China rates now down to 5.31%

Update on the interest rate in China.

In my opinion it has a lot further to go and the disappoint is expected. China is still learning and this gradual approach is fine for now. The millions of savers will be unhappy with every rate cut.

What is interesting is that the FT even get the phrase "social stability" into the journalist "key" first line. Otherwise this article is a good example of padding an article to make it longer than 1 line which was really all that was needed.

China cuts rates further to 5.31% [FT]

China cut interest rates for the fifth time in three months as the government tried to pump money into the economy to restore the high growth rates it considers crucial for social stability.

The benchmark one-year lending rate was cut on Monday by 27 basis points to 5.31 per cent, while the one-year deposit rate was lowered by the same amount to 2.25 per cent.

The People’s Bank of China, the central bank, also reduced the amount of money banks must hold in reserve by cutting the required reserve ratio by 50 basis points, a move that analysts say will release Rmb300bn ($43.8bn) for the banks to lend.

Faced with a much more severe slowdown than anticipated, China’s leaders have moved quickly in recent weeks to shore up crumbling growth, announcing a series of fiscal stimulus initiatives and infrastructure projects.

“Monetary policy is now all about freeing up funds to be lent into government-backed investment projects,” said Stephen Green, head of China research at Standard Chartered.

“For every Rmb1 of central and local government spending, Beijing is hoping for an additional Rmb1 from others and it is the banks that will be expected to provide that financing.”

The government has made employment for millions of recent university graduates and workers laid off from export-intensive industries its top priority and has ordered all levels of government and industry to take all necessary steps to “ensure 8 per cent growth” next year.

GDP growth fell from 11.9 per cent for the whole of last year to 9 per cent in the third quarter and more pessimistic forecasters, such as Royal Bank of Scotland, put growth at 5 per cent for the whole of next year.

.

The Impact of Chinese Monetary Policy Shocks on East Asia

A recent working paper from the Bank of Finland (who write a surprisingly large amount of papers on China for a northern European central bank) looking at the impact of Chinese monetary policy on the rest of Asia.

The conclusions are unsurprising I am not not a fan of SVAR models myself but it might interest some.

The Impact of Chinese Monetary Policy Shocks on East Asia [SSRN]

TOMASZ J. KOZLUK
Organisation for Economic Co-operation and Development
AARON N. MEHROTRA
Bank of Finland - Institute for Economies in Transition (BOFIT); European University Institute - Economics Department (ECO) April 25, 2008

BOFIT Discussion Paper No. 5/2008

Abstract:
We study the effects of Chinese monetary policy shocks on China's major trading partners in East Asia by estimating structural vector autoregressive (SVAR) models for six economies in the region. We find that a monetary expansion in Mainland China leads to an increase in real GDP (temporary) and the price level (permanent) in a number of economies in our sample, most notably in Hong Kong and the Philippines. The impact could result from intertemporal substitution present in a general equilibrium framework which allows for positive domestic impacts of foreign monetary expansions. Our results emphasize the growing importance of China for its neighboring economies and the significance of Chinese shocks for the design of monetary policy in Asian economies.


Keywords: monetary policy shocks, Asian production chain, SVAR, East Asia, China

JEL Classifications: E52, F42

"Hot Money" in China: the noose tightens

Today the FT reports on China's continuing problem with "hot money". The flows are perceived to be hampering China's attempt to curtail the ever increasing inflationary pressures.

The policy of requiring exporters to park money is a backward development and is more red tape to trade. This is a dangerous move and could even have inflationary ramifications in the West if cheap Chinese goods prove harder to come by.

China to tighten capital controls in clampdown on 'hot money' [FT]

China announced a major strengthening of capital controls last night in an attempt to limit the amount of speculative "hot money" entering the economy and frustrating its efforts to contain inflationary pressures.

In an announcement on its website, the State Administration of Foreign Exchange, the country's foreign exchange regulator, said exporters would be required to park revenues in special accounts while the authorities verified the funds were the result of genuine trade.

The new system risks becoming a cumbersome burden for exporters such as suppliers of cheap goods to western retailers.

Exporters will now be required to provide documentary evidence that their invoices are based on genuine transactions if they wish to change dollars into renminbi. The regulator said the new computer system for checking invoices would be introduced from August 4. A trial period begins on July 14.

Recent leaked figures showed record inflows of capital entering China over the past two months. Officials believe some money came in illegally after companies exaggerated export revenues.

China has become an attractive country for investors and companies because interest rates are now above US levels and the renminbi is expected to appreciate.

According to Reuters, China's foreign exchange reserves increased by a record $114.8bn (£57.6bn) in April and May to $1,800bn. Although it is impossible to calculate how much of that inflow is short-term, speculative capital, the figures were substantially higher than the combined numbers for the trade surplus and foreign direct investment.

The capital inflows have made economic management more difficult because, even though domestic inflation has been high in recent months, the Chinese central bank has been reluctant to raise interest rates for fear of attracting more hot money.

