Why China should keep raising interest rates
The recent decision by the People's Bank of China to raise interest rates comes as a surprise because, first, headline inflation is below the central bank's target of 4 per cent and, second, administrative measures to rein in credit growth have been seen as the main tool to prevent the economy from overheating.
The official explanation cited concerns over inflationary pressures, but stock markets in Shanghai and Hong Kong seemed to take a more cynical view by staging a relief rally. Many investors interpreted the 25-basis-point rise as either a message from China to blunt the mounting attacks on the yuan exchange rate policy in the run-up to this week's G20 meeting or a symbolic reaction to asset inflation in China. In other words, the market remains buoyed by the perception that real interest rates in China will remain negative.
Is such a scenario likely? In the short term, yes. The dominant thinking of policymakers in Beijing is that the risk of a slower-than-expected recovery among developed countries outweighs the danger of domestic inflation. Yet, in the medium term, the social cost of negative real interest rates will probably become painfully apparent. Because food expenditure no longer accounts for a significant share of their disposable incomes, urban Chinese consumers are more immune to food inflation than in previous decades. However, it is public knowledge that inflation is underestimated. The brunt of this unacknowledged inflation is borne primarily by consumers who can't hedge against inflation, and the urban poor reliant on fixed incomes. Negative real interest rates will continue to erode their livelihoods and worsen China's income disparity as the well-off reap the benefits of asset price inflation.
The main reason behind China's understated inflation figures is that service costs are not accurately captured. Due to delayed price reforms in areas such as energy and utilities, the cost of such services will continue to climb. Furthermore, it is in China's best interest to accelerate the process of price reforms so that the economy can become more fuel-efficient in the long term. Aware of this, the government increased retail petrol prices by almost 20 per cent; utility prices are also expected to rise in the coming months.
Although these adjustments will probably cause an uptick in headline inflation, they will help statistics better reflect real price trends in the Chinese economy. In terms of price reform, it could take years to lose the legacy of artificially low factor prices. Unless the economy suffers from a severe retraction in growth, it is unthinkable for China to return to a low-inflation era.
Given that China is unlikely to undertake a sharp revaluation of the yuan exchange rate, it is only sensible for policymakers to tighten monetary policy through higher interest rates.
There are two main points against raising interest rates - the adverse impact on bank asset quality and added incentives for hot money. Judging by the recent record profits announced by commercial banks, it is hard to think that banks need more bailing out from the government. On the other front, the threat of hot money could sabotage the PBOC's tightening due to China's increasingly large foreign reserves, which may only reinforce expectations of yuan appreciation. The stubborn calls for appreciation of the currency should eventually be muted by the rise in the real exchange rate resulting from persistent inflation.
China's rising inflation is not a food price phenomenon. Reforms of key input prices will keep headline inflation relatively high, probably 4-6 per cent in the medium term, suggesting the rate rise probably marks the start of a tightening trend.
Xu Sitao is the Economist Corporate Network's director of advisory services in China
