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China and Inflation

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China and Inflation

Our Correspondent
Oct 22, 2010
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China and Inflation

www.asiasentinel.com

Two bits of economic news in three days have shown how unwilling China's leadership is to tackle fundamental issues. Instead, Premier Wen Jiabao and his colleagues content themselves with small adjustments in the hope that by doing so rapid economic growth can be sustained in the short to medium term, and serious currency revaluation and inflation both avoided. And just hope for the best for the longer term – when they won't be in office.

The first was the announcement of the first rise in interest rates in three years – a one-quarter percentage point to one year deposit rates of 2.5 percent and lending rates of 5.56 percent. That was greeted by much of the media, foreign and local, as a major step, showing official determination to rein in growth in general and asset prices in particular.

Then came the news that consumer price inflation hit 3.6 percent year-on-year in September – even by official numbers, which many believe reflect both official massaging and outdated weightings as well as price controls and subsidies.

In other words interest rates for savers remain negative in real terms and the cost of borrowing remains minute, particularly for the state enterprises with the easiest access to bank lending. Not only is the cost of funds low but banks seldom discipline their major clients.

Even though lending is supposedly being restrained by baby steps increases in bank reserve requirements, it is still expanding at a rate of 20 percent following a 30 percent increase in 2009. A 20 percent-plus rate for several years is similar to the growth seen in the likes of Thailand and Malaysia prior to the Asian crisis.

Of course, the Asian crisis was propelled by borrowing in foreign currencies as well as by over investment in projects with poor returns. But a domestic banking crisis sometime in the next three years or so looks very likely when it becomes apparent that loans cannot be serviced let alone repaid once interest return to more normal levels. Easy money cannot continue forever without a surge in inflation which is probably politically the most dangerous outcome.

Banking problems might, ironically, be made worse by the one measure which is needed to bring other aspects of the economy back into balance: a significant rise in the yuan. Such a rise would stimulate consumption, reduce inflationary pressure, promote a shift from export-led growth and help distribute wealth from the coastal exporting regions to the interior.

However, it would also add to forces finally exposing just how unproductive so much of the investment financed by cheap and excessive bank lending has been. That is obvious enough in the grandiose public projects, high-cost, high-speed rail schemes and empty apartment developments that dot the country. It is thus far less obvious in massive over-capacity in many capital intensive industries from shipbuilding yards to aluminum smelters that are dependent at least in part on exports, directly or indirectly.

The longer the over-investment continues in assets with meager, if any, returns, the more dangerous it will be for the banks, and the more difficult for the authorities to shift demand towards consumption.

China can reasonably argue that a sharp rise in the yuan would send many of its exporters operating on razor thin margins to the wall. But that argument does not sway other countries concerned about China's trade surpluses which have resulted from two decades of export-oriented growth fuelled in part by cheap capital.

How great the pressure on China becomes is uncertain but the next few weeks could be critical given the US mid-term elections and the G20 summit in Seoul. The first will influence the pressure in the US to move from rhetoric to action against China. The second will show how far G20 members such as India, Brazil and South Africa blame China's cheap yuan policy for the threatened currency war or view the US dollar-printing as equally or more to blame.

One way or another however, the only way for China to counteract Fed Chairman Ben Bernanake's dollar deluge and US Treasury Secretary Geithner's now admitted preference for a weak dollar is to speed up revaluation. Otherwise it is hard to see how China can avoid continuing its own, and entirely inappropriate, cheap money policy.

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China and Inflation

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