Authorities have so far prevented the inflows from causing money supply to grow too sharply by issuing bonds and lifting bank reserve requirements.

There has been a growing discussion among private sector economists about whether the authorities should introduce a large, one-off appreciation of the currency in order to limit speculation. However, most economists believe that the government would be very reluctant to take such a step as parts of the export sector are already suffering badly because of higher costs, including the stronger renminbi.

.

FDI reversals - high costs leading to fleeing Koreans

After years of spectacular growth in FDI in China the tide might be turning in the face of rapidly increasing costs.

The International Herald Tribune highlight this problem in a recent article. The word of the day is "flee" which gives the impression of a less than orderly exit from the China.

There are two issues here:

1. If China is no longer the cheapest location to produce goods where is? Costs are rising everywhere.

2. The "fleeing" of thousands of factory owners in the face of increased costs merely represents reality kicking in. Rising costs and a US recession mean that easy money can no longer be made and it is merely the least efficient firms going out of business.

What all of this does mean is that prices of consumer goods may well rise in the UK and elsewhere (on top of all the other energy and food related price increases).

Just when the West wants to be cutting interest rates to help with the credit crunch we get inflationary pressures suggesting that the opposite is required.

Interesting times.

Rising costs forcing some South Korean factory owners to flee China [IHT]

Scores of South Korean-owned factories are closing surreptitiously in eastern China as their owners flee rising costs, leaving behind embittered workers like Li Hua.

Li and more than 200 colleagues have been fighting for a year to get the six weeks' wages they were owed when the owner of the toy factory where they worked fled during the 2007 Lunar New Year holidays.

../

Her case is not a rarity in Qingdao, a major seaport and industrial city in eastern China that sits across the Yellow Sea from South Korea. A two-hour flight from Seoul and home to about 100,000 South Koreans, the city is a hub for South Korean factories benefiting from cheap labor.

But lately, a growing number of South Korean factories have abruptly closed down and the South Korean owners have disappeared as a slew of policies, including rising labor costs and an end to tax breaks, bite into their profit margins.

../

Qingdao mirrors, on a smaller scale, what is happening in the Pearl River Delta near Hong Kong. There, thousands of factories, mostly run by Taiwan and Hong Kong companies, are moving inland or abroad or are simply closing as rising costs undermine the assumption that China is the world's cheapest manufacturing location.

US rate cuts puts the PBC under increasing pressure

China's slapdash approach to economic management that has so far appeared to work in spite of the PBC often not seeming to know what it is doing will come under increasing pressure as recession in the US and perhaps the EU gets closer.

The dramatic rate cut of 0.75 points in the US also brings with it problems. Massive Chinese trading losses on exchange rage movements will also anger the Chinese people.

The loss the Chinese will realise on US paper has been inevitable for years. This policy of buying US paper to keep exchange rates low to boost exports was never sustainable. These losses are in many respect a travesty.

This excellent article outlines the technicalities. It also illustrates very clearly that macroeconomics can get complicated very quickly.

US action adds to pressure on China [FT]

The sharp cut in US interest rates has increased the conflicting pressures on Beijing's management of its economy and its simult-aneous efforts to stem potential losses of billions of dollarsin its foreign exchange holdings.

To keep the currency stable, the People's Bank of China buys almost all incoming foreign currency, and then attempts to "sterilise" the monetary impact by issuing renminbi bills to take the funds out of circulation.

The US cut means China's central bank will pay almost 200 basis points more on the bills it issues at home to manage its currency than it will get on purchases of US Treasuries.

The PBoC pays about 4 per cent on its so-called "sterilisation" bills, while one-year US Treasuries now carry an interest rate of 2.07 per cent.

Both countries are likely to maintain their policy biases in coming months, the US cutting rates, and China lifting them, a trend that will intensify the pressure on Beijing's currency policies.

"Things just got a lot more complicated for the managers of China's economy," said Stephen Green, of Standard Chartered bank, in Shanghai, yesterday.

China does not release the exact makeup of its foreign exchange holdings, nor how they are invested, making it difficult to get a precise reading on their profitability.

But Hong Liang, Goldman Sachs China economist, calculates the PBoC is losing about $4bn a month on its bills because of the turnround in the interest rate differential over the past 18 months.

"The trend is clearly accelerating as the reserves continue to grow faster than GDP," she said.

China has lifted rates eight times since early 2006, to cool an economy that grew by more than 11 per cent last year and, more recently, to combat inflation, which hit an 11-year high in November.

But further use of interest rates is constrained by Beijing's tight management of the renminbi, a policy aimed at preventing it appreciating too rapidly.

The government fears more rate rises could attract speculative capital inflows, adding to already swollen foreign reserves, which stood at $1,530bn at the end of 2007.

Despite this objection, the government's commitment to fighting inflation means further rate rises are inevitable, China economists say.

