Inflation as bitter medicine
The most recent increase of the reserve requirement rate by the People's Bank of China, the eighth time since the beginning of 2010, has pushed the rate to a record high.
Thus far, the rate has been the preferred tool for policymakers to rein in excess liquidity. Interest rates tend to affect investment and consumption with a considerable lag.
At the same time, the destabilising potential of interest rate rises for China's equity markets means that such moves would be avoided as much as possible in the run-up to the leadership transition at the 18th National Congress next year. However, PBOC governor Zhou Xiaochuan pledged recently that the central bank would use all available tools, which also include interest rates and exchange rates, to combat inflation.
It is difficult to predict how high the reserve requirement rate will be, but interest rates in comparison have more room to be raised while a one-off revaluation of the renminbi exchange rate remains an unlikely event this year.
Inflation has been a hot topic in China. Current inflation (around 5 per cent) has a very different dynamic from previous bouts. In the summer of 2008, inflation was at 8 per cent when the renminbi was under immense upward pressure. But inflation then was largely caused by inflows of hot money and food supply shocks. The price rise moderated as economic growth decelerated significantly for more than six months due to the severe external shock of a global financial crisis.
This time around, inflation has been mainly caused by massive liquidity resulting from the 4 trillion yuan stimulus package (HK$4.5 trillion at the time it was unveiled in late 2008) and fiscal expansion taken by both central and local governments.
With labour shortages in coastal areas, rising commodity prices, and government programmes to raise workers' wages and other key input prices such as fuel and water, inflation is expected to remain high over the next few years.
Therefore, the inflation-fighting that Zhou referred to is mainly about withdrawing excess liquidity from the system or adopting a decisive 'exit strategy'. If such a strategy is executed successfully, excess liquidity will be mopped up, real interest rates will remain positive and a sharp revaluation of the renminbi will be avoided.
On several occasions, Zhou has compared monetary policies to Chinese medicine in terms of methodology and implementation, meaning that policymakers should take a gradual approach and try various means.
Higher reserve requirement rates curtail bank lending but undermine banks' profits. That is why all state banks have been aggressively raising funds through equity issuance for a year in order to withstand future shocks. Therefore, the central bank is likely to raise interest rates another three or four times this year.
Meanwhile, given that interest rate deregulation is China's stated long-term goal, interest rates will be on the rise in China anyway as financial institutions compete harder for deposits in the long run. Despite the official rhetoric to fight inflation, I expect China to tolerate the price rises in the medium term for a number of reasons.
First, steady inflation is being used by China to reduce, if not wipe out, exchange rate undervaluation. Assuming that the nominal exchange rate appreciates against the US dollar by 3 per cent a year in the next two years, with additional inflation differentials of 4 per cent during the same period (a sensible assumption), the renminbi will have appreciated by roughly 15 per cent against the US dollar in real terms in two years.
Second, if we understand Zhou's analogy of Chinese medicine and view policymaking as more of an art than a science, then the self-imposed inflation ceiling of 4 per cent will probably not be applied too stringently.
Third, labour shortages in coastal areas co-exist with high unemployment rates among university graduates. The central government is unlikely to use overly tight policies for fighting inflation if unemployment becomes a bigger social issue.
Xu Sitao is the Economist Corporate Network's director of advisory services in China