Inflation in China – The Biggest Surprise of 2010?!?

It is NOT surprising at all, that Chinese authorities raised interest rates over the weekend of December 25/26 (the second such raise in 10 weeks) amid inflationary concerns. Analysts and experts, both domestic and foreign, have been predicting such a development due to the high levels of growth during the last three years (9.1% GDP Growth in 2008 – 8.4% GDP Growth in 2009 – and expected to be over 10% GDP Growth in 2010) and the aggressive government efforts to stimulate the economy after the drop in exports in 2009 (caused by the global financial crisis).

According to the Peoples Bank of China, the benchmark one-year lending rate will rise by 0.25 percentage points to 5.81%, and the one-year deposit rate will also rise by 0.25 to 2.75%, effective immediately. This was the second rate hike in three months, in response to earlier reports of inflation reaching 5.1% in November, as the Chinese government confronts the fastest inflation in the last three years. More hikes are expected 2011, at least three times according to J.P. Morgan Chase.

Accelerating inflation in recent months has been driven largely by increasing prices for food and housing that disproportionately affect the lower-income people. Limiting a possible asset bubbles in the real estate market is the governments’ primary objective with these interest rate increases. Higher rates in China are meant to soak up cash in its economy by increasing the incentive to park money in bank deposits and by deterring borrowing.

Unfortunately, this development is not at all surprising. After flooding the economy with cash from late 2008 to drive the recovery, the Chinese government is finally trying to limit asset bubbles in the real estate market and prevent rising prices that could lead to social unrest. The 2008 stimulus plan by the government was 4 trillion Rmb ($600 billion), and it included a multitude of infrastructure related projects (like massive development projects designed, in part, to soak up surplus steel, cement and labor capacity), tax cuts and export rebates, telecom development, green energy programs, healthcare reform, and rural development initiatives.

However, the only way to get all that money quickly in the economy was to channel it through banks to the large state-owned enterprises. In effect, the nation’s banks extended a record 9.6 trillion Rmb ($1.4 billion) in loans in 2009 (more than double the amount lend in 2008), and this year’s target of 7.5 trillion Rmb ($1.1 billion) was almost reached in 11 months.

Banks were obliged to lend, and large state-owned enterprises (SOE’s) or local governments took the money, not really having any real investment needs. Because the SOE’s and the local governments didn’t really need the money for their main business operations, they mostly put that money into real estate. Therefore, all the banking reform of the past decade, which was suppose to introduce modern risk management and credit evaluation procedures went out the window, in pursuit of stimulating the economy and maintaining economic growth.

Furthermore, for ordinary Chinese, there are few options available for safely investing their savings, other than buying property; bank deposits pay negative real rates of interest, the stock market is volatile, and because of capital controls they can’t take their money out of the country.

In order to curb inflation, the government is introducing other measures beyond raising interest rates. Last week, the government raised state-set fuel prices for the second time in two months. Other policies by the government include raising taxes to slow consumption (like the tax raises on small cars announced last week), and letting the renminbi appreciate against the dollar. Policy makers recognize that a stronger renminbi will help in curbing inflation. They are convinced that the renminbi has very strong fundamentals and the country has a very large current-account surplus.

This is why last week we also saw the renminbi strengthened beyond 6.6 per dollar for the first time in 17 years, bringing gains for 2010 to 3.6%. Many economists say China could better fight inflation by allowing its currency to appreciate, which reduces the prices of imports in local-currency terms.

Conversely, in the U.S. the Federal Reserve is battling economic weakness by holding rates near zero and pumping liquidity into the economy through its quantitative easing program. Chinese officials have openly criticized the Fed’s quantitative easing program, in part because they say it burdens emerging economies with potentially excessive capital inflows that could fuel inflation.

Chinese officials also blame the Feds quantitative easing for making China more attractive for speculative investors to shift funds into China. Chinese authorities rightfully detest such “hot money” because it weakens their control over the economy and adds to upward pressure on the renminbi. To curb hot-money inflows after the rate increase, authorities will have to impose more capital-control measures. However, as we saw earlier, Capital controls are responsible for part of the rise in inflation.

Of course, all this is leading up to Hu Jintao’s visit to Washington DC in mid January 2011, when most experts expect the main appreciation of the renminbi to happen, and where most of the real breakthroughs in U.S.-China economic relations will happen. However, China’s current inflationary problems are mostly of its own doing. Although the Fed’s policies might be causing some of China’s inflation, the main culprits are the excessive bank lending, the capital controls, and the undervalued renminbi.

Once again we see how intertwined the two economies are, and how much solutions to national problems will require transnational approaches.