The PBoC, in expectation of losses on its sterilisation bills, has used other tools in the past year to drain the funds, mainly by requiring commercial banks to leave more money with it on deposit. Chinese banks are required to place 15 per cent of their deposits with the PBoC, at a much lower interest rate than the 4 per cent offered by the sterilisation bills.

The heavy use of this measure has allowed the PBoC to limit losses on its foreign exchange holdings.

Some economists argue the reserve losses are only on paper, but "at some point, that paper loss may result in a fiscal loss", said Brad Setser, of the Council on Foreign Relations. "It certainly represents a fall in domestic purchasing power of China's external foreign assets. Money held in dollars will end up buying fewer Chinese goods in five years than it does now," he said.

.

PBoC raise the reserve requirement again

An entirely predictable move by the Chinese central bank, the highest level since 1984.

Chinese central bank to raise reserve requirement ratio by 50 basis points[China View]

BEIJING, Jan. 16 (Xinhua) -- China's central bank announced Wednesday it will raise the required reserve ratio for commercial banks by half a percentage point as of Jan. 25.

The ratio will be raised to 15 percent, the highest since 1984.This increase, the first this year, comes a month after the ratio was raised by a percentage point on Dec. 25.

The People's Bank of China (PBOC) said in a statement that the adjustment, part of its stringent monetary policy, is to draw back excess liquidity at banks and curb the overly fast credit growth.

Excess liquidity is a major challenge for the government as it could result in bubbles and economic overheating. China's benchmark Shanghai Composite Index almost doubled last year and the economy expanded 11.5 percent in the first three quarters.

The problem of excess liquidity becomes more prominent as the record trade surplus pumps more cash into the country.

China Financial Markets comments.[China Financial Markets]

.

TheAtlantic.com: The $1.4 Trillion Question

From the inbox:

This is a 5 page US-centric article by James Fallows that asks whether "The Chinese are subsidizing the American way of life. Are we playing them for suckers—or are they playing us?"

The article begins well with a description of the Blackstone saga and the belief among many Chinese that it is them who are subsiding the US with the Chinese government paying $3 billion for a 8% non-voting share of Blackstone. Since it lost $1 billion recently that deal is not looking so clever after all.

Take this quote and think how it sits compared to the usual press stories you ready about the US-China relationship:

Through the quarter-century in which China has been opening to world trade, Chinese leaders have deliberately held down living standards for their own people and propped them up in the United States. This is the real meaning of the vast trade surplus—$1.4 trillion and counting, going up by about $1 billion per day—that the Chinese government has mostly parked in U.S. Treasury notes.

I would strongly advise reading this accessible article very carefully - it covers all the basics in manner that makes some difficult concepts easy to follow.

The $1.4 Trillion Question [The Atlantic.com]

Further tightening of monetary policy

China continues to be concerned with the effects of an overheating economy.

The answer? To tighten monetary policy but what does that really mean?

China is currently worried that inflation that has been rampant in the food sector will spillover into the rest of the economy.

The primary tools that China is employing is tightening of bank lending (growth of bank lending has slowed from 17 to 13% - still high).

Interest rates have risen 5 times but with little effect. The question is how high will interest rates have to go? I suspect a lot higher.

China acts to tighten economy [FT]

China has announced it has shifted its monetary policy stance from "prudent" to "tightening" in another sign that Beijing is concerned about the acceleration of an economy already growing at double-digit rates.

The decision, formally taken at an annual economic conference in Beijing this week, signals growing concern that investment, the prime driver of growth, is picking up pace again on the back of rising construction.

The government is also concerned that inflation, which has so far been confined to food, could spill over into other sectors. The change in language symbolises such concerns and will give policymakers, including the central bank, greater leeway to dictate the lending practices of local financial institutions.

../

The government's most important policy tool to keep construction in check is curbing the rate of growth in bank lending, from about 17 per cent year on year so far in 2007, to about 13 per cent in 2008. This will have a limited impact on overall investment, as about half of it is now funded through retained earnings, and only about a third to 40 per cent through bank lending.

There is no sign that profits as a source of funding are about to be choked off, with earnings of listed companies in the Shanghai market rising 74 per cent year on year in the third quarter and by 89 per cent in Shenzhen.

China has already raised interest rates five times this year, mainly in an effort to keep pace with inflation, with little appreciable impact on the real economy.

"You may see more rate hikes, depending on how the inflation figures pan out," said Mr Anderson.

.

Statistics: FDI up 13%, inflation hits 11 year high

Two news stories catch the eye today. The more worrying concerns inflation. As this quote states:

China has a history of relatively mild price increases spiralling into double-digit inflation.

