Reading Chinese tea leaves

October 22, 2010

China’s GDP and Inflation figures for the quarter ending September are out . And they look promising indeed . GDP at 9.6% although a tad lower is still pretty impressive. Inflation at 3.6% per cent is a little more than August’s 3.5% .

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The figures mean that  China is growing robustly and the economy is not yet on the threshold of overheating . And this provides an interesting perspective to Tuesday’s interest rate hike by the Peoples Bank of China .

The 25 basis point interest rate hike, the first in three years ,  was in itself not a ground shaking event. But it had a huge psychological impact . Markets all over the world were spooked amidst fears that the world’s fastest growing economy is overheated and planning to curb growth .

Although the markets are right to worry about the overheating of Chinese economy, Tuesday’s move by the Central Bank ,like all things Chinese , was based on  much more complex, and political, reasons.

This rate hike is to be seen as a signal to US before the coming G-20 summit . One of the major argument proposed by US favouring a devaluation of the Yuan was based on the premise that a weak Yuan causes inflation in China , and in todays era of sluggish economic growth it is in China’s interest to let the Yuan appreciate rather than going for the more risky option of interest rate hike. China has hit back by doing the exact opposite.

China has let it be known that it has enough confidence in its growth to accept the risk of interest rate hikes. Tuesday’s cuts are a signal to the world that the China is not going to do much about its currency and would prefer to handle any inflationary pressures through domestic policies.

Impressive indeed . But behind all this nationalistic grandstanding , lurks a very real and potent danger to the Chinese miracle : a rapidly building asset price bubble. And  the Chinese leaders, who are busy proclaiming the resurgence of their nation and letting it be known to the whole wide world that China would not cave in to any external pressure ever again,  are doing precious little to tackle it.

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China is awash in money. As the great Chinese middle class becomes richer and richer, a boom mentality is setting in . Interest rates in the Chinese informal market are running at 20%, rates that were last seen during the dot com bubble in US. There is a mad rush towards the real estate sector. Couples are faking divorces to get past the “one house per  family” policy. High-end property prices in dozens of Chinese cities have doubled during the global financial crisis.   An asset price bubble, particularly in the real estate sector , appears to be rapidly building up.

Sooner or later this asset price bubble would spill over as inflation in the customer price index . Although, the September figures show only a marginal increase, there is a clear and persistent danger of inflationary trends in the Chinese economy.

Precious little is being done by the Chinese political mandarins to rectify the situation . Much of Chinese competitiveness , as this article points out , is based on low interest rates. The Chinese government is worried about the potential adverse effects any monetary tightening could have on this competitiveness. More worryingly, powerful political interests in China have vested interests in not letting the rates rise . Tuesdays interest rate hikes, by their relative ineffectuality, serve to demonstrate, at least for the time being,  the unwillingness of the government to tackle the situation head on .

But again , we must not rush to draw conclusions . One of the best strategy when dealing with the Dragon is patience. Let us wait and watch , because this could well turn out to be more complex than it seems .




One Response to “Reading Chinese tea leaves”

  1. sunil Says:

    Interesting diagnosis.

    The rise in interest rates is indeed strange given the asset bubble, as it would increase inflows to the economy and at the same time lead to an upward revision in the yaun thereby hitting Chinese exports.

    Is it a wise move?? As you pointed out we can just wait and watch with the Dragon.

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