China wages a cool war
By Olivia Chung

HONG KONG - The Chinese government, which spent 2007 trying to prevent the country's economy overheating, caught investors on the hop this week with the sixth interest rate rise of the year, adding to indications that it will intensify its efforts to cool the economy in the coming 12 months.

With effect from December 21, the one-year deposit rate was raised by 27 basis points to 4.14% , while the one-year lending rate was raised by 18 basis points to a nine-year high of 7.47%. These and other interest rate adjustments came as a surprise as



previous rate increases were revealed on Fridays after the stock markets had closed or during weekends.

In another move to encourage depositors to keep their money in banks and not invest them in stock and the property markets, the People's Bank of China, the central bank, lowered the rate paid on money held in current accounts to 0.72% from 0.81%. A PBoC spokesperson said that the move was meant to encourage depositors to put their money in fixed deposits instead of current accounts, so that more money will stay in banks longer, instead of flowing into the asset markets.

The government's action followed the PBoC announcement on December 8 of the 10th and the largest increase in the reserve requirement ratio for banks this year, possibly presaging more aggressive macro-economic controls in the coming year.

With the latest 1% rise, the reserve requirement ratio for commercial banks reached a record high of 14.5%. That is, for every 100 yuan deposit they receive, they now have to put aside 14.5 yuan (US$13.50)in reserve, limiting the scope for lending. The central bank has raised the ratio nine times this year, the latest being a more aggressive rise than the 0.5 percentage point increases on previous occasions.

Jun Ma, chief economist of Greater China Head of China/Hong Kong Macro Strategy at Deutsche Bank Hong Kong, said in a research note after the announcement of the latest rate changes: "We think the PBoC will raise rates by one or two more times in the first half of next year, and will be on hold in the second half of next year, as inflation is likely to remain at or above 5% in the coming months but will likely fall towards to 4% or below in the second half of next year.

"The cumulative rate increases in 2008 [by up to 54 basis points for the one-year deposit rate] is likely to be much more modest than in 2007 [162bps]," he said.

The December 8 increase in the reserve requirement was in line with the policy principles set this month by the Central Economic Work Conference to tighten monetary policy in 2008 to curb "excessive liquidity" in the economy, or too much money in the market and people's pockets. The conference, convened at the end of each year to set policies for the coming 12 months, was attended by all members of the Politburo Standing Committee and senior party and government officials overseeing the country's economic affairs.

The conference set two main goals for 2008: to prevent the economy from overheating while keeping relatively high-speed growth, and to prevent structural prices rises from becoming entrenched inflation. The meeting pledged to shift its monetary policy from "prudent" - an approach it has followed for the past 10 years - to "tight", while continuing a prudent fiscal policy.

To attain the goals, China will act to curb money supply to curb investment and inflation while increasing government spending to boost domestic consumption, seeking to ensure the economy will not have a hard landing.

Therefore, while the central bank tightens the belt, the National Development and Reform Commission (NDRC), the country's top economic planning body, pledged that the government will increase its overall investment budget and continue to adjust investment structures.

NRDC head Ma Kai said after the Central Economic Work Conference that, following the "continuous and rapid" increase in tax and other revenues in recent years, China will mainly use its fiscal spending to improve people's livelihood and boost economic and social development in weak and backward areas. He didn't disclose specific figures for 2008, noting that the financial ministry is working at the budget.

China's fiscal revenue may expand by 27.23% to more than five trillion yuan this year, compared with 3.93 trillion yuan in 2006, according to Yao Jingyuan, chief economist with the National Bureau of Statistics. The forecast is lower than the 31.4% growth rate in the first three quarters, although Jia Kang, director of the Research Institute for Fiscal Science, under the Ministry of Finance, said earlier this month that this year's revenue might reach 5.1 trillion yuan, up 31% over last year.

The budget for government spending for 2007 reached 2.69 trillion yuan, up 14.4% year on year. Although the spending figures are lower than the indicated revenue, the government runs a deficit, which it has said will narrow to 245 billion yuan this year from 295 billion yuan in 2006.

Analysts say Ma Kai's remarks suggest the Chinese government will continue to have a budget deficit even as it increases its spending on social welfare, public health, education and other public services in addition to infrastructure projects.

Chen Jiagui, deputy dean of the Chinese Academy of Social Sciences (CASS), a top mainland think-tank, said at a press conference in early December that the economy was overheated, judging from the increase in fixed-asset investments, exports, consumer goods prices and housing prices as well as share prices.

"The economy has been in the fast lane, so it's not easy to slow down. Soaring food prices are spreading to other sectors. The pressure of serious inflation is accumulating," Chen said.

The latest and higher-than-usual rise in banks' deposit reserve ratio, expected to take about 400 billion yuan out of the banking system, indicates China will introduce more stringent policies to curb excessive bank lending, which starts usually at the beginning of a new year, Guo Tianyong, economist with the Central University of Finance and Economics, said.

