Don't Expect Beijing To Move Boldly, But Structural Reform Is Underway

Amid much debate over recent Chinese monetary policy moves, STRATFOR sources in Beijing indicate that the People’s Bank of China will raise interest rates again in December, possibly in the first week of the month. Other STRATFOR sources close to Chinese financial policymaking circles suggest that the Oct. 18 Chinese interest rate hike is only the first in a series of up to three or four such increases in the coming year, two of which could occur within the next six months.

China's Gradual Economic Reform

Interest rates work differently in China than elsewhere. To continue high levels of industrial production and investment, China’s central bank and state-controlled banks maintain low interest rates to ensure the banks pay as little returns as possible to China’s massive population of savers and can provide inexpensive loans to state-owned enterprises (SOEs) and other corporations. This is a means of providing growth and employment, and hence social order.

And this means that when inflation is taken into account, real interest rates are often negative. The real return on savings deposits has been negative since April. At present, the one-year deposit rate stands at 2.5 per cent and inflation for the year is so far at 2.9 per cent compared to 2009. (Inflation hit 3.6 per cent for the month of September, compared to the previous year, and official inflation gauges notoriously give the impression that inflation is lower than it is felt to be on the ground.) For those who can avoid saving, the incentive is clearly to invest their money elsewhere (for instance, in the booming real estate sector). Meanwhile, SOEs and businesses with good connections have every incentive to borrow at such low rates.

China's Gradual Economic Reform

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The Oct. 18 interest rate hike for both deposits and loans was small but marked the first increase since December 2007, before the global economic crisis. A small move like this will have little effect on overall conditions, one reason why further moves can be expected. Throughout 2010, China’s growth has been red hot. The need to fight inflationary tendencies has become increasingly apparent. China has decreased its target for new loans by 20 per cent compared to the high level in 2009, tightened real estate regulations, increased banks’ reserve ratio requirements, and now — further emphasising the desire to tighten monetary conditions — has raised interest rates. This is part of China’s ongoing policy of attempting to moderate economic growth somewhat; slow down price growth in housing and other areas that causes social dissatisfaction; and dampen the inflationary tendencies that rose after the massive credit infusions of 2009, the rebound in global trade and international excitement about investing in China.

On a deeper level, Beijing is keenly aware of the need to shift the balance of its economy away from investment and exports and toward domestic consumption, though it has not made much progress so far. One way of doing this is through targeting substantially higher interest rates. Higher rates would encourage saving and put more money into the hands of savers while discouraging inefficient or wasteful borrowing. Higher interest rates also will create further pressure on Beijing to appreciate its currency, something it is pursuing gradually to undercut inflation, strengthen domestic purchasing power and ward off international trade frictions (particularly U.S. pressure).

China's Gradual Economic Reform

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Significantly, however, the effect of interest rates is muted in China’s system. The close relationship that state-owned companies have with state-owned banks means China controls lending primarily through setting loan quotas that almost always are met or exceeded. This undermines the ability of higher interest rates to discourage borrowing, thus making further reductions in loan quotas (down from a targeted 7.5 trillion RMB in 2010 and the final 9.6 trillion RMB tally in 2009) a far more important component of such corrections than interest rate hikes alone.

To fundamentally restructure the economy, Beijing would need to be willing to make such moves aggressively. Therein lies the problem. Reducing new lending targets, raising rates and tightening regulations will slow growth, and meaningfully slower growth would threaten jobs and the social order. Since the global crisis, investment as a share of China’s economy has grown dramatically and exports have dropped off due to weaker external demand. Hence, leaders are especially reluctant to do anything that risks substantially reducing domestic investment, choosing instead to focus on controlling it.

Moreover, Beijing is well-aware that after the rapid growth of the past few decades, a downturn in the business cycle is due. Judging by what other Asian economies have experienced, this correction could be disturbingly abrupt. Beijing therefore does not want to force the onset of a deep slowdown. With the China’s top Communist Party leaders set to retire in 2012, there is little impetus to attempt a dramatic overhaul of the system. That is a chore that can be left to the next generation. So even as Beijing looks to continue tightening monetary policy and moderating growth while attempting structural reforms in the coming year, it will not move boldly. If possible, its steps also will be made reversible in case of unforeseen adverse circumstances.

*This report is reprinted with permission of STRATFOR. It may not be reprinted by any other party without express permission of STRATFOR.

To learn more about STRATFOR, click here.

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