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China is fiddling while its economy overheats

China is fiddling while its economy overheats

Chinese inflation is at a 10-year high and what do economists expect officials in Beijing to do?—Raise interest rates a little.

Granted, economists are right. The People’s Bank of China tends to move in baby steps—0.18 or 0.27 percentage points at a time. Its preference for such increments rather than, say, 25 basis points has to do with the Chinese calendar, superstition and that ancient counting device known as the abacus.

Yet, the next time China raises its benchmark lending rate, one wonders if it shouldn’t add a zero to whatever basis-point increment it decides on.

That won’t happen, of course. There’s no way the Communist Party would allow 270 basis point increase in short-term rates, even if that’s what China needs. That, and an assortment of other bold policy changes, is necessary to get control over the fourth biggest economy, one on which the world is increasingly depending.

The biggest mistake China’s central bank is making is thinking it’s like the Federal Reserve or European Central Bank. In developed economies with liquid debt markets, transparency and an independent central bank, 25 basis point moves matter. In a developing, immature economy like China’s, small moves do little. Chinese central bank governor Zhou Xiaochuan on Tuesday said China Business News that “fighting inflation is our objective." If so, he’s failing in his job.

Inflation woes

Consumer prices rose 6.5% in August from a year earlier after gaining 5.6% in July. Food costs drove the increase, jumping 18.2% after a shortage of pigs pushed up meat and poultry prices. As leaders prepare for a five-yearly Communist Party congress next month, they are right to be concerned that food inflation will lead to broader price gains and will fan unrest in the most populous nation. After all, inflation was one of the catalysts behind the Tiananmen Square uprisings in 1989. This is no longer about calming markets; it’s about keeping China from going off the rails. China really needs to get serious about slowing growth and cooling asset markets.

China will claim it’s doing just that. Aside from rate increases, the required reserve ratio for banks has been increased seven times this year. The government is looking at additional measures to cool speculation in the stock and property markets. It also is opening up outbound capital channels to relieve pressure on the monetary system.

Underestimating risks

Yet, China could be underestimating the risks associated with overheating. To keep citizens from amassing at Tiananmen Square once again to demand change, China must create millions of jobs. For all the lip service about cooling the economy, slower growth may be the last thing China’s leaders really want. Inflation pressures are partly a side effect of growing affluence. The proportion of meat in the diet and shortages in arable land and water could mean even higher food prices down the road, says Jing Ulrich, chairman of China equities at JPMorgan Chase & Co. in Hong Kong. That’s hardly a small issue considering hundreds of millions of Chinese live on less than $2 (Rs81) a day.

The bigger problems involve too much money supply growth. China has great difficulty keeping its $1.3 trillion (Rs52.65 trillion) of currency reserves from boosting credit expansion. M2, the broadest measure of money supply, grew 18.5% in July. It was 10.3% in the euro area and 6.1% in the US. China also isn’t doing enough to dissuade companies from overinvesting. The country’s efforts to date have merely brought investment from exorbitant levels to ones approaching excessive.

Beijing is fiddling

Its actions have been the equivalent of a doctor fiddling with minor knee surgery when he needs to cut off the entire leg. China is fiddling with incremental increases in the costs at which banks borrow. What it really should be doing is decreasing the profit potential of companies borrowing from the banks.

If you are a chief executive and you can double your money in a year, what difference does it make if your borrowing costs rise a percentage point here and there? While free market cheerleaders like Milton Friedman would strongly disagree, China should consider attacking these excesses with higher taxes, including sharply higher ones on capital gains.

Accelerating inflation only increases incentives to speculate. Households can go ahead and put their savings in a 12-month deposit returning 4%, or they can invest in a stock market that seems to rise no matter what the government does. Rising prices also hurt China’s efforts to get consumers to spend more and create an economy led by domestic demand. The trend is becoming a global problem. Price spirals, which originate in China, may only spread around the globe at a time when central banks are cutting rates to add liquidity to credit markets. That would be a huge change from recent years, when China was exporting deflation.

“We currently are looking for one more 27 basis point rate hike this year, but clearly the pressures for more are growing," Stephen Green, senior economist at Standard Chartered Bank Plc. in Shanghai, wrote in a report to clients on Tuesday.

It’s time for China to stop fine-tuning its economy and start doing a bit of major surgery.

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