Fight or Flight

By HU YUE

Fight or Flight

By HU YUE

China faces the dilemma of whether to continue tightening its monetary policy or not

While worries proliferate that China’s tightening efforts to quell stubborn inflation may trigger a sharp slowdown of the domestic economy, another unforeseen calamity occurred in the developed world.

For the frst time in history, the credit rating frm Standard & Poor’s downgraded the rating on U.S. sovereign debt to AA-plus, sending a chill through global fnancial markets.

A compromise deal to raise the U.S. debt ceiling has soothed default worries, but fears are taking hold that fragile U.S. growth and the European debt crisis may push the world back into recession.

If external demand turns even more lackluster, Chinese exporters will have no place to hide. Many economists believe such a gloomy export outlook would lead China to stop its tightening measures.

“Clouds are already gathering, although a double-dip is unlikely,” said Dong Tao, an economist with Credit Suisse. “July probably marked the peak in infation, giving Beijing some room for monetary easing to cushion the blow of falling external demands.”

China is likely to slightly adjust its credit structure in the future and its monetary policy will be “directionally loose,” he said.

“We had anticipated a hike in interest rates as a result of higher infation in July,”said Shen Minggao, chief economist for Greater China, Citigroup Inc.

“However, the downgrade of the U.S. sovereign credit rating and the ensuing global financial market turmoil has significantly increased downside risk to the global economy,” he said.

“Policymakers in China will likely be very cautious in such an uncertain environment, especially given the experience in 2008 when the United States started to cut rates and China still continued monetary tightening.”

Ba Shusong, Deputy Director of the Research Institute of Finance at the Development Research Center of the State Council, also said the government must stay alert on the risk of over-tightening.

“China’s present monetary environment is almost as tight as in 2007, and the economic foundation is shakier than four years ago,” said Ba.

China’s consumer infation rate escalated to 6.5 percent in July, the highest level in three years and well above the government’s target of 4 percent for this year.

The government has taken a prudent monetary stance this year, bidding farewell to the moderately loose policy adopted to counter the financial crisis. The People’s Bank of China, the central bank, has ordered banks to raise the interest rates three times and increased the reserve requirement ratio six times so far this year.

Between August 2006 and December 2007, the central bank raised interest rates seven times to tackle soaring inflation, and it relaxed its monetary stance at the end of 2008, when the economy felt the pinch of the global credit contagion.

Growth woes

While Chinese policymakers have been pushing all the buttons to tame inflation, the tightening measures have inficted a toll on the economy. Smaller firms have borne the brunt of the heavy blow as commercial banks shut them out of the loan market to avoid lending risks. The plight of fnancially strained smaller businesses is a serious concern for policymakers as small and mediumsized enterprises (SMEs) create more than 80 percent of jobs in the country.

Newspapers are filled with reports of massive factory closures and job losses in east coastal Zhejiang Province, a hotbed of private businesses.

The financing stress has forced many Zhejiang SMEs to turn to underground banks, triggering higher debt risks.

The purchasing managers index (PMI), a barometer of manufacturing activities, for small enterprises stood at 46.4 percent in July, the third consecutive month below the boom-and-bust line of 50 percent, said the China Federation of Logistics and Purchasing (CFLP). A reading below 50 percent indicates economic contraction.

“Acute costs infation and power shortages across the nation are rubbing salt into wounds of the small frms,” said Zhou Dewen, Deputy Director of the China Association of Small and Medium Enterprises. “If the trend continues, 40 percent of SMEs in Zhejiang would go bankrupt next year.”

“Major economic indicators such as growth in industrial output have shown signs of tapering off,” said Huang Yiping, a professor at the National School of Development of Peking University.

The added value of industrial enterprises above a designated size—annual sales revenue of 20 million yuan ($3 million)—grew 14 percent year on year in July, 1.1 percentage points slower than in June, said the National Bureau of Statistics (NBS).

In July, the PMI for the whole manufacturing sector stood at a 29-month low of 50.7 percent, the fourth consecutive month of decline, said the CFLP.

Loosening or not?

Looking ahead, economists are divided on how China will respond to the complicated economic situation.

“China will try to target its credit easing at small frms,” said Stephen Green, a Hong Kong-based economist with the Standard Chartered Bank.

“But money is fungible. It moves where people want it to go or where people pay for it to go,” he said. “So any kind of effort to signifcantly ease credit conditions for SMEs is going to affect the overall credit conditions.”

Ma Jun, an economist with Deutsche Bank, believed the likelihood for a loosening is even greater than expected, particularly in the fourth quarter, with growth in the West stalling due to U.S. and European debt ailments.

“The waning global economy will also add downward pressures on China’s consumer price index (CPI) as international commodity prices are falling sharply,” he said.

But Fan Jianping, chief economist with the State Information Center, believed it is still too early to loosen the monetary policy since inflation still outweighs growth as China’s top macroeconomic risk.

“If we fail to reap a bumper harvest of autumn grain, then food-price-driven infation will continue through the rest of the year,”he said. “Worse still, the United States may launch a third round of quantitative easing, adding fuel to China’s imported infation.”

“We are only half-way on the tightening process, and there is no way back to monetary expansion,” he said. “Because of a lagging effect, we must wait until the fourth quarter to see if the tightening measures are taking effect.”

Lu Ting, an economist at the Bank of America Merrill Lynch, said China is unlikely to ease up on its monetary policy and may have a fscal response, including more spending on public housing and water conservancy.

“Beijing is in wait-and-see mode regarding monetary policy stance,” he said. “It’s quite safe to expect no interest rate and reserve ratio hikes in the second half.”

Lu Zhengwei, chief economist with the Industrial Bank Ltd. expected China to raise interest rates and the reserve requirement ratio one or two times later this year.

“There is still room for hikes in interest rates, which remain negative in real terms due to high infation,” he said.

China should make policies based on its own conditions, and the external environment is a less important factor, said Lu. “However, the deteriorating health of the U.S. economy makes it more difficult to predict timing of these moves.”

Moreover, loosening policy too early will only pave the way for infation to come back quickly and blow up the asset bubble, he said.

Qu Hongbin, chief China economist at HSBC, said the government is unlikely to change its monetary stance any time soon, as domestic infation remains a daunting challenge.

He estimated that the CPI will stay above 5 percent for another few months before dropping to around 4 percent by the year-end.

On August 10, the central bank released the China Monetary Policy Report for the second quarter of 2011, pledging to maintain a prudent monetary policy to combat inflation.

“Stabilizing consumer prices remains the top priority of the country’s macroeconomic control,” said the report. “Meanwhile, it is necessary to closely monitor domestic and overseas economic situations and make monetary policy more targeted, fexible and foresighted.”

“In addition, the country will optimize the credit structure and step up credit support to small companies, agriculture, the modern service sector and environmental protection,” it said. “Vigorous efforts will be made to strike a balance between maintaining relatively fast growth, restructuring the economy and managing infationary expectations.”

WAN XIANG

HAN CHUANHAO