Independent Monetary Policy is Vital for China

By EO Editorial Board
Published: 2010-11-09

Issue 493, November 8
Translated by Tang Xiangyang
Original article:

Facing the prospect of future inflation, should China stick to the familiar monetary policy instruments of raising interest rates and tightening liquidity or should the country instead take a "wait and see" approach that examines the effects of the U.S. Federal Reserve's second round of quantitative easing on the domestic economy? If the country has no choice but to make a decision, an independent monetary policy is essential.

That means China should raise interest rates and the cost of capital according to both the outlook for inflation and the level of liquidity, it will also require that the central government gradually reduce the pace of fiscal expansion.

Without a doubt, this will be a gradual process.

What the central bank and policy makers need to do is, make sure that the market receives clear signals of how the central government plans to proceed rather than monetary policy continuing to always emerge from an unpredictable "black box."

The American's US dollar has long been a problem for the whole world and now that the Fed has opened the liquidity floodgates to stimulate their still weakened domestic economy, it is causing turbulence around the world.

It's impossible for the Chinese economy to either cut itself off from the dollar or to avoid the effects that the recovery of such a large economic zone will have.

Therefore, many people believe that China should maintain the present level of stimulus, and at the very least, not go against the current of the Fed's move by starting to retreat from stimulus settings.

Many others believe that sticking to such an expansionary monetary policy is equivalent to setting oneself on fire - but perhaps that's taking things a bit too far.

Before issuing any new prescriptions, we should first take the pulse of the Chinese economy, so as to get a better understanding of the overall health of the system.

China is perceived as being the first economy to emerge from the economic crisis. Though it is showing some signs of slowing, the chances of a double dip are tiny. Most investment banks have predicted the growth in 2011 will remain above 9 percent, so the slow down is not that scary.

In fact, growth of 9 percent is approaching the upper limit of China's potential for growth.

The effects of the excessive pace of growth that propelled the economy forward since 2003, has shown that the country's environment is not really capable of supporting double-digit growth.

The huge amount of liquidity that was released from the heavens to support the stimulus has also begun to show its ugly side.

The price of everything from bulk commodities to agricultural products and daily necessities has surged and people's inflation expectations have continued to rise.

There is no doubt that China is now starting to pay the price for the excessively-loose monetary policy adopted over the past year or more.

Under these circumstances, the adoption of a moderately-tight monetary policy and the gradual return to normal monetary conditions is the obvious policy response.

This will not only help contain the asset price bubbles that have emerged, but it will also help to "cool" the inflow of hot money.

After all, as hot money is seeking quicks profit, such investors will not be as interested in waiting for the slow profits that can be made off a more gradual and sustainable form of growth.
The focus of the Chinese economy over the next five years will be on "shifting" the nature of growth, but if the asset price bubble is not pricked, capital will be kept away from the real economy and efforts to upgrade industries and move up the supply chain are likely to be in vain.

There are some who say that our concerns about inflation are over done. For example, some experts have said that China will be able to keep the annual inflation rate for 2010 below 3 percent, but that sounds to us like simply playing with numbers.

The inflation outlook China is facing is not as optimistic as many people think. Especially as price reform in China's resource sector has now entered a critical period, we cannot ignore its inflationary effect.

Even though the government may attempt to contain prices by issuing policies and through other administrative measures; the general trend of prices cannot be altered. Even if prices can be held down this year, they're likely to bounce back with even greater ferocity later.

So, China does not need to follow in the footsteps of the U.S. Federal Reserve.

Instead, China needs to take appropriate policy responses in accordance with both the domestic and international economic environment. This is not beyond China's capability. The central bank raised the interest rate on October 20. This is the first time for it to do so in three years, indicating that the central bank has recognized the need for an independent monetary policy.

Now, given the Fed's decision to engage in a second round of quantitative easing, market liquidity will increase even more.

During the past months, the State Administration of Foreign Exchange, for the purpose of deterring hot money, has published the names and punished some companies that have broken the regulations and sought to make a profit off expected RMB appreciation. This policy will remain effective for some time in the future.

What is worth noting is, according to the "Impossible Trinity" hypothesis, if China chooses an independent monetary policy and further intensifies capital controls; it cannot stick to a pegged foreign exchange policy. So, China should push ahead with a more flexible exchange rate policy. This is both the price and the cost of having an independent monetary policy.

This article was edited by Rose Scobie and Paul Pennay