China hopes to dampen inflation with another quarter point hike. Can China’s strategy of baby-step rate hikes work given credit is expanding at 35% a year with GDP rising less than a third of that?

Please consider China hikes interest rates again to damp inflation

China’s central bank raised interest rates for the second time in just over a month in a bid to dampen high inflation and guide blistering economic growth to a sustainable level.

The People’s Bank of China announced Tuesday on its website that the benchmark 1-year deposit rate would rise by a quarter percentage point to 3 percent and the 1-year lending rate would increase by the same amount to 6.06 percent. The increases are effective Wednesday.

In January, the central bank signaled that fighting inflation would receive priority this year, saying in a report issued after an annual planning meeting that “stabilizing price levels will receive more prominent status.”

Last year’s rapid growth was driven by a flood of investment in property and other areas. Analysts have urged Chinese authorities to do more to rein in the lavish lending by state-run banks that is driving investment, a large chunk of which is believed to be in speculative property deals.

In January, the banking regulator again ordered banks to tighten risk controls after the country’s biggest state-run commercial banks splashed out nearly 240 billion yuan ($36.4 billion) in new loans in the first 10 days of the year.

Authorities are also considering ways to penalize banks for flouting orders to cut back lending.

Borrowing for real estate development and other projects is the lifeblood for the sales by local governments of land use rights that provide a huge share of their revenues. Such sales rose 70 percent in 2010, helping push property prices 6.4 percent higher compared with a year earlier.

China’s Real Estate Bubble Continues to Expand

Hiking rates a quarter point a pop reminds me of Greenspan’s policy of hiking rates at a measured pace. US speculation in residential real estate went on for another three years, followed by another 18 months of commercial real estate speculation.

In theory, China has other options given the nature of its command economy. Then again practice is a different matter given China’s expectation to grow 9-10% a year.

Currently it is taking credit growth 3-4 times GDP growth to achieve China’s growth target.

Something has to give. Can China grow 10% without huge investment-driven growth, without rampant credit expansion? What about speculation in the stock market?

Michael Pettis at China Financial Markets expects the Chinese stock market to be firm until President Hu Jintao and Premier Wen Jiabao retire next year.

I am not so sure. It is quite possible a series of hikes weighs on the market. Besides, stock market rallies per se will not help China achieve its GDP targets.

In a newsletter Pettis writes …

I am moderately bullish, but not because of GDP growth. I am bullish about stocks mainly because it seems to me that hot money inflows, rapid credit expansion, and the impact of still-rising inflation on real interest rates (which are already negative) will mean that money continues flowing into asset markets.

In addition, the single most important player in the market, the government, is able and very likely to behave in ways that are not subject to economic or value analysis. One consequence of this is that local markets do a poor job of rewarding companies for decisions that add economic value over the medium or long term.

When Do Imbalances Matter?

At some point, China will be forced to address massive imbalances in its investment-driven growth model, make numerous market-driven changes in its banking system, and address the untenable nature of its growth targets in general.

Will the stock market and China’s economy wait for a leadership change or will the market force some changes via CPI spikes before then?

I suspect the latter. Moreover, it’s entirely possible the series of quarter point baby steps hikes weighs on the equity markets sooner than expected, especially if the frequency of those hikes increases faster than expected, even if credit growth continues unabated.

Regardless, long term growth targets of 10% that take credit expansion 35% a year is not a sustainable situation.

Nonetheless, when China’s imbalances matters is a subject of speculation. That the imbalances will be addressed by China voluntarily, or the markets forcibly, is not. China bulls have not factored this setup into their models.

Mike “Mish” Shedlock
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