By Rebecca Wilder
Premier Wen Jiabao made stabilizing prices China's top economic priority for 2011. Amid the surge in world energy costs, this story didn't make the front page. However, Chinese policymakers did take their time spent out of the limelight to allow the Chinese yuan to appreciate roughly 0.3% against the U.S. dollar.
Chinese inflation is elevated and near 5% (4.9% is the official rate as of January 2011). I understand that China's growth adjustment will take time, but if you've got unwanted inflation, then domestic policy is too loose (fiscal or monetary). And in this case, it's the monetary policy that's too loose. That goes for both currency and rates policies.
On the rates front: There's a very frothy feel in domestic asset markets, specifically the property market. Low rates and easy money have sparked a(nother) property boom in China, one that policymakers are trying to tamp down. The Economist published a recent article to this point.
But it's going to take much, much more than raising down-payments and reserve requirements to shore up demand for risk assets. I mean, it really doesn't take a genius to see that real rates are entirely too low. What's the investment strategy here? Nominal GDP is expected to grow at 11% in 2011 (according to Economic Intelligence Unit), while the lending rate is just 6.06%. There's no rocket science here: Money's entirely too easy and inflationary pressures are there.
Furthermore, deposit rates are too low and capping domestic consumer demand. Rates need to rise.
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On the currency front: Although there's been some appreciation in the nominal currency, the yuan, Chinese policymakers only recently allowed their currency to fluctuate at all (again) on an annual basis (see chart below). Notice how the annual appreciation was near 0% spanning Q3 2009 through Q4 2010. Since the central bank doesn't fully sterilize the inflows of foreign currency from export sales, the depressed nominal rate on the yuan feeds through to the economy via inflation.
Inflation is rising, which is perking up the Chinese real exchange rate. In January 2011, the trade-weighted real effective exchange rate appreciated at a 4% annual rate (according to the JP Morgan Index). The real exchange rate takes into account the nominal rate plus shifts in the purchasing power of the domestic currency, as measured by relative price fluctuations.
The chart illustrates that the nominal exchange rate is now gaining traction on an annual basis, since the Chinese government halted its movement against the USD in 2009. I suspect that the nominal momentum will continue to grind upward throughout this year in order to temper some of the inflationary impetus coming from outside its borders (like Fed policy). But as I said before, it's Chinese policy that's too loose at home.
The problem is that Chinese policymakers want to rein in accommodative policy without raising rates too much, because they don't want the currency to appreciate markedly and are unable to fully sterilize all the flows. Inflation results.
If Chinese policymakers question how to achieve their top economic priority -- price stability -- then the answer to this self-induced problem is pretty obvious: Significantly raise rates and the value of the currency.