International | Oct 20 2010
By Greg Peel
About a week ago, the People's Bank of China announced an increase of the reserve rate requirement for China's six major banks to 17.5%. The RRR represents the level of liquid reserves required to be on bank balance sheets, and in raising the rate the Chinese central bank is affecting a tightening of monetary policy. More required reserves mean less money to lend to China's booming economy.
Increases in the RRR have been the PBoC's preferred policy tool in 2010 as a means of forcibly slowing China's economic growth rate down from “bubble” to “sustainable”. Last week's increase was the fifth this year.
The rest of the world has watched on in trepidation at each step as Beijing has carried out its policy objectives. It was disappointing enough that Beijing would be slowing Chinese growth at a time when developed economy growth was sluggish and China had been proving a saving grace on the global GDP front, but it became more of a concern when first the European crisis hit and next the US economy appeared to come to a standstill.
The European crisis appears now to have been largely averted. While there remains a lingering risk one of the smaller economies such as Greece or Ireland may yet default on sovereign debt, the European Central Bank has felt comfortable enough in recent weeks to gradually withdraw emergency loans to European banks aimed at preventing a systemic continental financial crisis. Global attention has now turned to the increasingly sluggish pace of US economic recovery, but that problem has been solved, or at least will be solved, by the expected expansion of Fed quantitative easing.
The world does not want the US to go into a period of Japanese-style deflation whether or not it is considered deserved. The US is still the world's biggest consumer and the likes of China and India have a long way to go to catch up.
Fears were allayed when clearly Beijing took the European crisis in particular as a signal to lay off on further policy measures, at least until the dust settled. China's GDP growth indeed slowed in the first and second quarters of 2010 but at last count was still well above Beijing's 8% target growth rate. Recent Chinese data have nevertheless seen a swing back to strength once more, and hence it is anticipated China's third quarter GDP reading, due tomorrow, might show a return to increasing growth.
If not the third, then economists expected the fourth quarter would see such a reversal given the way the data have been reading.
As such, economists across the globe have been expecting Beijing would again return to tightening monetary policy. Last week's RRR increase was thus no great shock, but some had gone as far as to suggest even an interest rate rise might be on the cards.
Others were dismissive of this notion, noting the PBoC itself had hosed down such speculation last week, suggesting a rate hike was unlikely this year. One day global markets will come to appreciate that the dissemination of truth has never been something particularly high on Communist China's scale of importance.
Nevertheless, it was therefore a shock when the PBoC announced an interest rate rise yesterday, not only because many had dismissed the notion but also because of the monthly “data dump” due tomorrow. Tomorrow is the scheduled date for the release of China's inflation, retail sales, industrial production and fixed investment numbers, along with the third quarter GDP result.
I've said it before and I'll say it again – China is amazing in being able to produce quarterly GDP results only three weeks after the end of the quarter when everyone else takes three months. And people still take Chinese officials at their word. Strange.
Clearly it is now assumed these numbers will provide some justification for the rate rise. Beijing is particularly concerned about rising inflation.
As far as “rate rises” go, and certainly in comparison to simple cash rate movements from the RBA and others, the PBoC's was convoluted. For starters, forget any notion of overnight cash.
The one-year lending rate has been increased by 25 basis points to 5.56% and the one-year deposit rate by the same amount to 2.50%. Additionally, lending rates beyond one year have been increased by 20 basis points while longer deposit rates have been substantially raised – the two-year rate by 46bps and the five-year by 60bps. While it all seems like a bit of a mess, it actually shows that China is beginning to get a hang of this monetary policy caper in a capitalist environment and economists have applauded the logic.
Aside from concerns that Chinese banks are lending too much money too quickly to businesses and thus fuelling runaway economic growth, Beijing has acknowledged that inflation, which may be as high as 4% in tomorrow's data, is resulting in negative real deposit rates. This discourages bank savings and forces Chinese investors to look elsewhere for a return. It's not hard to see where the money is going – it's going into China's bubbling real estate market.
