China’s caught in a real bind right now, and fresh quantitative easing from the U.S. isn’t helping.
Inflation is a threat in China, and it is at least partially driven by speculative capital entering China due to expectations of a yuan appreciation, higher interest rates in China vs. the developed world, and strong relative Chinese GDP growth.
Yet should China hike its interest rates to control inflation, it will only widen the gap with U.S. interest rates, which could attract even more capital. If China does nothing, then inflation could get worse.
Problem now is, Bernanke’s QE2 just gives capital yet another reason to choose China over the U.S., threatening further inflation. It thus compounds the problem above.
But China has to do something, and they’ll likely be forced to mix interest rate hikes with domestic price controls in a haphazard struggle to keep the nation on track says Credit Suisse:
Credit Suisse’s Dong Tao:
With the Fed conducting QE2 and hot money flooding into China, we believe the PBoC may hold back from another rate hike before the end of this year to avoid widening the interest rate gap at this time. The risk of raising the reserve requirement ratio before the year-end would be higher, in our view. Nevertheless, we believe the negative real interest rates will eventually force the central bank to raise nominal interest rates again in 1Q11.
We project CPI inflation to reach 4.5-5% in 2Q11. This may lead to a total of three to four interest rate hikes in 2011, with the deposit rates rising faster than lending rates, and rates for longer duration rising faster than those in the short-end, in our judgment. It has also become more likely that Beijing may re-introduce price controls in areas such as fuel and grain at the retail level, similar to what it did back in 2006 and 2007.
However, the one thing they won’t do is budge on the yuan-dollar exchange rate:
We maintain our view that Beijing is unlikely to allow the RMB to appreciate anything more than in a symbolic sense, even if this means possible trade wars ahead. China seems to be making adjustment in the RMB real exchange rate, via wage increases, much more aggressively than in the nominal exchange rate.
(Via Credit Suisse, China Economics, Dong Tao, 3 November 2010)