A slew of Chinese data is due to be released on Thursday: GDP, PPI, CPI, investment, industrial production and retail sales. Despite several tightening measures — mostly increases in bank reserve requirements rather than interest rate hikes — I expect both production and inflation data to be strong. The market got very excited back in November about the potential for Chinese monetary tightening, but I don’t think such tightening will have much of an effect on the Chinese economy for some time.
Politically, the Chinese authorities are in a difficult situation. They are terrified of weak growth, let alone recession, because they believe that continued growth is the main thing keeping a lid on political tensions in the country. For that reason they got though the global recession by ordering a massive credit expansion through the state-owned banking system, which led to rocketing residential and industrial investment, much of it by state-owned companies and local governments. Strong credit growth continued through 2010.
However, the credit-expansion strategy is now looking unsustainable. The fixed exchange rate, rising international commodity prices, a lack of productivity growth in the domestic agricultural sector and negative real interest rates are creating rising inflation, which makes for political tension — which is exactly what the authorities most fear.
What is the government’s response? A tighter monetary policy would reduce inflation, but it would do so by slowing the economy. The government cannot stand by and do nothing (and there will be a variety of camps with the institutions of government), so there have been some modest tightening measures, but nothing that would hit growth enough to cut the inflation problem dead. Meanwhile, pressure from the government for wage restraint is likely to be muted because higher wages are necessary to keep workers in line in the face of rising food bills. Thus neither growth nor inflation is likely to be significantly reduced.
What are the investment implications of this picture? In the short term, I expect commodity prices to continue to be buoyed upwards by China’s boom, perhaps with the odd pullback as (ungrounded) fears about monetary tightening come to the fore. In the long term, I think China’s government risks painting itself into a corner. As I said in my last post, the Chinese only plan one move ahead. That means they will allow the credit boom to continue in order to finance a continuation of the country’s remarkable growth, and hope that the inflation problem goes away. If it does not, then deciding on the next move will be a lot more difficult.