This should not be taken lightly. For all the governments pledges to "intervene" to ensure price stability the Chinese government should be warned that getting the cat back in the bag after it has been let out is not so easy. The problems with diesel shortages demonstrate this. Without price increases the suppliers of fuel are making a loss. So economics dictates that they will cease to supply fuel - result shortages. Therefore, it China wants the fuel to flow it needs to increase prices - firms need to make a profit or will shut. Capitalism (from which China has done so well recently) works both ways.

Moreover, there is nothing like a bit of food price inflation to really get the government worried about social unrest. A lack of food more than anything is liable to get people onto the streets. These are relatively large values for such staple foods.

Food prices rose 17.9 per cent in October from a year earlier, with pork up 54.9 per cent, fresh vegetables rising 29.9 per cent, and eggs up 14.3 per cent.

China inflation back at 11-year high[FT]

Chinese headline inflation rebounded to its highest level in more than a decade in October driven by soaring food prices, spurring expectations the central bank will continue taking steps to cool the red-hot economy.

The consumer price index rose 6.5 per cent in October from a year earlier, matching August’s 11-year high, after a brief reprieve in September when inflation dropped to 6.2 per cent.

../

He blamed global oil and food price increases and said the government would ensure price stability. ”We have methods to ensure supply, we will take many different measures to stabilise prices,” a report on the central government Web site quoted Mr Wen as saying.

China has a history of relatively mild price increases spiralling into double-digit inflation.

Food prices rose 17.9 per cent in October from a year earlier, with pork up 54.9 per cent, fresh vegetables rising 29.9 per cent, and eggs up 14.3 per cent.

Non-food inflation was 1.1 per cent, affected by the government’s decision to raise tightly controlled pump prices for petrol, diesel and jet fuel by 10 per cent in late October.

That was the first rise in 17 months and came in response to shortages that have spread across the country as refiners cut production in the face of huge losses resulting from the difference between record high crude prices and government-fixed pump prices.

Some parts of the country are still reporting diesel shortages that some have blamed on outlets hoarding supplies in the expectation of another price rise.

Higher oil prices helped push producer price inflation up to 3.2 per cent in October from a year earlier.

Analysts now expect the central bank to continue raising interest rates and to introduce more forceful measures to rein in bank lending, which expanded by the largest margin ever in October.

The central bank has already lifted interest rates six times this year and raised the proportion of deposits banks must hold in reserve nine times to an all-time high of 13.5 per cent.

On a more encouraging note, FDI inflows are higher again. However, such inflows can cause their own problems not least upward pressure on inflation and increasingly large foreign exchange rate reserves.

China's foreign direct investment up 13.2% in Oct. [The China Post]

BEIJING -- Foreign direct investment into China rose 13.2 percent in October compared with the same month a year ago, the government said Monday.

Foreign enterprises invested US$6.8 billion in China last month, the commerce ministry said in a statement on its website.

The figure was up from US$5.3 billion in September. In the first 10 months of 2007, foreign direct investment rose 11.2 percent from the same period in 2006 to US$54 billion, the commerce ministry said.

Last year actual foreign investment in China was US$69.5 billion, down 4.1 percent from 2005.

Foreign direct investment, along with booming exports, are among the top factors resulting in China's massive build-up in foreign exchange reserves.

The foreign exchange reserves, the largest in the world for more than a year, hit US$1.43 trillion by the end of September, according to the most recent data.

.

IMF on global growth

China gets a good mention in the lastest IMF news letter.

Emerging Markets Main Engine of Growth[IMF]

China is now the single most important contributor to world growth, in terms of both market and purchasing-power-parity (PPP) exchange rates.

Its economy continues to grow at breakneck speed, turning it into a driving force in the global economy.

Market exchange rates are those prevailing in the foreign exchange market, while the PPP exchange rate is defined as the rate at which the currency of one country needs to be converted into that of another country so as to be able to purchase the same amount of goods and services in each country. Use of PPP exchange rates gives a greater weight to emerging market economies in the global growth aggregates.

China's economy gained further momentum in 2007, growing at 11½ percent, and is expected to grow by 10 percent in 2008. Other emerging markets are also growing strongly. India continued to grow at more than 9 percent in 2007, and Russia grew by almost 8 percent.

In fact, these three countries alone accounted for more than one-half of global growth over the past year. Other emerging market and developing countries have also maintained robust expansions. Rapid growth in these countries counterbalanced continued moderate growth in the United States (see "IMF Forecasts Slower World Growth in 2008").

Looking ahead

Emerging market countries are reaping the benefits of careful macroeconomic management over the past decade and are benefiting from favorable external conditions, including high commodity prices. But there are uncertainties about the outlook.

In China and India, growth may not slow as anticipated if recent monetary policy tightening proves insufficient to cool domestic demand growth. But the main downside risk is that continued turbulence in global financial markets could disrupt financial flows to emerging markets and trigger problems in domestic markets. This is particularly a concern in countries with large current account deficits and substantial external financing needs. And recent buoyant activity and rising commodity prices (see related article on commodity prices) are leading to tightening resource constraints, which could put upward pressure on inflation.

