Friday, August 26, 2005

Inflation, interest rate and Yuan

Nowadays, Chinese policy makers have difficult time ahead. Such as inflation pressure, global protectionism (especially in the West), Chinese currency and the growth, none of those is an easy task to handle. Making things more difficult, those issues are interactive to each other, and therefore cannot be separately dealt with. The officials are aware that those problems should be solved as soon as possible, because the economy gets hurt, but the dilemma is where to start and which one. Big concern is the consequences on each other are difficult to calculate or control. For example, Yuan revaluation helps to reduce inflation pressure, protectionism, and trade imbalance, but hurts the growth. It is tough to balance the gains and losses. The officials, therefore, are waiting to see some outcomes before the next movement (unlikely within three months). The likely scenario would be Yuan gradually rise against Dollar based on so-called market force.

Yuan revaluation is good and a fist step of wide and deep financial reform to deal with other related problems, such as price-control, which is inefficient and distorts market orders. For instance, price-control on oil is blamed for the current fuel crisises in many regions. But to remove it is likely to cause inflation spike, and, even worse, may cause wide social unrest, which is the last thing the officials want.

After Yuan unpeged Dollar, the PBOC also gained some comfort as they will be able to adjust the monetary policy more freely. Another interest rate hike is not immediate, since the economy is slowing down and the inflation (using price control on utility, power, and oil) is still within the central bank's target, 3.5%-4%. In fact, the central bank has started to ease the tightening policy. The broader money supply measure M2 keeps rising to 16.3% from 14.6% in the past two months, and is greater than 15%, the central bank's target, for two months. This fact may indicate the PBOC starts to concern about the slowdown. Another reason may be to prevent the hot money from betting Yuan revaluation by increasing the liquidity to push long-dated treasury yields lower. However, if the government starts to ease price control, it is not a surprise to see another 50bp hike. This time the PBOC would react much quickly to the inflation than the previous.