Wednesday, January 13, 2010

China Will Tighten Monetary Policy More

The current rapid Chinese boom has two sides: one unsound side in the form of the structural strength of the Chinese economy with a high savings rate, shift of resources from the rural sector and limited government spending. The second factor is an excessive credit boom.

The structural strength of the Chinese economy means that long-term prospects remain bright. However, the credit boom risks creating even more malinvestments and asset price bubbles, which in turn threatens growth.

The latest move to increase reserve requirements is a step in the right direction, but it is certainly not good enough. China should and most likely will move forward with more actions to restrain credit growth. Higher reserve requirements is one effective measure to achieve that, ending or reducing tax breaks for exporters is another move that would be effective (a lower trade surplus will reduce the need to expand the central bank balance sheet, and so restrain monetary inflation).

Raising interest rates and allowing the yuan to appreciate could perhaps also achieve it, but the risk is that higher interest rates and an appreciating currency will lure even more "hot money" into China, causing the central bank balance sheet to expand. Recent moves to restrict such inflows will reduce that risk, but not eliminate it.

But regardless of which sort of action they choose, it seems very clear that they will be forced to continue with more tightening measures as the latest one will prove insufficient to bring down credit- and money growth to more sustainable levels.