But despite these and other risks linked more directly to the global outlook, the IMF expects emerging markets to remain strong in the foreseeable future.

.

Heat in the workshop: Chinese export prices on the rise

FT article looking at how the famous "Chinese price" is coming under increasing upward presure.

What is remarkable is that the last 5 years have seen "deflation" until the recent rises. No wonder Western manufactures were feeling squeezed and were moving production to China in their thousands.

One interesting observation is that the reason prices were so low for so long and why prices have taken so longer to pick up speed is the relocation of factories from the coastal hubs to the less developed regions where there is still a plentiful supply of cheap labour and improving infrastructure.

Here is a quote I never thought I would see:

"We have stopped our sock production because we can't find enough workers."

Even in China the economics of scarcity hold. More importantly there is also a shortage of skilled labour that may be more pressing and requires the Chinese government to invest more heavily in the domestic education system.

Heat in the workshop [FT]

The "China price", that once unbeatable benchmark retailers pay for the products made in the world's workshop, is not what it used to be. Data compiled by statisticians in China, Hong Kong and the US all show that, after at least five years of deflation, Chinese export prices have begun to creep up over the past 18 months.

"China's era of exporting deflation to the world is coming to an end," says Jing Ulrich, Hong Kong-based chairman of JPMorgan's China equities business. "Manufacturers are raising their average selling prices and feel confident they can pass on any future [cost] increases. Pricing power has returned to a number of industries due to consolidation, the closure of smaller producers with poor environmental and safety records and natural attrition over the past half-decade, when many manufacturers faced severe margin compression."

../

Jonathan Anderson, an economist at UBS, cites Hong Kong statistics because "they are closest to the Chinese factory gate". These show the China price inflating at about 3 per cent a year.

../

The wonder, however, is that the China price has not been accelerating at a much faster clip - as it would have to before China's export juggernaut began to slow. The country's January-September exports grew 27 per cent to $878bn (£432bn, €620bn). As Jim Leonard, a Boston-based trader for East West Basics, a trade sourcing company, puts it: "Volume covers a lot of sins."

One answer to the riddle can be found in southern Jiangxi province. The region is famous for being the cultural homeland of China's Hakka or "guest" people, whose name derives from their itinerant history. But county governments in the area, near where Mao Zedong and his ragged band of peasant rebels began their Long March to power, are now playing host to a new generation of migrants - factory owners from Hong Kong, Taiwan and further afield, all seeking cheaper bases for operations away from China's coastal manufacturing hubs.

"We treat the companies that invest in our industrial park as gods," says Zhong Xuhui, vice-chief of Longnan county. "We assign a government official to serve each big company, helping it prepare administrative documents. Companies in our park don't waste their time and energy on paperwork."

../

Labour, land and power costs in the Pearl and Yangtze deltas, for example, have been rising at double-digit rates. There have been exponential price increases for essential raw materials such as copper and petroleum-based plastics. Now China's general level of inflation is setting off alarm bells in Beijing, having touched 6.5 per cent in August.

Adding to these pressures, the renminbi has appreciated by 7 per cent against the US dollar ever since it was allowed, three years ago, to drift from its mooring of Rmb8.30 to the greenback.

Mr Anderson argues that this last phenomenon is largely academic in export sectors where factories are merely turning around imported - and therefore often US dollar-denominated - components. But that has not stopped exporters from trying out the excuse anyway, especially last year when the renminbi crawled past the Hong Kong dollar, which is still pegged to its US counterpart at a rate of HK$7.80. And why not, asks Mr Leonard, who sources houseware products for American retailers. "You'd be crazy not to ask."

"Increasing labour and raw material costs are having a significant impact on my business," says Yu Zhonghua, owner of a hat and sock factory in Yiwu, in the Yangtze River Delta. "We have stopped our sock production because we can't find enough workers. Three or four years ago, we could easily find workers to make socks for Rmb900 [$120, £59, €85] a month. Now, even if we pay Rmb1,400-Rmb1,500, they think the job is too tiring and the pay not enough. Other small sock makers face the same situation."

../

The fact that the China price has barely budged relative to its underlying cost pressures is partly a reflection of how fat life was for China-based exporters - most of them owned by Hong Kong, Taiwan and other overseas investors - through the 1990s and the first few years of this decade. Stephen Green, a Shanghai-based economist with Standard Chartered, recently visited some of his bank's manufacturing clients in Shenzhen, across the border from Hong Kong, and says that net furniture margins there have fallen from an "unnaturally high" 30 per cent a few years ago to a more reasonable 10 per cent.

../

"It's hard to find skilled workers here [in Longnan]. That hurts our efficiency," he adds. While it takes three months to train a worker in Longnan, highly skilled workers can be poached from the Pearl River Delta's much deeper talent pool. The monthly wage rates at Top Form's three China factories sum up their capabilities: Rmb1,600 in Shenzhen, Rmb1,200-1,300 in Nanhai and Rmb1,000 in Longnan.

