China’s policy combo not enough to curb inflation

December 3, 2010

Beijing wants to tighten monetary policy to be more “prudent”. Yet it also pledges more public spending. These contradictory goals may compromise the ruling party’s ability to contain inflation, while raised interest rates will put more upward pressure on the yuan.

China probably needs more tightening to rein in consumer inflation which is running at a 25-month high of 4.4 percent. The new monetary policy is really only slightly less loose.

Moreover, China’s money growth target for 2011 still looks quite expansionary. New loans are expected to grow by $1 trillion, according to a central bank adviser. That is 7 percent lower than this year’s new loans quota, but will still be the third largest annual increase on record.

Meanwhile China’s expansionary fiscal policy requires an increase in the supply of money. Beijing is considering investments of up to $1.5 trillion over five years in industries such as alternative energy. It also plans to build more public housing projects. Assuming a 10 percent budget increase, public spending will grow $130 billion in 2011.

Fortunately, Chinese policies are rarely set in stone. But to be effective, China must be prepared to pay the price of prudence. It is far from clear as to whether it is ready to do that.

Of course, the authorities are right to be aware of the unintended consequences. Higher interest rates could put upward pressure on the exchange rate — although that could be good for controlling inflation. That said, Beijing has been reluctant to hike interest rates, for fear of sparking a rise in bad debts.

The Communist Party wants policies that promote lower inflation, stimulate good levels of high growth, and sets the framework for a stable exchange rate.  Achieving all these things simultaneously represents a huge, and perhaps impossible, task. If Beijing is unwilling to sacrifice growth or let the yuan move up more, it may have to bear higher inflation risks.

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