2011. But the government has already raised rates by 50 basis points and there are still 11 months to go in the year.
Indeed, economists now see 50 basis points of further tightening before the end of the year, according to a Reuters poll conducted yesterday after the latest rate rise.
That median forecast could again wind up being too low, failing to register a change of tune in Beijing.
Chinese officials have in recent months expressed concern about raising rates too quickly, contending that higher rates would be counter-productive, attracting hot money inflows and so adding to the excessive liquidity at the root of rising inflation.
But Jianguang Shen, an economist with Mizuho Securities in Hong Kong, noted that a jump in inflation at the start of this year was shifting the terms of the debate.
“The central bank’s decision to raise rates may represent the required change of view towards more aggressive rate hikes,” he said.
Although annual inflation slowed to 4,6 percent in December, analysts polled by Reuters expect data next week to show it picked up to 5,3 percent in January, the fastest pace in more than two years.
In the latest rate rises announced on Tuesday, the central bank increased benchmark one-year deposit rates by 25 basis points to 3 percent and one-year lending rates by a similar amount to 6,06 percent.
Global investors have taken the increase in their stride. The Dow Jones industrial average notched a seventh straight day of gains and commodities markets, hit initially, soon rebounded, judging that the move was too small to weaken China’s voracious demand for raw materials.
As is its policy custom, China leaned most heavily on administrative measures in its tightening over the past year, ordering state-owned banks to lend less and forcing them seven times to lock up more of their deposits as required reserves.
Although it is too early to declare that Beijing has settled on a new model, its policy mix does appear to be changing somewhat. Since late December, the central bank has raised interest rates twice and required reserves only once.
“Required reserve ratio hikes and administrative interventions cannot substitute for rate adjustments in containing inflation expectations,” Shen Minggao, Citigroup’s chief China economist, said in a note to clients.
Despite this week’s interest rate increase, real deposit rates are still deep into negative territory.
As inflation erodes the value of their bank savings, households are looking to preserve wealth via other assets. The property market, which the government has been trying to cool for the better part of a year, beckons as the favourite alternative.
Looking to entice savers to keep cash in banks, Beijing has made long-term deposits more attractive. While raising benchmark one-year deposit rates by 75 basis points since October, the central bank has raised the five-year tenor by 140 basis points.
But this layered approach to interest rates will only be helpful at the margins. Deposits with terms of five                 years or more account for a mere 0,1 percent of all               bank savings, while demand deposits, which can be withdrawn at any time, make up about 50 percent, bank analysts say.
And even if the central bank does raise benchmark rates quite sharply, the nature of the state-directed financial system in China means that the volume of credit is a far more important determinant of monetary conditions than the price of credit.
On that count, Tao Wang, chief China economist with UBS, said that a likely 7 trillion yuan (US$1,1 trillion) in new lending this year would be too much.
“The rate hikes may be ahead of what the market expects, but I still think the central bank is falling behind the curve in terms of inflation and the economy,” she said. “What I would consider aggressive is if the government suddenly tightens the credit target and stops approving new projects.” — Reuters.