As the United States and Europe attempt to claw their way out of a financial crisis, Aussies have been patting themselves on the back for hitching their economic wagon to China. China’s rapid growth has provided a strong demand for Australia’s abundant natural resources. And Australian businesses have enjoyed prosperity across the board, not just in the commodities sector. Yet recent moves by the People’s Bank of China to tighten monetary policy and control inflation have reminded Australian investors that what goes up must eventually come down (see Fig. 1).
Since October 2010, the PBOC has raised the benchmark interest rate three times and the bank reserve requirement ratio four times. Discussing the most recent 25-basis-points rate hike of 8 February, John Noonan, Senior Currency Strategist at Thomson Reuters, said, “The markets did react quite drastically at first. Commodity prices moved down; we saw the Australian dollar also fall because of its sensitivity to China and heightened rates there. But at the end of the day, the markets really calmed down.”
In general, experts are taking a pragmatic but positive view of the policy tightening measures.
Shane Oliver, Head of Investment Strategy for AMP Capital, says that he anticipates further monetary tightening, but doesn’t expect it to threaten China’s continued growth. “Rather,” Oliver says, “what is required is for growth to slow back to more sustainable levels, i.e., around 9% in China and 5-6% in the rest of Asia.”
Because China and other emerging markets are currently underperforming relative to the US and Europe, Oliver explained, “monetary tightening is required to take monetary conditions back to neutral – as has already occurred in Australia.”
Noonan summarised the events that led to the interest rate hikes. “They tried ‘quantitative tightening’, if you like, by just tapping the brakes gently, trying to slow down segments of their economy, particularly the property market which has definitely turned into a bubble, and which is its biggest source of concern. They were very hesitant to raise rates for a long time because a lot of money was flooding into China every time the yields went up, because it was an investment opportunity. Now they’re forced to.”
“So I don’t think it was a shock”, Noonan said. “I think currency watchers and China watchers expected China to move at some stage. Everyone knows they have to raise interest rates to get ahead of the inflation curve this year. In some ways, the sooner they do it, the better.”
The Year Ahead
Oliver said, “This is likely to continue the next six months or so, but with underlying inflation in these countries a long way from getting out of control and policy makers already responding, a hard landing is unlikely in the emerging world.”
Noonan also expects the tightening to continue throughout 2011. “We’ve seen the growth numbers coming out of China and the inflation data in particular,” he said. “Their efforts until now have not worked. So now we can expect more rate hikes; they’re going to use the interest rate tool between now and the end of the year, and we could see three or four more rate hikes quite easily from China.”
Ian Stannard, Senior Currency Strategist at BNP Paribas, took a more bearish view of the situation, suggesting that China’s tighter monetary policy might lead to a reversal of trade.
“What is not yet completely understood by market participants is that the combination of stronger western growth and higher Asian inflation will terminate the liquidity trade”, Stannard said. “Expressing this trade in currency terms is selling the Australian dollar.”
“The bottom line is that one should be prepared for the prospect of significant monetary tightening from China in the year ahead,” Stannard said. “Given the Australian dollar has been driven to overvaluation extremes by global liquidity, if Chinese authorities act to move ahead of the curve and raise rates, the Australian dollar will have a substantial scope to weaken.”
Glenn Stevens, the Governor of the Reserve Bank of Australia, said, “If China and India maintain, on average, their recent rates of ‘catch-up’ to the productivity and living standards of the high-income countries, and if they follow roughly the same pattern of steel intensity of production as seen in the past in other economies, a strong pace of increase in demand for resources will likely persist for some time yet.”
Dr. Hui Feng, a research fellow in international political economy at the University of Queensland, told TheBull that China’s macroeconomic policies have had limited effects on growth and containing inflation. Suggesting the difficulties a communist country encounters in managing capitalist growth, Feng said, “Beijing’s grand fiscal stimulus package after the global financial crisis pulled the economy out of a recession caused by a severe downturn in export. However, the way the package was designed and implemented fostered the development (and hence monopoly) of the state enterprises, thus further choking the private investment and enterprises that have been the main provider of employment.”
Feng also noted that a large part of China’s stimulus funds went to speculations in the financial market, resulting in a surge of asset prices in China. “This structural factor, coupled with a short-term, seasonal factor of food shortage and external speculation on RMB revaluation in the form of hot money, have driven up the CPI well beyond the central bank’s comfort zone”, Feng said. “Hence a series of tightening moves, including interest rate hike and reserve ratio increases.” Feng noted, “the central bank have been more inclined to using quantitative measures such as the reserve ratio in quelling rising inflation, but the impact has been limited at best.”
“Unless Beijing forms the political will to tackle the inflation issue head-on,” Feng said, “there won’t be effective monetary policy on the part of the central bank.”
Proceed with Caution
Thus, while no one is pushing the panic button on the Chinese economy, it isn’t clear whether China’s monetary policy will be effective in controlling growth and inflation, or how it will impact Australian investors. Most analysts are predicting a slowing of China’s growth rather than a “hard landing.” The consensus seems to be that China and Australia will continue to enjoy a mutually beneficial economic partnership for many years. However, Stevens urged “consumer caution”, saying, “We should not assume that the recent pace of [Australia’s] national income growth is a good estimate of the likely sustainable pace. We should allow a good deal of the income growth to flow into saving in the near term.”
Next week, we’ll ask our experts to look into their crystal balls and tell us what the future holds for the Australian economy and sharemarket. Business as usual – or perhaps something quite unexpected?