For How Much Longer Can China Resist Raising Rates?

Includes: CNY, CYB
by: Bo Peng

The main focus of QE2 is not domestic, but international, exporting inflation and forcing BIC's hands. This is highlighted by Brazil's immediate and very public, very undiplomatic response, as well as Bernanke's very undiplomatic jab at China shortly after QE2 announcement. In this, it's been very successful. BIC have been trying very hard to resist. Although India has given in and raised rates, Brazil and China (along with other export economies such as Japan and South Korea) have been resorting to other means. But for how much longer can they resist?

China's inflation is particularly worrisome to its policy makers. As a saver's society (and because of the fact that a large portion of the populace still has little disposable income), Chinese people are very sensitive to inflation. And it is because of the same reason that Japan has chosen, wisely so far, the path of lost decades rather than risking over-stimulus and hyperinflation. But Beijing erred badly in their over-reaction to the 08 crisis in late 08 and early 09, going all out trying to stimulate domestic demand and flooding everybody with cash. That was the direct trigger of today's rapidly rising inflation, on top of the chronic inflation pressure due to exchange rates. But China's history is littered with lessons of inflation causing revolutions and social turmoil. Beijing knows this all too well. Although there are potent domestic political forces and economic interests against revaluing the Yuan, when inflation threatens the power, Beijing will have to quickly choose between two evils, and the anti-revaluation camp will quickly recognize it's better to lose some money than losing power all together.

Furthermore, rates are rising everywhere and the dollar is rebounding. These factors give Beijing some breathing room and the pro-revaluation camp some much needed cover.

The risk, and I suspect a main argument, used by the anti-revaluation camp in Beijing is the Euro collapse. But as inflation stats keep coming in high and Europe stubbornly hangs on, time is running out. And, the later they act, the harder it will be to engineer a soft landing.

Not only do I think China may raise rates soon (when or shortly after the next inflation figure comes in if it turns out to be high, which is all but certain), but also there's a nontrivial probability that China might even resort to revaluing the Yuan some time after if inflation persists. China must fight inflation at all cost. See? Uncle Ben gets it. Forcing inflation is much more effective than all the political pressure and threats.

What would this mean to US and US investors?

1. Inflation will pick up, effectively exported back to the US through higher costs of imports (and in this regard the Chinese import price is arguably as important as raw commodities, if not more. So, be careful what you wish for). Maybe this is exactly what the Fed economists with PhDs from decent departments wanted, but I happen to think this is a bad form of inflation born from higher input prices as opposed to vibrant economic activity. How could this type of inflation possibly drive up employment? Oh I get it, everybody will be so desperate that we will all be scrambling to take back the illegals' jobs, which used to be so below us.

2. Unless/until an Euro crisis materializes, or at least grabs headlines again, interest rates will be rising worldwide, but BEFORE the developed economies are in solid recovery ground AND as emerging economies are still trying to cool down. This is a pre-emptive strike that will most likely kill any prospect of sustained recovery in the developed world, but may play right into the hands of emerging economies. In other words, the developed world is committing economic suicide by forcing global rising rates. Thanks, Uncle Sam.

3. Even if I'm wrong about the timing and method in China's effort of fighting inflation, the inevitable fact is they will have to cool it down one way or the other, be it a soft landing, hard landing, or revolution. And sooner rather than later. When that happens, expect a pull-back in commodities and equities worldwide, possibly severe, and possibly coupled with a rise in treasury yields if it turns out to be a soft-landing (as the Yuan value rises, the PBoC needs less foreign reserves and will unload some treasuries). Ouch, nowhere to hide.

Until then, enjoy the recovery-in-anticipation.

(Update hot off the plate: Rental in Beijing increased 23% YoY in November. Yikes.)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.