China: Watch The Political And Economic Pressures

The latest rate rise from China's central bank should make investors and others just that teensy weensy concerned about the country's economy.

Not very concerned, yet, but enough to make you think again when looking at the way countries like Australia are dependent on China's continuing strong growth, and the ability of authorities not to crash the economy in the next year while trying to curb inflation and handle a difficult political transition.

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China's stockmarket wasn't concerned at first,opening higher Thursday, but then fading to end 0.6% lower.

That was the second fall in as many days. Previously Chinese investors had ignored the rising level of rate rise speculation.

But other markets in the region were mostly higher, a trend that continued into Europe and the US despite the rate rise from the European Central Bank.

The ECB lifted its key rate 0.25% to 1.50% for the second increase this year.

European inflation is running at an annual 2.7%, China's could be well over 6%, yet the Chinese economy is still growing at around 9%, while the European economy's current rates range from 6% in Germany to a deep recession in Greece and Ireland.

Chinese manufacturing has slowed to just above the break even between expansion and contraction, reports continue of a cash (credit?) squeeze for many smaller companies in China with money market rates on short term cash at high levels.

Chinese bank lending has fallen and we will learn during the course of next week how lending, production, trade, car sales and inflation went in June.

The increase in the one-year Yuan lending rate to 6.56% from 6.31% applied from yesterday, as did the rise in the one-year Yuan deposit rate to 3.50% from 3.25%.

If inflation is above 6%, the lending rate will be barely positive, but the deposit rate remains deeply negative and Chinese investors are continuing to chase higher returns from property, speculation in metals and other quasi legal investments.

According to Marketwatch, a number of Chinese government economic officials told local media yesterday that there could (should in several cases) be more tightening in coming months.

Marketwatch said Xia Bin, an academic adviser to the People's Bank of China, was the most vocal in calling for more interest rate increases.

Wednesday's rate hike is "still not enough" as deposit rates remain well below the level of inflation, Xia told the state-run China Securities Journal.

"Curbing inflation should remain the top agenda for the government. It's better to raise interest rates sooner than later to stabilize expectations," the report quoted Xia as saying.

Li Daokui, another adviser to the central bank, was quoted as saying in the 21st Century Business Herald that up to now the PBOC has hesitated to raise rates too frequently for fear of attracting more capital inflows.

Zheng Xinli, head of the macroeconomic research department of the State Council Development Research Center, was quoted by Xinhua as saying that tightening may continue since there is still excess liquidity in the system. However, Zheng added that the pace of tightening may slow.

No one mentioned a freely floating exchange rate, which in the case of China, would have been helping press down on inflation for the best part of the last year.

But instead we have a managed float with a peg to the US dollar.

The Yuan has risen by around 7% in the past year or so, but that has not been enough to squeeze inflation like the 27% rise in the value of the Australian dollar has helped the Reserve Bank's anti-inflation campaign in Australia.

But now economic imperative is starting to run into the political in China.

Take this comment 10 days ago by Premier Wen Jiabao in an interview with TVB in Hong Kong (while on a trip to London).

"I believe it will be difficult to keep inflation at around 4% this year, but with hard work I believe it is possible to keep the level under 5%.......Taken together, inflation and corruption can impact a nation's political stability. Therefore, we must stabilise prices at the forefront."

Note the use of the word "difficult" and then the phrase "political stability".

Wednesday night's rate rise was the third this year and the fifth in 8 months, plus the many increases in the reserve requirement for banks: inflation is certainly proving very difficult to contain, with new reports in Beijing saying the CPI could have hit an annual rate of 6.4% in June.

But with China facing a leadership transition in 2012 (around a year away), with all the attendant knock on effects down the line in Beijing and throughout every province, political stability is the watchword.

And if the clamp down on inflation starts threatening that stability (just as inflation has caused public demonstrations in recent months) what do you think the Chinese leadership will do to preserve stability while the transition happens?

It will do anything to keep stability in place, even if it means easing off on the crack down on inflation.

This week, Wen JiaBao issued a statement on Tuesday, a day before the central bank lifted rates, and a day after it published a statement after a monetary policy meeting that reaffirmed the current "prudent" approach to monetary policy.

Mr Wen said in his statement that maintaining price stability is a priority.

During a trip to the northeastern Chinese province of Liaoning, Wen said some of the factors behind the climbing prices have been restrained, but they haven't been completely eliminated, according to a statement on the central government's website.

Wen said he had taken note of the recent sharp rises in pork prices, and the government is taking steps to rein in inflation.

"Inflation will be effectively suppressed when government policies take effect," he said, without specifying what policies he was referring to.

Authorities have used an array of measures to put the brakes on inflation, tightening the money supply, placing limits on bank lending, slapping curbs on home purchases and using public censure for some companies that have talked of raising prices. There is also speculation the government could sell pork from state reserves.

Some critics of the central bank in other government ministries and various state think tanks have started to argue for a looser monetary policy, in particular to help small and medium-sized companies gain access to credit.

Wen also said that the starting of construction on 10 million affordable houses this year is a task that "must be completed".

China has been trying to speed up construction of lower cost housing as a way to keep surging real estate prices in check. It has said it wants to start building 10 million units of lower cost housing this year but has conceded that plans are way behind schedule as local governments scramble for funds.

The official Xinhua News Agency reported recently that construction had begun on only 30% of the housing units as of May.

Already we have seen a credit crunch evident in the Chinese short term money market as the central bank battles to control a sharp rise in interest rates.

That has led some comment in Chinese media that monetary policy should be loosened to help small and medium businesses.

But some western commentators say that approach could actually benefit the so-called princelings, the well connected children and relations of powerful Chinese leaders past and present who dominate much of the business community at all levels.

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