No need for a shift in monetary policy in China

Economist Intelligence Unit ViewsWire  |  Aug 12th 2008

There are few countries in the world where double-digit rates of GDP growth would qualify as a cause for concern. However, China has become so used to supercharged rates of expansion that, despite GDP growth of 10.1% in the second quarter, panic is spreading over the state of the economy. Amid press reports of slowing sales of cars and other key consumer goods, of soaring costs for labour, materials and power, and of problems in the export sector, the lobby pressing the government to relax monetary policy has gathered strength. When top officials conducted a tour of China’s coastal regions in person to assess the state of events on the ground in July, there was a widespread expectation that this was a prelude to a formal change in government priorities.

On the face of it, expectations were justified when pronouncements at the end of July, following a key government economic policy meeting, appeared to shift the priority from controlling inflation back to maintaining steady and fast development. This was accompanied by an adjustment in the export VAT rebate regime, which reversed some of the steps taken last year by increasing the rebates available to garment and apparel producers from 11% to 13%. The People’s Bank of China (the central bank) is also reported to have increased the annual loan quota for 2008 by around 5%, instructing banks that the new funds should be channelled towards small and medium-sized enterprises (SMEs) and areas affected by the May earthquake in Sichuan. Some observers have also made much of the fact that the renminbi has actually fallen against the US dollar for much of the past month—weakening from around Rmb6.81:US$1 in mid-July to Rmb6.86:US$1 in early August.

The government appears to have pulled off something of a confidence trick, however. In reality, policy does not appear to have been relaxed much at all. The renminbi, for example, is continuing to strengthen on a trade-weighted basis; recent trends against the US dollar reflect the US currency’s upwards trend against other major currencies like the euro, yen and sterling in July. The VAT adjustment is more a case of micro-level tinkering to provide relief to a labour-intensive sector. Its macro-level impact is likely to be minimal—especially as it was accompanied by a reduction in the rebates available for other, polluting products like high-grade zinc and some types of battery. Indeed, the loan increase is the only really substantial move to relax policy, but even this was minor, opening the door to another Rmb200bn (US$29bn) of lending against a total loan stock of some Rmb28.6trn (US$4.2trn).

Given the tightening effect from slowing exports and falling equity and property prices (the government’s conservative property data showed house prices falling month on month in 15 cities in June), the help the government has provided will give only marginal relief. However, the relief is well targeted. China’s SMEs are the most dynamic part of the economy, but the least well served by the financial sector, and they have borne a disproportionate burden during the policy-induced credit rationing. Measures to support labour-intensive industries also make sense if the government is seriously worried about the political ramifications of the export sector’s troubles, especially during the Olympic Games. Nevertheless, in the long run the prospects for low-value-added apparel do not appear good.

The continued tight policy stance shows a welcome firmness in official decision-making. Inflation has been falling since April and is expected to remain on a downward trend until early 2009, as pork prices fall sharply relative to a year ago, but underlying inflationary pressures are widespread. With producer price inflation at 10% year on year in July and still rising, companies may increasingly seek to pass on costs to customers. Retail sales are still expanding strongly, up by 21.4% year on year in nominal terms in the first half of 2008 (an acceleration even in real terms), with strengthening rural demand apparently offsetting some weakness in urban areas. Such strong demand could give confidence to companies wanting to experiment with higher prices.

Meanwhile prime lending rates, at 7.47%, remain bizarrely divorced from nominal GDP growth, which stood at over 22% year on year in the second quarter. Against this background, demand for credit has naturally remained very high, forcing the government to ration access to it through credit quotas on the banks. Ideally China should be raising interest rates in order to reduce reliance on quotas, which tend to benefit those with the political leverage to gain access to credit rather than the most efficient producers, as well as encouraging firms to resort to non-regulated (and often illegal) financing. A stronger renminbi would also help to reduce inflows of liquidity into the economy. However, whichever method the government chooses to control the money supply, there is certainly no sign yet that policy needs to be relaxed.

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