While the U.S. unleashes a stampede of fiscal and monetary stimulus to keep its economy from stalling and deflation from taking hold, China is wrestling with a festering inflation problem and has begun taking steps to rein in its policy accommodation measures. The policy trade-offs that Beijing chooses to address growth and inflation in 2011 may have a significant impact on the global economy.
China's latest consumer price index data indicates that prices rose 5.1 percent in November (Figure 1). This figure was well above the government's 3 percent inflation target and represents the largest monthly increase since July 2008. While higher food prices, up 11.7 percent due to bad weather and increased vegetable costs, were a major contributor to the headline inflation figures, non-food inflation also picked up to 1.9 percent from October's 1.6 percent rate. This indicates that inflationary forces and expectations could be taking root beyond food prices.
Figure 1
Source: Bloomberg / China's National Bureau of Statistics
In response to these price pressures, Beijing has officially communicated a shift from "moderately loose" to "prudent" monetary policy in 2011. This change is significant not only because it contrasts with the policy outlook in Western developed economies, but also because it signals a shift to more balanced growth policies as China embarks on its next five-year plan in 2011.
Although China's leadership has communicated concern for rising price levels and indicated a desire to balance its previous all-out growth strategy, we have not yet seen an interest rate increase. The PBOC's last move was in October when the benchmark lending and deposit rates were increased 25 bps each to 5.56 percent and 2.5 percent, respectively. Instead, Chinese policy makers have focused on removing liquidity from the economy by adjusting bank reserves and the lending target. Reserve requirements, for example, have been increased six times this year, including three increases in December alone, to 18.5 percent. While the magnitude of this move certainly indicates a willingness to take action, the impact of an increase in reserves is likely to have a decidedly muted impact on the economy in contrast to that of an interest rate increase.
In choosing to forego interest rates as a policy tool at this time, the Chinese government is likely weighing not only the temporary nature of food price inflation, but to a greater extent the impact tighter policy would have on the value of the yuan. In addition to placing a more forceful brake on the economy, higher interest rates would likely attract additional foreign asset flows into China, effectively increasing upward pressure on the yuan.
China may be correct to exercise caution, but there are real risks to letting inflationary forces take hold, especially for a government whose legitimacy is predicated on its ability to maintain social stability. Beyond the potentially disruptive social implications of rising inflation and food prices, the current low level of benchmark interest rates forces Chinese savers to endure negative real rates on bank deposit accounts. These negative real rates, combined with restrictions on capital flows out of the country, create an appetite for yield which may lay the foundation for asset bubbles in local equity and property markets.
Despite the PBOC's reluctance to act thus far, many economists expect a 100 basis point increase in both the lending and deposit rates in 2011. This will help tap the brakes on the economy and restrain inflationary forces to some extent. The outlook for the yuan is less certain. At a December economic policy meeting in Beijing, China communicated that the current currency policy would remain largely intact next year, despite increased international pressure to allow for further yuan appreciation. Regardless, exchange rate policy will be a likely conduit for change as price pressures build and China seeks a more balanced approach to growth. Additionally, as China prepares for President's Hu Jintao's first visit to the U.S. in January, keep in mind that Beijing has a track record of politically timed action.
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