China’s latest interest rate increase puts it near the end of a sustained campaign of monetary tightening, a shift in policy stance that will support economic growth this year but lay the groundwork for asset bubbles down the road.
The steady drip-drip of actions to tame inflation since October has succeeded in reining in money growth and slowing the upward momentum of price pressures.
Base effect dictates that consumer price inflation should fade quickly in the second half after reaching a forecast 32-month-high of 5.2 percent in the year to March and possibly as high as 6 percent in June.
That will give officials the confidence to slowly take their feet off the monetary brakes, especially given their worries about the economic impact of Japan’s disaster and Europe’s debt crisis.
“Generally speaking, the inflation rate is stabilising. And that, together with some signs of growth moderation, means that they don’t need to tighten so much anymore,” said Ken Peng, an economist with Citigroup in Beijing.
So runaway price increases are not on the cards. The far bigger worry is that with inflation stabilising, officials will feel little urgency to raise interest rates much higher — and that low real rates for an extended period will greatly increase the risks of over-investment and a property bubble in China.
To be sure, no one is forecasting a relaxation of monetary policy, just a gradual phasing out of tightening moves.
Economists polled by Reuters expect only one more interest rate increase this year after four in the past six months and they see three more reserve requirement increases after six since November.
The central bank may also slightly loosen its grip on lending by commercial banks, a crude control measure that is China’s most important monetary policy tool.
“Our view is that the central bank may have a brief period of policy pause, amidst the growth slowdown and better-behaving lending activities,” Dong Tao, an economist with Credit Suisse, said in a note.
“The pause is unlikely to be publicly announced, in our view, but the authorities may have more tolerance towards lending activities,” he added.
While a short-term pause or, at least, slowdown of tightening might be prudent and keep the economy on track for 9 percent growth this year, the implications of a longer pause would be more troubling.
The problem is that, once the dust has settled, the new normal for Chinese inflation will be higher than in the past, averaging about 4 percent because of structural forces in the form of steadily rising wages and food demand.
As a result, deposit rates, which now stand at 3.25 percent at the benchmark one-year tenor, will probably stay very low or negative in real terms for quite some time.
For China, which is struggling to cool its property market and faced a shares bubble just a few years ago, this threatens to fuel soaring asset prices and financial instability.
“Most household saving currently exists in the form of bank deposits. Very low interest rates, especially negative real rates, will encourage households to look for alternative investments,” said Tao Wang, chief China economist for UBS.
“At this moment, because of the lack of development of capital markets, that asset tends to be property,” she said.
The upshot is that the central bank will have to resume raising interest rates next year to make real deposit rates positive, Wang said.
Yi Xianrong, a researcher with the Chinese Academy of Social Sciences, a top government think-tank, agreed that the central bank still had a long way to go to clean up from explosive lending unleashed over the past two years to fight off the global financial crisis.
“The aftermath of massive money-printing can’t be cured by four modest interest rate increases, and China has to do a lot more to get monetary policy back to normal,” Yi said.
The central bank appeared to acknowledge as much in a closed-door meeting on Wednesday, saying that there was still too much cash in the economy. It called on banks to buy a large chunk of maturing bills this year to keep a lid on money growth, sources said.
But no matter how active the central bank is in open-market operations, keeping real interest rates low for months or even years will add to bubble risks. And it could also set back attempts at more fundamental reform of the Chinese economy.
The focus of Beijing’s Five Year Plan for 2011-15, announced in March, is on stimulating more consumption to reduce the nation’s reliance on unsustainably high rates of capital investment.
That goal will be put in jeopardy unless interest rates are increased more decisively, said Peng of Citigroup. Low rates act as an implicit subsidy paid by households to firms. Investment is extremely cheap for big companies, while ordinary people do not earn a decent return on their savings in banks, adding to their reluctance to spend.
“We end up having a very low cost of capital,” Peng said. “This is not what the Five Year Plan set out to do.”