../

"[Manufacturing] activity is moving away from the coast," agrees Bruce Rockowitz at Li & Fung, a trade sourcing company with 16 offices on the Chinese mainland. "Where the product is today is not where it was yesterday. You can't look at [China] as one country. We look at it as a multi-country sourcing area."

Yet change beckons even for relatively new-found destinations such as Longnan. "In the beginning, we didn't choose what type of companies came here," Mr Zhong, the county's vice-chief, says in his thick Hakka accent. "But now we don't want companies that need lots of labour, consume too much electricity or occupy large tracts of land. We now welcome capitalintensive and high-tech companies."

When Top Form arrived in Longnan, hundreds of people would queue outside its gates looking for work. Now a gathering of 30 or 40 workers would be considered a good-sized crowd. As Mr Ho says: "We can never stick to one place for good. For now it's Jiangxi. But Jiangxi may not be competitive in five years' time. Maybe our next factory will be even further inland."

.

Inflation in China - a global issue?

Good summary of the causes and consequences of an increasingly inflationary China.

Thomas Pally has nailed down the feedback mechanisms at work and also highlights the influence of stock and property asset bubbles that are working against current Chinese efforts to curb inflation.

It is inconceivable that China is not aware of these issues - the question then is how much more will the currency appreciate and will it be too little too late.

China's inflation policy stirs the world [Asia Times Online]

China's government recently announced that inflation hit a 10-year high of 6.5% in August. This increase in inflation is directly related to global trade imbalances, yet China is trying to control inflation without addressing that problem.

That carries two consequences. First, it is doubtful this strategy can work, which likely signals rising Chinese inflation. Second, the strategy aims to shift the onus of global trade adjustment on to the United States, which may come back to haunt China and the global economy.

China's current inflation is a textbook case of prolonged undervaluation of a fixed exchange rate in tandem with export-led growth. As such, significant exchange rate revaluation should be a central element of its anti-inflation policy.

However, instead of making such an adjustment, China's authorities are hoping to control inflation by exclusive reliance on tighter domestic monetary policy. It is doubtful this strategy can succeed because it leaves intact the inflationary impulse from China's trade surplus and undervalued exchange rate.

One important contributing factor in China's inflation is the rise in global commodity prices, including oil and base metals, which are now feeding through into prices. Food prices are also on the rise because of increased global prices for wheat and corn. Furthermore, China has been hit by a virulent outbreak of swine flu that has decimated its hog population, driving up the price of pork, which is China's favored meat.

In coastal areas, which have been the hub of China's export-led growth, wages have started going up in response to rising living costs and to the gradual elimination of extreme surplus-labor conditions.

Most important, China is beset by significant asset-price inflation that borders on an asset-price bubble. This asset-price inflation is the product of massive expansion of the money supply caused by China's trade surplus and foreign-investment inflows.

Dollars earned by Chinese exporters have flowed back to China and been converted into local money by the central bank, which has bought them at the fixed exchange rate to prevent appreciation.

Holders of these money balances have then bought stocks and real estate to gain higher returns and to protect against potential inflation. This has driven up real-estate prices, triggering a massive construction boom that has in turn caused inflation.

The implication is clear. China is suffering from imported inflation caused by higher global commodity prices, domestic-demand inflation caused by excess demand in export industries, and asset-price inflation due to an increased money supply caused by China's trade surplus.

The undervalued exchange rate is a key culprit, since it contributes to excess demand in export sectors, and it also drives the money-supply increase via the trade surplus - which has hit record highs in 2007. That suggests significant exchange-rate revaluation should be a central component of China's anti-inflation strategy.

Moreover, revaluation would also diminish the impact of global commodity-price inflation because commodities are priced in US dollars, so that a revaluation lowers their domestic price in yuan.

Instead, China has chosen to rely exclusively on monetary tightening, raising interest rates and reserve requirements on bank deposits. This strategy is unlikely to work. First, there is already significant asset inflation and extensive debt-financed speculative investment, which means the monetary authorities are constrained from sufficiently meaningful tightening for fear of triggering a financial collapse.

Second, raising reserve requirements on bank deposits lowers the return on deposits and makes them less attractive. That provides an incentive for depositors to spend their money or invest elsewhere, which spurs more inflation.

Third, and most important, continuation of China's undervalued exchange rate means continuing trade surpluses and large inflows of foreign direct investment, which means further monetary expansion in China.

Putting the pieces together, the picture is one of rising Chinese inflation, and with that comes the risk of inflation-triggered social and political problems. In this regard it is worth recalling that the Tiananmen Square disturbances of May 1989 were in part caused by industrial-worker unrest over erosion of living standards by inflation.

As for the global economy, China's anti-inflation policy and continued refusal to adjust its exchange rate place the burden of trade-imbalance adjustment squarely on the US. This adjustment will likely happen via recession, and there are signs that process may already be under way. This is a sub-optimal approach that could injure all.

