Drought a reminder that it never rains but it pours

Suddenly the battle to bring inflation under control is looking a lot more urgent. On Tuesday, the People’s Bank of China announced an increase in interest rates. The latest rise was the third since October last year, and came just weeks after the mainland authorities instructed banks to lock away a greater proportion of their deposits as reserves.

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Guanyu said…
Drought a reminder that it never rains but it pours

Tom Holland
10 February 2011

Suddenly the battle to bring inflation under control is looking a lot more urgent. On Tuesday, the People’s Bank of China announced an increase in interest rates. The latest rise was the third since October last year, and came just weeks after the mainland authorities instructed banks to lock away a greater proportion of their deposits as reserves.

Clearly, the central bank wants to create the impression that it is on top of price pressures, to dampen expectations of inflation among consumers.

But it will have its work cut out. Although the mainland’s official rate of consumer inflation eased to 4.6 per cent in December, the decline is likely to be no more than a temporary dip. With many prices continuing to climb on a week by week basis, the authorities are almost certain to announce next week that inflation accelerated to well above 5 per cent in January.

And the rate looks set to go on rising over the coming months, despite the central bank’s action.

Part of the reason is that, although the authorities want desperately to be seen to be tackling price pressures, the bank reserve ratio and interest rate increases in the past few months hardly amount to aggressive monetary tightening.

Reserve ratio increases are mainly a cheap way for the central bank to mop up the domestic liquidity it creates by intervening in the foreign exchange market. But given that the banking system is sitting on excess reserves, they do little to restrict banks’ ability to make new loans.

Similarly, the interest rate rises we have seen so far have also had little effect. With greater increases on both short-term and long-dated time deposits than for benchmark one-year rates, Wednesday’s round of rate rises was clearly intended to persuade savers to leave their money in the bank.

But considering that deposits across the maturity curve are still paying interest rates well below the headline rate of inflation, the paltry rate rise is unlikely to convince many that the bank is a rewarding place to keep their savings.

Instead, they are likely to do what mainland savers have done during past bouts of inflation, which is to take their money out of the bank and either invest it in the property market, exacerbating asset price inflation, or use it to buy consumer goods in the expectation that they will get more expensive, which adds to inflationary pressures.

Nor will Wednesday’s interest rate rise do much to constrain runaway bank lending, which has been the main cause of the monetary expansion that is driving inflation higher.

Even following the latest increase, lending rates remain only between 1 and 2 percentage points above the inflation rate.

In an economy growing at a nominal 17 per cent rate - or 10 per cent after adjusting for economy-wide inflation - that hardly acts as a deterrent to new borrowing.

In any case, most bank loans go to the mainland’s state-owned companies, which are notoriously insensitive to interest rate rises.

If the authorities really want to tighten monetary conditions, they need to restrict the quantity of lending available, not raise its price.

They are trying. With the central bank believed to have cut its implicit target for new loans this year to 7 trillion yuan (HK$8.3 trillion), compared with actual loans of 8 trillion yuan last year, there is certainly a lot of talk about quantitative controls.

But if reports that the country’s banks made 1.2 trillion yuan in new loans in the first three weeks of last month are correct, there is little evidence that the financial sector is listening.
Guanyu said…
As a result, if the central bank really wants to stamp out inflation, it will have to get a lot more aggressive, jacking up interest rates so that depositors earn a decent return and imposing much stricter quantitative controls on lending.

That will risk weakening the banking sector, but the task is rapidly becoming urgent.

A worsening labour shortage in east coast manufacturing and service sectors is pushing urban wages sharply higher, which threatens to exacerbate the pressure on prices.

At the same time, a severe drought across grain growing regions has driven wheat prices up to hit a record high on the Zhengzhou Commodity Exchange this week. With foodstuffs making up a third of the consumer inflation basket and food prices already rising at a 10 per cent annual rate, fears about a poor June harvest are only going to fuel inflation.

A drought now, when they are already behind the curve, is the last thing mainland monetary authorities need.

It is all a reminder that, when it comes to inflation, it never rains but it pours.

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