China Faces Inflation Test in 2011

On the very last day of 2010, Zhou Xiachuan, Governor of the People’s Bank of China, said that the Bank’s number one priority for 2011 is the stabilization of food prices. It is hard to argue against the need for such action as in the past year alone, food prices in China rose a staggering twelve percent.

But it is not just the cost of food that is squeezing consumers in this fast growing market. In 2010, GDP grew by 9.6 percent during the third quarter while the first and second quarters expanded by 10.3 and 11.9 percent respectively. This is well above the two or three percent most central banks strive for as a sustainable growth rate and unless this expansion is moderated and soon, China risks an inflation crisis.

When an economy expands at too great a rate, prices for consumer goods increase very rapidly. This often outpaces wage increases and for the consumer, results in an erosion of actual buying power. Over time, this forces consumers to divert more of their earnings to the staples of food and shelter and fewer dollars find their way towards the non-essentials. As demand drops for these items, manufacturing firms respond by cutting production and reducing staffing levels to match the decline. The combination of declining buying power and increasing unemployment can have but one outcome – a decline in consumer demand that, if left unchecked, could develop into a recession.

In response to growing inflationary pressures in China’s economy, authorities implemented a series of actions over the past few years to moderate the rate of expansion. To limit the amount of foreign investment or “hot” money flowing into the country, China placed tighter rules on outside investment. To lessen the potential for a property bubble, China introduced measures to reduce foreign property ownership and has tightened mortgage rules making it more difficult to finance multiple properties.

To further reduce spending, authorities raised the minimum cash reserves China’s commercial banks are required to segregate outside of their operating funds. Intended to shrink the availability of cash within the banking system, it was hoped this would reduce lending levels without resorting to increasing interest rates. By the second half of the year however, China was forced to implement two quarter point increases.

China’s monetary authorities fear that hiking interest rates will cause the yen to appreciate against the US dollar and Euro, thereby making goods produced in China more expensive for these two important markets. While the Bank of China may accept that interest rates must rise if inflation is to be kept to an acceptable level, it is clear that the Bank will be keeping one eye on exchange rates to monitor the effect on the yuan.

Outlook for 2011

Given the Bank of China’s predilection for a more gradual appreciation of the yuan, analysts expect at most, one or two small rate hikes in the first half of the year. Also, if Europe performs as poorly this year as most expect, weaker demand for exports from China could lead to a “natural” cooling of China’s economy and could be sufficient to save the Bank of China from further interest rate action later in the year.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.