Thomas Palley is founder of the Economics for Democratic and Open Societies Project.

China to Freeze Prices: the start of new period of intervention or a lost cause?

Today the FT reported on China's attempts to curb inflation by imposing price freezes. This is a dangerous route to go down. Market forces are often hard to stop once they get going.

At the moment the freeze is only on prices that the government still controls such as carparking and oil.

Although such policies may have worked in the past, the number of products under direct control is a lot lower. This new stratey may have a limited effect. The question then is "what next"?

Beijing imposes price freeze [FT]

China is to enforce a freeze on all government-controlled prices in a sign of Beijing’s alarm about rising popular anger over inflation, now at its highest rate in more than a decade.

The order freezes a vast array of prices still under the control of government in China, ranging from oil, electricity and water to the cost of parking and park entrance fees.

The order, issued jointly by six ministries on Wednesday, comes after a vaguely worded announcement on the need to prevent price rises by the State Council, or cabinet.

“Any unauthorised price rises are strictly forbidden . . . and in principle there will be no new price-raising measures this year,” the ministries said. Events since the initial State Council announcement that inflation in August hit an 11-year high of 6.5 per cent appear to have galvanised the bureaucracy into a tougher stance.

Qing Wang, of Morgan Stanley, said in Hong Kong: “As inflation has gotten worse, the government may have felt it had to toughen its stand.”

Rising inflation is sensitive in the run-up to the five-yearly meeting of the Communist party, which is due to open on October 15 in Beijing and will choose the senior leadership until 2012. The sharp spike in inflation is largely due to higher food prices due to a shortage of pigs after a disease killed millions and the rising cost of feed – a global phenomenon.

But Chinese leaders and economists are increasingly worried that the impact of inflation and the subsequent government policy response, could cause severe problems for the economy.

Though they were once solely a domestic concern, Chinese prices are now an international issue because of the possibility of the higher cost of consumer goods produced in China fuelling inflation in large export markets such as the US and Europe.

Beijing has raised borrowing costs five times this year, both to cool lending and to prevent negative real interest rates, which provide an extra incentive for people to take money out of banks to buy shares.

China has raised the one-year deposit rate to 3.87 per cent, which is about equal to the eight-month average for inflation but well below August’s 6.5 per cent.

The price freeze is the kind of administrative measure redolent of China’s former planned economy but it may be less effective in China today, economists said.

“They will not be able to control the price of everything,” said Chen Xingdong, of BNP Paribas, in Beijing.

Inflation update

Inflation reaches 10 year high. Remember when reading these stories that the data tend to be unreliable. My guess is that inflation is being understated if anything.

We have posted previously on food price inflation which is a worry for the poor in China. The government will be watching carefully - civil unrest would not be welcome. I am not sure why Bloomberg see bring up 1989 in this article but it shows the debate that economists are currently having.

Inflation is important and China may well export it around the world. However, China's vast pool of labour should help restrain wage inflation.

China's Inflation Rate Jumps to Highest in 10 Years

Aug. 13 (Bloomberg) -- Inflation in China, the world's fastest-growing major economy, accelerated to the highest rate in more than 10 years, fueling speculation that the government may raise borrowing costs for a fourth time in 2007.

Consumer prices jumped 5.6 percent in July from a year earlier, after gaining 4.4 percent in June, the National Bureau of Statistics said today. That beat the 4.6 percent median estimate of 17 economists surveyed by Bloomberg News.

Food costs climbed 15.4 percent after a shortage of pigs pushed up meat prices and bad weather destroyed crops. The central bank is concerned that food inflation will spread, overheating an economy forecast to contribute more to global growth than the U.S. this year.

``It's still mainly a food-price phenomenon, but the central bank will continue to be worried,'' said Huang Yiping, chief Asia economist at Citigroup Inc. in Hong Kong. ``We expect another interest-rate hike this year and one more increase in the reserve ratio for banks.''

The yield on the benchmark 10-year government bond rose 0.03 percentage point to 4.34 percent at 3:27 p.m. in Shanghai. The benchmark CSI 300 Index of stocks closed 0.1 percent lower.

The official China Securities Journal said last week that the inflation rate would probably be 5.6 percent, citing unidentified people. The central bank said on Aug. 8 that consumer-price gains aren't solely from ``temporary factors.''

Interest-Rate Increase

China's economy, the world's fourth largest, expanded 11.9 percent in the second quarter from a year earlier, the fastest pace in more than 12 years, on exports and investment. Cash from record overseas sales raises inflation risks.

``With this massive headline number, plus evidence of heightening concern of the central bank, the chances of another rate hike soon are very high,'' said Stephen Green, senior economist at Standard Chartered Bank Plc in Shanghai.

The 3.5 percent rate for the first seven months is above the central bank's target ceiling for the year of 3 percent.

