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Yiping Huang :What China?s rate rises may reveal


October 23, 2010
THIS week, the People's Bank of China announced a series of rate rises. Although economists have been arguing for monetary tightening for months, this move was a surprise to many in the market.

To me, this policy adjustment tells us several things: (1) monetary policymakers see greater inflation risks than the headline CPI data; (2) the government is probably trying to avoid the Japan mistake: loosening domestic monetary policy in order to reduce pressure for currency appreciation; (3) therefore currency appreciation is likely to continue, if not accelerate; and (4) the authorities might adopt certain measures to control the capital account temporarily in order to discourage ''hot money'' inflows.

China's headline CPI rose to 3.5 per cent year-on-year in August, up two-tenths of a percentage point from the previous month. And disaggregated data reveals that inflation is mainly about food prices. This is the reason why some officials argue that monetary tightening was neither needed nor effective.

Advertisement: Story continues below However, during the 30 years' reform period, almost every major inflation problem, in 1988, 1993 and 2007, was initially caused by food inflation. So the monetary policymakers would not treat food inflation lightly.

The current momentum of inflation is already pretty serious. CPI rose by 0.6 per cent month-on-month in August, which can be translated into an annualised rate of 7.2 per cent. This certainly is way above the central bank's target.

More importantly, the headline number is probably grossly underestimated due to under-represented service prices in the basket. Some economists put down a more realistic CPI reading at 5-6 per cent, compared with the official number of 3.5 per cent. The Ministry of Commerce collects market prices for agricultural food every week. These numbers confirm that food prices have already risen during the past three months at an annualised rate of more than 30 per cent.

But that's not all. Two more factors shadow the outlook of China's inflation picture. One, loan growth is increasing. This year's new loans will likely surpass the central bank's target of 7.5 trillion - about 5 per cent more than in a normal year.

Two, wages are rising by 20 per cent. Economists and government officials still dispute the notion that China is rapidly approaching the Lewis turning point. But every business person in China agrees that it is happening: it is increasingly difficult to find additional workers and labor costs are skyrocketing.

Some policymakers have been concerned about an asset bubble since the start of the year and the government has implemented a number of tightening measures towards the housing market.

This week's rate rise is unlikely to lead to a collapse of housing prices, which have the potential to go up further in the coming years, given healthy balance sheets for households and banks.

But the latest change in the mindset of government officials may be able to help China avoid major asset bubbles like those experienced by Japan in the late 1980s and by the US during the early years of this century.

There is a worry that the rate rise might lead to more inflows of ''hot money''. This is probably true, given that all major central banks and those in Asia are in a pause mood, if not a loosening mood.

But if the rate rise adds downward pressure on asset prices, it may at the same time discourage ''hot money'' inflows. The net impact is not clear. But ''hot money'' is not something the government can completely eliminate.

In the short term, it is probably safe that the government would allow the currency to continue to appreciate. With risks of a double-dip receding, the policymakers are probably more confident about the growth outlook. There is also a possibility that they may tighten controls over certain types of capital inflows in order to reduce ''hot money'' flows.

These, however, should be viewed as temporary responses to volatile market conditions. The long-term trend of capital account liberalisation remains on track.

Yiping Huang is professor of economics at the China Centre for Macroeconomic Research, Peking University.