What does PBOC's latest rate hike tell us?

On 19 October, the People’s Bank of China announced a series of rate hikes. Although economists have been arguing for monetary tightening for months, this move was a surprise to many in the market.

This policy adjustment tells us several things:

• China's monetary policymakers see greater inflation risks than the headline CPI inflation data;
• the government is probably trying to avoid the mistake made by Japan in the 1980s: loosening domestic monetary policy in order to reduce pressure for currency appreciation;
• therefore currency appreciation is likely to continue, if not accelerate; and
• the authorities might adopt certain measures to control the capital account temporarily in order to discourage “hot money” inflows.

China's headline CPI rose to 3.5% year-on-year in August, up two-tenths of a percentage point from the previous month. A look at the disaggregated data reveals that inflation is mainly driven by food prices.

This is the reason why some officials argue that monetary tightening was neither needed nor effective. Nevertheless, during the thirty years' reform period, almost every major inflation problem (those of 1988, 1993, and 2007) was initially caused by food inflation. Monetary policymakers have learnt not to treat food inflation lightly.

The current momentum of inflation is already pretty serious. CPI rose by 0.6% month-on-month in August, which can be translated into an annualised rate of 7.2%. This certainly is way above the central bank's target. More importantly, the headline number is probably grossly underestimated due to under-represented service prices in the basket.

Some economists suggest CPI is currently closer to 5%-6%, compared with the official number of 3.5%. The Ministry of Commerce collects market prices for agricultural food every week. These numbers confirm that food prices already rose during the past three month at annualised rate of above 30%.

But that's not all. Two more factors shadow outlook of China's inflation picture.

• One, loan growth is slowing; this year's new loans will likely surpass the central bank's target of 7.5 trillion.

This is about 50% more than in a normal year. With negative real deposit rates, liquidity holders desperately look for opportunities to invest. They first pushed up stock prices and then housing prices. When these prices stabilised, they shifted their focus on certain types of commodities, such as beans, cotton, garlic, and sugar. As long as liquidity is abundant, some prices will rise dramatically.

• Two, wages are rising by 20%.

Economists and government officials still dispute the notion that China is rapidly approaching the Lewis turning point. But every business person in China agrees that it is happening. It is increasingly difficult to find additional workers and labour costs are skyrocketing.

Increases in wages are actually a positive development for China today. It has already led to improvement in consumption and therefore should be good for rebalancing the economy. But inevitably, it will be inflationary.

The rate hike on 19 October is not only an effort to combat potential inflation, it is also an important departure from the typical Japanese approach of fighting currency appreciation. In the months following implementation of the Plaza Accord in 1985, Japan lowered interest rates and increased its money supply in order to reduce pressure for appreciation and mitigate its impacts. That approach, however, caused even more devastating consequence – a bubble, which eventually collapsed in 1989 (see Corbett and Ito 2010 and Ito 2010 on this site for more discussion).

Some Chinese policymakers had a similar mindset in the early days, believing China could not raise rates because to do so would exacerbate currency pressures. But since the beginning of this year, the asset bubble has been a persistent source of worry. Indeed, the government has already implemented a number of tightening measures aimed towards the housing markets. Yet these measures, unfortunately, have not had much impact since they have not addressed the root cause of the bubble risk: liquidity.

The rate hike on 19 October is unlikely to lead to a collapse of the housing prices, which have potential to go up further in the coming years given the healthy balance sheets of households and banks. But the latest change in the mindset of government officials may be able to help China avoid major asset bubbles like those experienced by Japan in the late 1980s and by the US during the early years of this century.

There is a worry that rate hike might lead to more inflows of “hot money”. This is probably true, given that all major central banks and those in Asia are in a “pause” mood, if not a “loosening” mood. But if the rate hike adds downward pressure on asset prices, it may also discourage hot money inflows. The net impact is not clear, but hot money is not something the government can completely eliminate.

In the near term, China’ government is probably safe to allow the currency to continue to appreciate. With risks of a double dip receding, China’s policymakers are probably more confident about the growth outlook. There is also a possibility that China may be tightening controls over certain types of capital inflows in order to reduce “hot money” flows. These, however, should be viewed as temporarily responses to volatile market conditions. The long-term trend of capital account liberalisation remains on the track.

Corbett, Jenny and Takatoshi Ito (2010), “What should the US and China learn from the past US-Japan conflict?”, VoxEU.org, 30 April.
Ito, Takatoshi (2010), “China’s property bubble”, VoxEU.org, 15 April.