November 9, 2011 4:37 pm

China’s inflation victory comes with high price

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China has slain its inflation demon for now, but in the process it has inflicted considerable damage on the broader economy and raised the spectre of a more serious growth slowdown.

China inflation

On the surface, the latest data looked every part the soft landing that Beijing has been trying to engineer. Inflation dropped sharply to 5.5 per cent year on year from 6.1 per cent a month earlier. Investment, which drives the Chinese economy, held steady with a 24.9 annual per cent increase.

But serious trouble lurks in the banking system, the private sector and, above all, the property market.

Beijing is certainly not blind to this. But doubts remain over whether its incremental approach to addressing these problems will keep the world’s second-biggest economy on track for robust growth.

With Europe’s debt crisis dragging on and the US mired in a sluggish recovery, the potential for mis-steps in China – of insufficient policy relaxation leading to a sharp drop in growth – is an unwanted risk for the global economy.

“We have already seen that the Chinese property market has a very high risk of entering into a slump. Given that the external environment has deteriorated sharply, the People’s Bank of China needs to take out an insurance policy and ease monetary policy immediately,” said Liu Li-Gang, head of China economics with ANZ.

Wen Jiabao, China’s premier, signalled that the government was ready to shift gears last month when he declared that it was time for “pre-emptive fine tuning”. The Chinese stock market has since climbed about 10 per cent in anticipation of easier monetary policy, but so far the government has only tinkered around the margins.

China’s reluctance to loosen more aggressively is in part borne of its struggle in the past year to unwind the stimulus programme it unleashed to power the economy at the outbreak of the global financial crisis in late 2008.

A record surge in bank lending kept growth humming along near a double-digit pace, but it saddled banks with a large amount of loans that may go bad and kindled inflation, which was running at a three-year high until recently.

To wrestle the economy back under control, Beijing raised interest rates five times since October last year, increased reserve requirements nine times and also ordered banks to cap their lending below mandatory ceilings.

Faced with the blunt lending quotas, banks have rationed their credit. They have doled out loans to large state-owned enterprises, which are seen as posing negligible default risk, and all but cut off smaller private companies.

That is hardly a desirable outcome for the economy. Small- and medium-sized enterprises generate about 60 per cent of gross domestic product and 80 per cent of employment, according to the commerce ministry.

A wave of small-scale bankruptcies in Wenzhou, a hotbed of entrepreneurship in eastern China, sounded the alarm for the government. Steps to boost financing to private companies in the past month, including the creation of funding vehicles, have helped alleviate the cash crunch.

No similar help is at hand for China’s property market.

Keeping control of bubbling house prices is a must for the long-term health of the Chinese economy, but the government’s heavy-handed tactics – for example, limiting the number of purchases people can make – are showing signs of precipitating a collapse rather than a gradual deflation.

In October, normally a peak month for home buying, real estate transactions plunged 25 per cent month on month, according to the statistics bureau.

Zhang Zhiwei, an economist with Nomura, said that Beijing’s push for more publicly funded housing should help offset a slowdown in private investment, but that success was far from assured.

“The risk from the housing sector is the number one downside risk,” he said.

When Mr Wen first made his fine-tuning comments, real estate developers breathed a collective sigh of relief. But he has since said that measures aimed at reining in housing prices will remain in force despite the developers’ cries of pain – and he drove that point home after the release of the latest data.

“I particularly want to emphasise that we cannot have the slightest wavering in our real estate controls,” he said in a statement on the government’s website.

With a growth slowdown overtaking inflation as China’s big risk, such inflexibility may prove dangerous.

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