Will China Repeat the Mistakes it Made in 2008?

By EO Editorial Board
Published: 2010-05-18

Cover Editorial - EO print edition no. 469
Translated by Tang Xiangyang
Original Article

For the past two weeks, observers of the Chinese economy have been in a period of confusion over whether or not China will increase interest rates and appreciate the value of the RMB. For observers worried about looming inflation and possible over-heating of the Chinese economy, the answers are obvious: The RMB needs to appreciate and the earlier interest rates are increased, the better. If these are the actions taken to deal with China's economic muddle, then another danger might be just around the corner: The Chinese economy could fail to control inflation in time and fall into recession, just like it did in 2008.

China is paying the price for the vast amount of loans it issued last year. As CPI rose by 2.8 percent in April on the level of the same period last year, inflation expectations increased. The Chinese government has claimed it will make moves to control the economy if the growth rate of CPI reaches 3 percent. Last week, Daoxiangcun, a famous snack brand in Beijing, raised the price of steamed bread by 0.1 yuan. A mere 0.1 increase may seem trivial, but it could perhaps be the beginning of a chain-reaction of increasing raw material prices. Although the real estate industry is being targeted by the most severe regulations in history, the housing price situation remains the same. Everyone is waiting to see how long developers will be able to carry on.

To recycle liquidity, China's central bank has raised the cash reserve ratio three times since the beginning of the year and has regulated the speed of loan issuance through the use of central bank notes. Appreciating the RMB and increasing interest rates are possible moves the central bank could make in the future. For the first time in nearly two years, the central bank mentioned its policy of adjusting the exchange rate in its Monetary Policy Report released last week, causing the spread of the market rumor that RMB appreciation is eminent.

All the measures mentioned above are targeted at controlling inflation. While increasing interest rates is the most explicit way to do so, before 2008 currency appreciation was another tool used by the government to tackle inflation. The Chinese government has been claiming it is merely fine-tuning economic policies in order to stabilize market expectations and eliminate risks before they are born, or at least before they become widespread. However, since China is the world's second largest economy and its largest exporter, international factors should be taken into consideration when forming macro policy, otherwise China may repeat the mistakes it made in 2008.

In 2008, China was also facing the risk of inflation and the central bank repeatedly raised interest rates and its cash reserve ratio. However, the government did not fully estimate how severe the world financial crisis would be and the extent to which it would affect the Chinese economy. A large number of Chinese enterprises went bankrupt due to the recession abroad and the tightening of policies at home. China's GDP only grew by 6.1 percent in the first quarter of 2008 compared with the same period in 2007 which forced China to alter its policy from focusing on curbing inflation to ensuring economic growth. Because prior to the crisis the Chinese economy had exceeded stable growth levels, China had to pay a much higher price to get its economy back on track. The four-trillion-yuan stimulus package helped China become the first country to pull out of the economic recession, but China's stimulus package is also why its economy is facing a more complex international environment.

Currently, despite receiving aid from the European Union and the International Monetary Fund, it remains to be seen whether Greece will be able to weather the financial crisis. Greece may not be the only one needing assistance; if the economic situation in the eurozone continues to worsen and the world economy dips again, China will not come out on top this time. At present, both the eurozone and the United States have delayed increasing interest rates. Last week, South Korea chose to maintain its current interest rates despite looming inflation. These actions indicate that central banks around the world need more time to observe the economic situation before making changes to their economic policy.

Although China has not increased interest rates nor appreciated its currency, its policies imposed on the property market which mostly concern the reduction and the restricting of bank loans, have greatly increased the cost of capital and have created an effect equivalent to that of increasing interest rates. The policy implemented by the China Banking Regulatory Commission requiring loans granted by local financing platforms to undergo a credit check and approval process is in fact a tightening of credit. Furthermore, since the four-trillion-yuan stimulus package mainly consists of long and medium term projects, it is very difficult to suddenly eliminate the loans given to these projects. Therefore, the current loans being reduced are mainly short-term loans that contribute to the "floating capital" of enterprises; even without an increase in interest rates, enterprise financing costs have increased.

To curb inflation, there is nothing wrong with increasing interest rates. However, with such a complicated situation at home and abroad, acting slowly is better than acting blindly. It is better to make a decision once things are more clear.

This article was edited by Rose Scobie