Friday, 20 July 2007

Inflation and interest rates - upward move likely

As China's rapid growth continues inflation is now beginning to rear its head. The solution - to increase interest rates.

What is interesting about this article is the statement from the governor of the central bank saying that China needs to slow investment so that China does not have "too many factories, cutting company profits".

This is remarkable. Econ101 economics would tell that competition leads to a zero profit condition - it firms are making supernormal profits then other firms enter the market. Is the governor suggesting protection for those lucky first movers? One problem is that profits do not always = jobs. If China wants to find jobs for its large population then protecting incumbents is not the way to do it. Moreover, preventing the building of factories will not necessarily slow inflation.

Sure, excessive investment in factories can lead to a serious hangover when the party is over. That is why banks need to have stringent lending policies (which was not the case in the run up to the Asian currency crisis in 1997/1998).

What is true is that inflation is becoming a problem with food prices driving the inflation rate up to 4.4% last month. Pork prices grew a whopping 60%.

What is the solution - the one suggested by Bernanke is to allow the currency to appreciate which would help China become "less export reliant". We have discussed this before - such a move has political ramifications.

See below for selected paragraphs from a Bloomberg article.

China Likely to Raise Rates This Quarter, Maybe Today[Bloomberg]

China is likely to raise interest rates this quarter to cool inflation and investment after the economy grew at the fastest pace in more than 12 years, a survey showed. Some economists expect an increase today.

The benchmark one-year lending rate will rise to at least 6.75 percent from 6.57 percent, according to 20 of 21 economists surveyed by Bloomberg News after the release of second-quarter data. One economist expects a 9 basis point increase. The deposit rate will probably climb to 3.33 percent from 3.06 percent.

Central bank Governor Zhou Xiaochuan wants to cool investment that threatens to leave the nation with too many factories, cutting company profits. The world's fourth-largest economy grew 11.9 percent in the second quarter and inflation rose in June to the highest in almost three years.

Inflation accelerated to 4.4 percent last month as food costs soared. Meat prices climbed 36 percent from a year earlier and the cost of pork jumped 60 percent because of a pig shortage.

Record trade surpluses are pumping cash into the economy and have pushed the nation's foreign-currency reserves to a record $1.3 trillion. China exported $112.5 billion more than it imported in the first half, up 84 percent from a year earlier.

Federal Reserve Chairman Ben S. Bernanke said yesterday that faster currency appreciation would help China's economy to move away from being ``too oriented towards exports, not enough toward home markets.''

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