Tags: BOC, China, Interest Rates, Jason Simpkins, Stimulus Package

China is Doing Exactly What the United States Should be Doing - Looking Ahead

By , Money Morning •

After boosting its economy with an $585 billion (2 trillion yuan) stimulus package, China is doing exactly what the United States should be doing - turning its attention toward inflation and excess lending.

The People's Bank of China (BOC) yesterday (Thursday) raised the interest rate on its three-month bills for the first time since Aug. 13. The central bank sold $8.8 billion (60 billion yuan) of three-month bills at a yield of 1.3684%. That's up from 1.3280% last week.

Also, the BOC this week drained a net $20.1 billion (137 billion yuan) from the money market through its open-market operations - its largest weekly fund withdrawal in nearly three months.

The BOC on Wednesday telegraphed the move by saying in a statement that its main goals for the New Year would be "to support steady economic growth and stabilize prices and effectively manage inflation expectations."

Analysts say the central bank's recent comments on price stability and its open-market actions are a strong indication that the central government is looking to head off long-term inflationary pressures and soak up excess liquidity.

China's consumer price index (CPI) rose for the first time in 10 months in November, increasing 0.6%. Standard Chartered Bank said in a recent note that it expects China's CPI to rise 3.5% in 2010.

However, Beijing is also seeking to curb lending and prevent asset bubbles - particularly in its red-hot real estate sector - from growing out of control.

Lending, which was spurred by the nation's massive stimulus, soared out of control as the nation rebounded from the world's strident economic downturn, particularly in the first six months of 2009. China's banks lent out about $1.08 trillion (7.37 trillion yuan) in the first half of last year, nearly double the total loans extended throughout all of 2008.

That surge in lending resulted in a huge increase in public and private investment, retail sales, and infrastructure development, but it also increased inflation expectations and stoked fears that over-investment would result in bubbles.

For example, housing prices in 70 major cities jumped 5.4% in November, the fastest pace in 16 months. Housing starts rose a staggering 194%. And while some of those increases have to do with a growing market for real estate, many analysts believe investor speculation is what's really driving prices higher.

"When you sit down with a table of businessmen, the story is usually how they got lucky from a piece of land," Andy Xie, an independent economist who once worked in Hong Kong as Morgan Stanley's (NYSE: MS) top Asia analyst, told BusinessWeek. "No one talks about their factories making money these days."

The problem is that if the real estate bubble bursts, the fast-paced growth the economy has enjoyed would grind to a halt. And that's precisely the kind of catastrophe the central bank wants to prevent.

"Credit policy is the key to curb the rising property prices, as it would have a direct impact on transaction volumes," Su Xuejing, an analyst with Changjiang Securities, told Xinhua. "We anticipate more policy tightening in the future like increasing the down payment and mortgage rates for second-home buyers."

Indeed, future policy tightening is now a matter of debate among many analysts. Some believe the BOC's recent actions are just the precursor to rising interest rates.

"It is a turning point," Ben Simpfendorfer, an economist in the Hong Kong offices of Royal Bank of Scotland plc (ADR NYSE: RBS) told the New York Times. "There is a convergence of events that will lead to higher rates."

However, other analysts argue instead that BOC's open-market operations are an indication that the government still prefers using liquidity management tools, rather than policy interest rates, to guide market funding costs gradually higher before inflation becomes a real threat.

"Mopping up excess liquidity via bill issues is still the most simple and flexible approach for the central bank," Wang Yingfeng, an analyst at Shanghai Securities, told The Wall Street Journal. "It won't hike policy rates unless it finds inflation has got out of control."

Another analyst, Qu Qing, a bond analyst at Shenyin Wanguo Research & Consulting, told The Journal that the rise in the central bank bill yield is in line with the BOC's Wednesday remarks, and we'll likely still see very low yield go up further in coming weeks.

Qu said he expects the three-month bill yield to rise to 1.5% in the near term, while the yield on one-year central bank bills may rise to 2.0% from 1.7605% currently.

Meanwhile, analysts continue to remain critical of U.S. policymakers for appearing none too concerned with the looming threat of inflation in the United States.

The Fed continues to keep interest rates at a record low range of 0-0.25% since December 2008 and has stepped up its purchases of U.S. Treasuries and mortgage-backed securities. And the minutes from the Federal Open Market Committee's Dec. 16 meeting showed no definitive move away from such accommodative policy.

"I've got to say [the minutes] were ho-hum," former Fed Gov. William Ford, who is now a finance professor at Middle Tennessee State University, told MarketWatch.

Others have suggested U.S. Federal Reserve Chairman Ben S. Bernanke wants to be certain economic growth is sustainable before acting, but Money Morning Contributing Editor Martin Hutchinson says that by then it will be too late.

"Bernanke has said he will keep interest rates around zero ‘for an extended period.' This fits with his record, which has been consistently to have the lowest interest rates possible while prattling incessantly about non-existent deflation," said Hutchinson. "With interest rates, the bottom line is that Bernanke is likely to keep them at a low level for far longer than he should. When he eventually does start to raise them, he'll do so only grudgingly, at first, even as inflation races away."

"At some point, this will all reverse," Hutchinson added. "The world's central bankers will get serious about interest rates, and commodities prices will crash as they did last autumn. However, because the world economy is just staggering out of a deep recession, that's unlikely to happen before the second half of 2010, and maybe not before the early months of 2011."

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