China's monetary base is highly correlated with its growing levels of FX reserves as the CNY is essentially fixed to the USD. To keep this peg in place, the People's Bank Of China (PBOC) needs to sell CNY against the USD. But this creates liquidity in its domestic market, and in the process, stokes inflation. Since commodities are denominated in USDs, the weak dollar of late also makes commodities more expensive. Hence, China imports inflation when they import materials to build the goods they export.
Above-consensus inflation reports suggest the persistent need for further monetary tightening. The PBOC raised the RRR (Reserve Requirement Rate) for its largest banks to 21% and resumed sales of 3Y bills at 3.8% (an expensive way to suck liquidity out of the economy versus raising the RRR). Other larger problems in China persist.
1. Inflated property prices: Chinese citizens have few options in which to invest their money outside of real estate. Bank deposit rates are set well below inflation (in real terms deposit rates are negative 3% and lending rates are slightly positive); the stock market is perceived as too risky and volatile (and rigged). Overseas investment is prohibited.
2. Large, state-owned industries are heavily invested in real estate. Most of their loans have come from state-owned banks. China's authorities coerced the state banks to make the loans to fight the global recession which took hold in 2008.
3. The Chinese government has also invested heavily in infrastructure and other projects, to the tune of 50% of GDP. But job creation has been anemic, growing just 1% a year. Job growth is key to keep stability in China and the communist party knows this well.
4. Political unrest is also a concern after the events in Egypt, Tunisia, MENA and the Jasmine uprising. Keep in mind that growth in China fell by 2/3 after the Tiananmen Square protests in 1989 to 4%. Political unrest produced economic stagnation.
5. In a little-noticed move after S&P warned this it might cut America's credit rating, Fitch said they might do the same to China...citing that they are worried about bailing out China's banks which are overlending against a backdrop of overpriced property. Fitch is not worried about China sovereign debt but instead a scenario where they would have to bail out the banks.
The PBOC raised the reserve requirement for banks for the fifth time this year after raising it 10 times in 2010; interest rates on deposits and loans have been raised four times since October 2010. Retail loans have halved since January 2010 and corporate loan growth is off by 30% in the last year. This tighter policy has resulted in a sharp decline in construction volume and property sales. Car sales are also lower by 20% and demand in China for material and raw commodities has fallen.
China has further tightened monetary policy since that May issue was published, with little success at stemming the inflationary pressures. And when China released its July CPI and its PPI data in early August, both showed gains that were higher than market expectations. CPI for July rose to 6.5%, a three-year high driven primarily by higher food prices. PPI in July came in at a lofty 7.5%.
Economic growth continues to weaken as the PBOC chooses to use a restrictive monetary policy to wean out inflation in the economy which is portrayed in the slowing GDP number of late. Rsource www.ibtimes.com
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