Editor's letter: China’s day of reckoning


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Last month, Euromoney attended a reception celebrating a landmark anniversary for one of China’s leading financial institutions. The event was held in an historic London building and was attended by several dignitaries and luminaries of the investment world.

All the talk was of China’s inexorable progress. No one could countenance the notion that China’s economy will suffer anything other than a minor hiccup in the year ahead. All bearish thoughts were dismissed.

Yet there was a fin de siècle air about the event. Perhaps it was former Labour government business secretary Lord Mandelson’s glad-handing that prompted the sentiment.

China’s economy is under strain as inflation threatens to spiral out of control.

Officially, consumer price inflation was up 5.1% in November year on year – a 28-month high. Goldman Sachs’s chief China economist says the country could see double-digit inflation unless Beijing takes more action soon. Many analysts believe consumer price inflation is already running at that level, given the rise in food prices.

Concerns are mounting over asset prices too. Real estate prices in November in 70 major cities were 7.7% higher than a year before. The problem is especially acute in the metropolitan areas. In Fuzhou the housing market is overvalued by 70%, in Hangzhou nearly 67% and in Tianjin 54%, according to a recent survey by the Chinese Academy of Social Sciences, a government thinktank. In Beijing house prices are 22 times disposable income; in the US at the market peak in 2007 it was 6.4 times.

Berating the Americans over their ultra-loose monetary policy might make Chinese officials feel better about themselves – and their accusations against the Federal Reserve of encouraging asset bubbles are not without merit – but the main reasons for China’s overheating economy lie closer to home.

China’s policymakers have relied on a mix of tightening bank reserve requirements – six times in 2010 – rate increases, home purchase restrictions and price controls to stem the tide. But these policies are insufficient and in some cases are fuelling the inflation fire rather than damping it down.

Raising nominal interest rates in a slow and gradual manner is meaningless when the acceleration in inflation means that real rates are negative and falling, stimulating lending, speculation and asset bubbles.

There is very little consumer finance in China apart from mortgages, so rate increases have a minimal impact on consumption. Instead, if anything, they encourage further distortion because China has such a high savings rate, with most household wealth held in the form of bank deposits. An interest rate hike increases overall household wealth and so potentially raises demand.

China’s inflationary pressures are largely a symptom of its economic model. Its money supply is one-fifth bigger than that of the US but its economy is one-third of the size.

China needs to adopt more credible policies. Reining in bank lending is one step. That the new loan quota for 2011 is rumoured to be a staggering $1.1 trillion is not a good sign. Regulations need to be tightened to improve oversight of banks’ balance sheets and diminish the influence of shadow lenders – special financing vehicles set up by local governments to enable spending beyond their budgets.

If not an investment bust awaits. Indeed Andy Xie, the former China economist at Morgan Stanley, reckons China’s inflation could trigger the next financial crisis.

For that reason China’s authorities need to go beyond basic tightening measures and accelerate structural reforms. Liberalizing the exchange rate, developing social safety nets, allowing companies to pass on their profits to households in the form of dividends, fostering the capital markets – all these initiatives would allow China’s economy to grow in a more balanced and stable way.

China’s leaders understand the economic merits of the argument. They only have to look at how Japan’s credit-financed export-oriented economy imploded to see what might happen if reform is left too late.

The noise coming out of Beijing is encouraging. The next five-year plan states that the creation of a more consumer- and service-oriented economy is its long-term goal.

The trouble is these goals are non-binding and have been stated before. China might make incremental gestures but will it undertake the more politically sensitive reforms? The country’s record suggests not.