Aside from generally slowing China's GDP growth, it is Beijing's determination to pop the real estate bubble before it pops even more violently by itself at some time down the track. Japan in 1990 is the test case. Because such a small percentage of the Chinese population by global standards have mortgages, Beijing has had no qualms in attempting to orchestrate even a full-on property “crash” in order to teach a lesson to property developers and speculators.
Yet while there had been some signs of easing in real estate price growth, the most recent data have shown a return to accelerating prices. With the European crisis now dulling (Europe is China's biggest export customer) Beijing obviously decided the coast was clear and the time was right to bring out the big guns in the form of an interest rate hike.
In economies where the currency floats against the reserve currency, such as Australia's, such an interest rate hike should have immediately affected a jump in the value of the currency. But given the renminbi's peg against the US dollar, it was only able to appreciate slightly.
In actual fact, the renminbi is no longer pegged in a range to the US dollar but to an unnamed basket of currencies which would include the dollar, no doubt the euro and yen and maybe others as well. This was another policy measure recently implemented by Beijing which served to provide some, albeit minimal, revaluation of the renminbi against the US dollar alone.
Nevertheless, the PBoC rate hike will only serve to fuel further anger across the globe as the “Currency War” rages. The rate hike will attract further “hot money” flows from foreign investors into China, further exacerbating global current account imbalances. But the anticipation is from economists that Beijing will simply be forced to revalue the renminbi shortly. Danske Bank, for one, is forecasting a 7% revaluation by year-end.
It would be a step in the right direction, albeit the renminbi is deemed to be anything between 20-40% undervalued to the US dollar. But today economists are unanimous in suggesting yesterday's rate hike is an indication that Beijing has become a lot more confident about China's economic growth – about its domestic economic growth drive and also the state of its export markets. Such confidence should, in theory, lead to a revaluation of the renminbi.
A revaluation of the renminbi should have an offset in a devaluation of the US dollar. Yet the global response last night was one of risk aversion. Thoughts of QE2 went straight out the window as overstretched short dollar positions were very quickly covered, resulting in a US dollar index rally of a sharp 1.6% (and, subsequently, US2.5c wiped off the Aussie).
The response simply takes us back to earlier fears. With European economic growth contained by austerity measures, and the US economy falling further into deflationary territory, the world needs a strong Asian economy (along with a strong Latin American economy) to drive global GDP. Obviously China is the lead driving force, and it is China's domestic economic growth the world is depending on.
Stifled by its own high unemployment, housing market disaster, and general aversion to lend, America is resting its hopes in the great export drive into China. If America can sell everything from cans of Coke to iPhones to Caterpillar bulldozers to Boeing jets to China, then the US deficit can diminish, the US economy can grow, and the US stock market can reap the rewards of increased earnings.
By forcibly slowing its domestic economic growth due to inflation fears, Beijing is putting at risk those dreams. At least that's the way Wall Street saw it last night as stock markets tumbled and commodity prices tanked. And such dreams are also those of European exporters, while commodity exporters such as Australia just want to make sure China maintains its record demand for iron ore et al.
But should the world really be panicked?
Realistically we're back where we were earlier in the year, before the European crisis, when Beijing first touted it wanted to knock its GDP growth rate down from 12% to 8%. Beijing was indeed making the same declarations around 2005 but at that stage hadn't quite got the hang of this monetary and fiscal policy malarkey. The world was very worried, but then which would the world prefer?
Consider it as: which would Australia prefer? To have a few more boom years of runaway Chinese growth and a struggle to even keep up with iron ore demand, forcing continuous RBA interest rate increases, and ultimately all ending in tears as the Chinese economy implodes just as Japan's did in the 1990's? Or to have possibly decades of measured but sustainable growth, with still solid commodity exports and less pressure on the RBA?
I know what I'd prefer.
Economists now suggest further Chinese rate rises ahead, although they disagree on the timing. ANZ expects another before year-end while others see the first half of 2011 as being more likely.
