China To Go Its Own Way On Rates

For all the talk of looming U.S. interest rate cuts and other central banks sitting on the sidelines, data this week are likely to support the case for further rate hikes in China - and soon.

There is much chatter about the risk of a recession setting into the U.S. economy, with Friday's unexpected drop in August nonfarm payrolls, the first in four years. But while that raises the risk in turn to the global economy, so far there hasn't been much talk of this filtering through to China, even if a fair amount of its exports go to the U.S. Part of that is because of intra-Asian trade, with Beijing liable to find other ready markets for its cheap goods. Part of that is because China has a fair amount of local appetite for goods with a burgeoning middle class and a still-strong stock market, plus infrastructure and other spending in the pipeline before the 2008 Beijing Olympics. And part of it is simply because the economy is so diverse and enormous that it might be more less vulnerable to outside shocks than others. There is likely to be more evidence of strength in the economy in August data due this week, including the consumer price index Tuesday. A Dow Jones Newswires poll forecasts CPI up 6% on-year, accelerating from July's decade-high 5.6% rise. Inflation is being driven by food prices, which are up on pork-supply problems, flooding and high global grain prices. Even if inflation starts to top out, expectations for high prices are likely to remain - which is where things start to feed on themselves. End-August M2 meanwhile is expected up 18% on-year, the seventh month running that broad money supply has stayed above the PBOC's 2007 target of 16%. Central bank Gov. Zhou Xiaochuan made it clear Friday that taking real interest rates into positive territory is a priority. "The central bank is paying close attention to the issue and hopes to see positive real interest rates," he told Reuters, though he added it was inappropriate to judge the level of real interest rates by looking at CPI changes over just one month. Throwing incremental rate hikes at the enormous Chinese economy is like throwing darts at a moving train, but eventually there will be a cumulative effect. The central bank could also opt to use the currency more, though so far it has seemed reluctant to let the yuan take the heat out of the economy. The PBOC has let the dollar fall at an annualized rate of 14% in the past three weeks - well ahead of its year to date pace of 5.5% but not fast enough to tame China's growth markedly (much less pacify critics in the U.S. Congress). Another hike in banks' reserve requirements - the ratio was lifted again last week - on its own won't fix the situation. To be sure, it's easy to view things as one big tightening, and in a sense it is. Liquidity can't be divorced from an economy, and vice versa. But to put a lid on inflation, and to catch the tail of a runaway economy, the central bank will need to lift interest rates again, possibly more than once, before the year is out.