China's economy is set to complete its fifth consecutive year of double-digit growth. CASS recently revised up to 11.6% its forecast for this year's gross domestic product expansion, from its forecast of 10.6% made in April. It also raised its prediction of consumer price index (CPI) growth for 2007, to 4.5% from 2.7%. The country's trade surplus would continue to expand next year, to $290 billion from this year's estimated $260 billion, the academy said.

China's trade surplus with the world for the first 11 months of this year hit $238 billion, far surpassing the $177.5 billion recorded for the whole of 2006. Even so, following government measures to adjust the country's trade balance, such as reducing or canceling export rebates for some products, the academy has adjusted earlier trade forecasts to show a pick-up in import growth and slowing rate of export growth.

CASS forecast that import growth rose in 2007 to 22.9% from 20.3% and export growth slowed to 20.5% from 25.1%. Last month, exports rose 22.8% year-on-year to $117.62 billion last month, while imports rose 25.3%, to $91.34 billion, bringing the trade surplus that month to $26.3 billion in November, compared with $27.05 billion in October.

CASS suggested that to further rein in economic growth the central government reduce fixed-asset investments - which it expects to rise 25.6% this year and 24.2% next year. Chen said the government may find it difficult to effectively implement a tight monetary policy as local authorities are reluctant to comply with instructions from the power center.

The swelling trade surplus helped the broadest measure of money supply, M2, including cash and all deposits, to increase 18.45% year on year to 39.98 trillion yuan in November, and the 10th straight month it has breached the central bank's annual target of 16%.

The increasing liquidity has led to fast investment growth and exacerbated price rises. In November, the CPI rose 6.9%. That is more than double the government's inflation target of 3% and is the biggest increase since 1996. Food prices, accounting for one-third of China's CPI, ballooned 18.2% year-on-year in November, compared with 17.6% in October.

Pork prices led the food price gains with a 56% increase, amid a supply shortage triggered by a pig cull following the outbreak of blue-ear disease. Local governments have been increasing subsidies for pig farmers to boost their profit margins and hopefully to lift the amount of pork available in the market. The NDRC forecast that the impact of the measures would be noticeable in the market from the second half of next year.

As they reel from rising cost of commodities including edible oil and vegetables, Chinese have also had to contend with an unstable supply of fuel. A diesel shortage was reported throughout China, from eastern Shanghai to southern Guangdong province and central Henan province to Beijing, with long queues seen at many gas stations. Retail fuel prices were raised by up to 10% from November 1, adding to the operating costs of train and bus companies.

To curb inflation, the central bank has raised the one-year benchmark interest rate paid on bank deposits to encourage savings. It has also cut to 5% the previous 20% tax on interest earned in savings deposits. Even so, growing inflation prompts some economists to argue that there is still room for interest rate increase.

"We think there will likely be 150-200 basis points [bp] additional increases in the reserve requirement ratio, further selling or issuance of special Ministry of Finance bonds and PBoC bills, one to two more rate hikes within the coming three to five months, and a slight acceleration of yuan appreciation to 6 to 7% versus the US dollar next year," Deutsche Bank's Jun Ma said in a research note on December 12.

In his note on the most recent rate changes, Ma wrote: "November CPI inflation reached a new high of 6.9% year-on-year, raising the urgency to contain inflation expectations." Larger increases for three-month and six-month deposit rates "were clearly attempts to discourage depositors from moving funds out of the banking system [due to higher inflation expectations].''

The PBoC changes effective December 21 included increases of  45 basis points in the three-month term deposit rate and a 36 basis point rise in the six-month rate.

"Although the reserve ratio requirement [RRR] was raised by a more aggressive one percentage point recently, it could be partly explained by the specific need to sterilize the liquidity injection from large sums of maturing PBoC bills and forthcoming withdrawal of significant fiscal deposits by year-end. Therefore, the RRR increase would not be a perfect substitute for the rate hike," he wrote.

Yi Xianrong, an economist with CASS, earlier said expected the central bank to increase interest rates soon, since negative real interest rates had created an excessive credit and asset bubble.

Despite the country's measures to rein in the real-estate boom, including tightening credit to developers and increasing supervision on land use, the country's larger cities have all reported rapid growth in housing prices this year. According to the NDRC, average housing price in the mainland's 70 large and medium-sized cities jumped 10.5% year-in-year in November compared with October's 9.5% growth rate and September's 8.9%, fueled by robust investment and demand. Investment in the real-estate market jumped 31.8% in the first 11 months of this year from 2006 to 2.16 trillion yuan, the NDRC reported.

Investment in the real-estate market jumped 31.4% in the first 10 months of this year from 2006 to 1.92 trillion yuan, the National Bureau of Statistics reported. About 1.37 trillion yuan was invested in residential property in the first 10 months, rising 33.7% from the same period last year.

Clement Luk, director and assistant general manager at Centaline (China) Property Consultant's Shanghai office, believed second-tier cities will remain the focus for property investors for 2008, due to higher profit margin.