Economists are split on the risk posed by consumer prices.

Liang Hong, at Goldman Sachs Group Inc. in Hong Kong, has said inflation is entering a ``perilous zone'' and today predicted ``decisive tightening measures.''

``China's inflation is getting out of control and the government is behind the curve,'' Tao Dong, chief Asia economist at Credit Suisse Group in Hong Kong, said in a July 30 note.

Others say the jump in prices is temporary and contained. Non-food inflation slowed to 0.9 percent in July from at least 1 percent in each of the previous five months.

Meat, Eggs

Inflation remains almost entirely food-driven and is likely to drop rapidly ``once supply disruptions have worked themselves out,'' Julian Jessop and Mark Williams, economists at Capital Economics Ltd. in London, wrote in a note.

Food accounts for a third of the consumer-price index. Meat costs surged 45 percent last month from a year earlier and egg prices climbed 31 percent.

China may use administrative measures such as food-price regulation to curb inflation, said Glenn Maguire, chief Asia economist at Societe Generale SA in Hong Kong.

Central banks globally are battling inflation as surging world growth forces up food and commodity prices.

Australia's central bank today raised its inflation forecast for this year to 3 percent from 2.5 percent, a week after increasing the benchmark interest rate to an 11-year high.

U.S. Inflation

Consumer prices rose 2.7 percent in the U.S. in June from a year earlier and 2.4 percent in the U.K. In India, the inflation rate was 4.45 percent in the last week of July.

Besides raising the benchmark one-year lending rate to 6.84 percent, the central bank has ordered commercial banks to set aside larger reserves on six occasions this year.

Wage gains, energy costs and expectations of price increases have broadened inflation pressures, the People's Bank of China said last week. Economic indicators are at ``alarming'' levels, the China Securities Journal today quoted Zhang Tao, the central bank's deputy international chief, as saying.

The central government has told officials in regions where inflation has surged to refrain from raising prices this year. It's ordered investigations into price-fixing after complaints about instant-noodle and fast-food costs.

The government may be balancing higher food costs and the risk of increased expectations for inflation against the benefit of improved farmers' incomes, according to Capital Economics.

Tiananmen Square

``This is a delicate calculation: high inflation fueled the anger which culminated in the 1989 Tiananmen protests,'' wrote Williams and Jessop. The army sent tanks and soldiers to clear democracy protestors from Tiananmen Square in Beijing on June 4, 1989, killing as many as 1,000 people, by some accounts.

Inflation has outstripped returns on bank savings. That has encouraged households to switch money to a stock market that the government is trying to cool.

Household savings fell in July by 9.1 billion yuan ($1.2 billion) from the previous month. The CSI 300 Index has climbed 133 percent this year.

China will overtake the U.S. this year as the largest contributor to global growth, according to the International Monetary Fund. The IMF forecasts the nation will account for 15.6 percent of the expansion, versus 15.4 percent for the U.S.

Foreign Direct Investment reaches 12 year high

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.''

China's reserve ratio rises again - interest rates next?

China appears to be set on controlling a potentially overheating economy by restricting the ability of China's commercial banks to lend money. This will have the affect of absorbing liquidity and lowering bank lending (especially for smaller banks).

However, such liquidity tightening methods are rarely used by Western governments as banks have endless methods of getting around such restrictions.

Moreover, such a small increase (even if it is the seventh in a row could be seen as minor tinkering given China's rapid growth (over 11%) and inflation creeping up to 3.3%.

Interest rates will have to rise and the currency appreciate. As we have said before on this blog however, is that domestic consumption needs to increase and savings need to fall - for this to happen requires huge structural and cultural changes with precautionary savings only falling as the social security net widens (which all costs money and requires investment).

The China Daily article gives a decent if badly written overview. Some quotes are included in this post.

China hikes bank reserve ratio to cool investment

The deposit reserve ratio for depository financial institutions will be raised by 0.5 percentage point to 11 percent starting on May 15, the People's Bank of China said in a statement on its website.

That marked the seventh hike in less than a year in addition to three interest rate increases as regulators try to prevent the economy from overheating.

China's economy surged 11.1 percent in the first quarter of this year after growing 10.7 percent in 2006, as shown in official statistics.

Meanwhile, fixed-asset investment countrywide grew a robust 23.7 percent during March, while the consumer price index (CPI), a key indicator of inflation, rose 3.3 percent last month, above the government's three percent target.

In the first quarter, China's commercial banks posted a 16.25 percent growth in loans, up 1.52 percent from the same period last year.

Meanwhile, Zhu noted the reserve ratio hike is a mild control mechanism, compared with an interest rate increase, especially during the current sensitive period leading to the May Day holiday. There has been speculation in the market that the central bank may raise the interest rate before, during or soon after the holiday.

This final quote is telling - expect a rate rise AFTER the May day holiday but not before.

The asset bubbles in China are growing....