China Monetary Policy: Inflation Won't Last – Growth Will

By: Money_Morning

Jason Simpkins writes: Investors yesterday (Thursday) were rattled by fears that China's economy is overheating after it was revealed that the country's gross domestic product (GDP) expanded by 10.3% in 2010.

However, the policy changes that will come as a result of the data ultimately will benefit both China and the United States.

No doubt, inflation will remain problematic for China in the short-term, but policymakers are poised to respond with tighter lending controls and an appreciation of the nation's currency, the yuan. That will help tame a politically sensitive trade surplus with the United States and ensure more stable growth for the world's second-largest economy.

The Dow Jones Industrial Average fell 0.02% yesterday to close at 11,823.25 after earlier falling as low as 11,745.98. The Standard and Poor's 500 Index ended the day 0.13% lower at 1,280.26 after dipping to 1,271.27 in morning trading.

Oil prices, which have hovered around $90 a barrel for months also declined on the news, tumbling $2, or 2.2%, at $88.86 a barrel on the New York Mercantile Exchange (NYMEX).

Still, analysts don't see any reason to panic.

"Concern about China is actually a good excuse to sell after a sharp run in stocks and commodities," Dan Veru, chief investment officer at Palisade Capital Management LLC told Bloomberg. "Does that change the fundamental outlook for the long term? I don't think so. In the U.S., the earnings picture is pretty impressive. Economic data points have been surprisingly positive. I just see a temporary pullback."

Naturally, the tone is slightly different in China where policymakers are scrambling to rein in rapidly rising prices.

Consumer prices in China last month were up 4.8% from a year earlier. That's down from an 18-year high of 5.1% in November but still well above the official target of 3%. Food prices rose 7.2% last year.

With analysts expecting inflation to remain at current levels, and even trend higher, the People's Bank of China (PBOC) will be forced to redouble its efforts to control prices.

The PBOC on Christmas Day raised interest rates by 0.25%, bringing its key one-year lending rate to 5.81%. The reserve requirement ratio for state-controlled banks has been raised seven times since early 2010. The most recent increase of 0.5% went into effect yesterday (Thursday), bringing the reserve requirement to a record high 19.5%.

However, these measures so far have not had the desired effect. Banks continue to lend excessively. The government in 2010 failed to hold lending below the targeted maximum of 7.5 trillion yuan ($1.14 trillion), and Chinese banks extended more than 1 trillion yuan ($152 billion) of new loans through Jan. 19, the 21st Century Business Herald reported, citing an industry source.

China Development Bank Corp. ordered its branches on Jan. 18 to halt lending for the remainder of the month, due to government notice the newspaper said.

Nomura Holdings believes the PBOC will raise its benchmark lending rate to 6.81% this year from 5.81% currently. The next rate increase could come in less than month, perhaps during the Lunar New Year, which begins Feb. 3. Nomura believes China will let the yuan rise as much as 6% against the dollar this year.

The yuan gained 3.6% in 2010 and rose to a 17-year high of 6.5824 per dollar on Wednesday.

Brian Jackson, an economist with the Royal Bank of Canada in Hong Kong, said he expects the yuan to strengthen to 6.20 against the dollar by the end of the year. That would be a change of roughly 6% from where the currency traded yesterday.

A rising yuan would make it cheaper for Chinese companies to import raw materials, helping to reduce prices. It would also placate U.S. policymakers who continue to assert China's currency is kept artificially low.

U.S. Sen. Charles Schumer, D-NY, on Wednesday said that the currency is undervalued by as much as 40%. President Barack Obama and other U.S. policymakers addressed the supposed discrepancy directly with Chinese President Hu Jintao during a rare visit yesterday.

"There needs to be further adjustment in the exchange rate," Obama said bluntly.

However, Chinese policymakers have pointed out that the United States has done little to backstop the value of the dollar. The U.S. Federal Reserve's benchmark Federal Funds rate currently stands at a record low range of 0-0.25%, and last year the Fed announced another $600 billion in Treasury purchases.

"We hope the yuan will get stronger but don't want the appreciation pace to be too fast," Ma Weihua, chief executive officer of China Merchants Bank, told Bloomberg. "The U.S. isn't taking responsibility. It called on China to adjust its yuan policy, but the whole world is suffering from its easing measures."

Since many commodities are priced in dollars, a weaker greenback has meant higher prices for the entire planet. Additionally, China holds $2.85 trillion in foreign currency reserves, mostly in dollar denominated assets.

Of course, a large portion of China's holdings derives from its trade imbalance with the United States. China reported a less-than-forecast $13.1 billion trade surplus for December, the smallest since April.

Even with the monetary tightening, the World Bank estimates that China's economy will expand by 8.7% this year.

"Coming from this very strong growth that we have seen recently, China should be able to ease gently into a more sustainable rate of growth in 2011 and the medium term," said Louis Kuijis, senior economist and the main author of the World Bank's China Quarterly Update.

Source : http://moneymorning.com/2011/01/21/china-monetary-policy-inflation-wont-last-growth-will/

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