RGE WEDNESDAY NOTE : STILL NO TIGHTENING IN CHINA / ROUBINI GLOBAL ECONOMICS ( VERY HIGHLY RECOMMENDED READING )

Greetings from RGE!

A credit-fueled investment boom successfully boosted China’s growth to 8.7% in 2009, but cheap money drove up asset prices as well, especially in property markets. As China’s output gap closes, loose money is now set to become inflationary, particularly if China’s potential growth rate has come down slightly, as RGE thinks it has. The People’s Bank of China (PBoC) has twice hiked banks’ required reserve ratios (RRR) in 2010, following a return to net liquidity reductions through open-market operations in October 2009, but RGE suspects that the tightening moves have had little effect. As discussed in a recent RGE analysis, “China: No Exit,” , China’s monetary policy has shifted toward a neutral stance in recent months, but it will have to tighten further if inflation and the property bubble are to be contained.

China has not yet started to tighten liquidity significantly, nor has it laid out a clear path for its exit from the extraordinarily loose monetary conditions put in place at the end of 2008. The recent RRR hike, which comes into effect on February 25, will drain just over RMB300 billion in liquidity, but in the first two weeks of February, the PBoC injected a net RMB508 billion into the banking system through open-market operations to ensure banks had enough cash on hand for last week’s Chinese New Year holiday. It is widely expected that the bank will drain this liquidity after the holiday, and the RMB300 billion withdrawn through the RRR hike will prove helpful but insufficient in this effort. Tuesday’s RMB17 billion one-year bill sale suggests that the central bank may be waiting to see the effect of the RRR hike before moving to a more aggressive tightening stance. It will be difficult, however, for the central bank to tighten very much, even if it had the political backing to do so.

Other sources of liquidity make this task harder. There are RMB1.2 trillion in central bank bills and repurchase agreements set to expire in the next two months. In March alone, RMB680 billion in bills will expire, more than double the RMB290 billion monthly average over the past four months. Banks are already thought to be holding about 1.5% of deposits in additional excess reserves at the PBoC, dulling the impact of the RRR hike even further.

The political will to tighten monetary conditions looks weak in China, particularly concerning any appreciation of the RMB. On Monday, President Hu Jintao headed a Politburo meeting on economic issues that reiterated the “active” fiscal and “moderately loose” monetary policies put in place at the end of 2008. On March 5, Premier Wen Jiabao will present the government’s work plan to the National People’s Congress (nominally China’s highest government authority), likely reiterating this stance.

Still, RGE expects the gradual tightening of monetary policy will continue in the coming weeks and months. Rising inflationary pressures are likely to push China’s policymakers to tighten monetary conditions in Q2. This will cause some pain to important interest groups this year, and in RGE’s view, policymakers will look to distribute the pain, including allowing higher consumer inflation.

Credit is likely to be tightened only moderately, through administrative controls and higher interest rates, as significant tightening could spark a large jump in non-performing loans. As highlighted in the Q1 2010 outlook for China, quasi-official municipal and development companies will soak up a greater portion of lending in 2010, which will lead to tighter conditions for all other borrowers. Small- and medium-sized enterprises would be hit the hardest, but even state-owned enterprises would be forced to tap their retained earnings to cover their financing needs, which could push them out of the market for levered bets on property price increases.

Thus, RGE expects lending to grow by around 20%, slower than the 30% in 2009 but still reaching slightly above the RMB7.5 billion targeted by regulators. Interest rates should be hiked modestly over the year, as early as Q2, and the RRR has at least another 100 bps or so to climb. These moves would let some of the air out of the property market, though probably avert a collapse, and would lead to a slowdown in investment growth. In order for this strategy to work, however, renminbi (RMB) appreciation will have to contribute to containing inflation.
Exporters, and their political backers, are the main source of domestic opposition to RMB appreciation. The Commerce Ministry has made Premier Wen’s tirades against currency appreciation look polite by comparison. The RMB’s relative strength against the euro, a result of re-pegging to the USD, and concerns about hot money inflows also will dampen China’s enthusiasm for using RMB appreciation to contain inflationary pressures. As such, RGE expects only modest RMB appreciation in 2010, with a small step-up of maybe 2% coming as early as Q2, and another 3% or so of appreciation to follow at a gradual pace. Assuming that the dollar remains strong on a trade-weighted basis, this move will dampen some of the inflationary pressures from imported goods, but will counteract the credit slowdown’s effect on asset prices.

China thus looks likely to be slow in exiting from its excessively loose monetary conditions, and somewhat higher inflation looks to be the path of least resistance in 2010. With core G3 central bankers set to remain on hold through 2010, Chinese authorities will be reluctant to increase interest rates, even though deposit rates are set to become negative in real terms as early as Q1. Any increase in the interest rate differential with the U.S. could further increase the attractiveness of investing in China, putting yet more pressure on China’s capital account. Should it want to limit the pace of appreciation, China might not only strengthen the implementation of its existing capital controls, as it has been doing for some time, but could also impose new controls on inflows.

Still, given the role that inflation has played in past episodes of political unrest, policymakers should move to rein in inflation once it surpasses 3% y/y growth for a couple of months. RGE expects the measures outlined above to halt inflation’s upward climb around July, when it will exceed 4% y/y. As RGE argued in “The People’s Bank of China and the Road Not Taken,” the Chinese monetary exit strategy could add to volatility in global asset markets, particularly of commodities, given the role that China has played in supporting Asian exports and its commodity demand. A reduction in Chinese liquidity should reduce speculative demand for base metals.