"Since some second-tier cities such as Tianjin and Chengdu have been well explored, some property developers have shifted their focus to third-tier locations such as Zhuhai, Weizhou and Dongguan," he said. Luk expected more tightening policies, including increases in interest rates and mortgage deposits. The central bank and the China Banking Regulatory Commission on September 27 raised mortgage deposits to 40% for second homes.

Stock volatility
With limited investment channels in China other than the property sector, the stock market has become the most favored target to boost income over the past year, China's stock market, which gained 130% in 2006, continued to surge in the first 10 months of this year, with the Shanghai Composite Index hitting a record high of 6,124 on October 16.

The number of new A-share stock accounts opened daily reached about 350,000 at their peak in April. As the country's stock markets became more volatile in the second half, the number of new accounts opened per day dropped significantly, falling to 122,000 in the last week of November, 37% down on the previous month.

Hu Weitao, chief investment officer of Valuefinder Investment Management Co in Shenzhen, expected the market downturn seen since last October to continue amid possible tightening monetary policy and sagging investment confidence.

The mainland stocks markets have gained about 88% this year, but concerns among mainland authorities that a bubble had developed eased with a contraction of about 20% from record highs set in October.

In a December 11 China Strategy research note, Morgan Stanley economist Jerry Lou ruled out a bubble scenario for Chinese equities, following the investment house's US economist's call for a mild recession in the coming year and seemingly aggressive tightening efforts by the PBoC.

Lou remained bullish on HK-listed offshore China equities in 2008. "We think corporate China can handle the three challenges including: 1) a US recession and export slowdown; 2) domestic asset price deflation; 3) monetary tightening and austerity controls, well through 2008."

The Hong Kong stock market is becoming increasingly Sinicized and more sensitive to central government actions as more funds, legal and illegal, enter Hong Kong from China and a significant number of mainland companies list in the former British territory.

Even as international funds cashed out, Hong Kong's benchmark Hang Seng Index gained 33% this year to mid-December, helped by the central government announcement in late summer that it planned to allow individual mainland investors to purchase Hong Kong equities. When Premier Wen Jiabao later said the "through train" plan might be delayed, the index retreated 5.01% on November 5 to close at 28,942.32, the biggest fall since the September 11, 2001, terrorist attacks.

This increasing sensitivity to mainland events is raising concern among some investors that the Hong Kong market in the coming year will fluctuate like its more volatile mainland counterparts, particularly in relation to government measures.

"It's getting obvious that the Hang Seng Index is driven up by mainland enterprises," said Conita Hung, head of equity markets at Delta Asia Financials. "Given the more volatile nature of the H-share index, the local stock market benchmark is likely to experience large fluctuations," she said. H-share companies are Hong Kong-listed enterprises incorporated in the mainland and with their main businesses based there.

As the central government tries to come to grips with worsening inflation and increasing trade surpluses, some analysts argue that a quicker appreciation of the yuan would help on both counts, while others contend that a sudden rise in the Chinese currency's value compared with the US dollar would not serve the interests of either China or the US.

A fast appreciation of the yuan would mean that "China will lose its competitiveness as the factory of the world, which will cost China its bargaining power with developed countries on product prices", Zhang Tingbin, deputy chief editor of China Business News, said in a recent column. "Faced with the subprime mortgage crisis, the most important task for the US government is to try to maintain the stability of the macro environment and of the exchange rate of dollars."

It is almost certain that the Chinese government will continue its gradualist approach toward yuan revaluation, recognizing that a quick change in the country's exchange rate would hurt the country's export-oriented manufacturing industries, putting the jobs of millions of workers at risk.

However, as PBoC governor Zhou Xiaochuan said recently, China may allow the yuan to float in a more flexible range, suggesting the government may expand the trading range in the new year. The yuan closed at 7.3797 to the US dollar on December 11, on the eve of the third round of the Sino-US Strategic Economic Dialogue in Beijing, a high since its revaluation in the summer of 2005. The currency has strengthened about 5.5% this year.

As the Chinese economy continues to grow strongly, the potential impact of a possible recession in the US looms large. Zhou Zhenhua, director of the Shanghai municipal people's government development research center, said the impact of the US subprime mortgage crisis will gradually be felt through to 2010.

"The impact of the subprime mortgage crisis will spread to the developed countries like those in the European Union and weaken their economies, which eventually will slow down China's export market," he said.

Fan Gang, a member of the central bank's monetary policy committee, however, said losses from a probable decelerating US economy could be offset by gains from European countries and Japan. "Past experience shows that a slowdown of the US economy will lead to a fall in China's exports to the US. In fact, in the past five years, China's exports to the US have been on the decline [in relative terms], so we think the probable US recession will have a smaller impact than we had expected," he said.

Fan also objected to the idea of a quick appreciation in the yuan, saying it would trigger large speculative capital inflows and outflows that would harm China's economic growth and financial stability.

Olivia Chung is a senior Asia times Online reporter.

(Copyright 2007 Asia Times Online Ltd. All rights reserved. Please contact us about sales, syndication and republishing.)