News Analysis

China’s limited anti-inflation tools proving ineffective

By Peter Hoflich

With Chinese inflation a proxy for global inflation, the government’s indecision and lack of policy tools have far-reaching implications.

While inflation rates in China keep rising, the government has just raised its reserve ratio for its banks for its fourth time this year, meaning that the first three were not effective. This is ostensibly an inflation-fighting measure, although it may in fact prove inflationary as a reduction in liquidity makes borrowers willing to pay a premium for funds. Chinese officials are being criticised for being too slow in responding to inflationary pressures, which have now come up to 5.4%, and even 12% for some food items, but the four responses in four months is certainly something that should have had some bite when patterned in with rising interest rates.

But now China is also using price controls for some food items, which shows a fallback in thinking to a pre-reform era. With the central bank being closely guarded by the government and the bank reforms to produce efficient and commercially-minded lenders that started a decade rolled back, China does appear to have in many ways reverted to a pre-reform era anyway. Infighting between reformists at the People’s Bank of China, with its globally-known faces and modern ideas, and the more conservative faces at the Ministry of Finance are certainly measuring these changes behind the scenes as one era of leadership gets ready to pass on to a new one.

One of the unique inflation-fighting tools that China has at its disposal is its state-owned enterprises (“SOEs”), which are China’s largest companies, and they could be slowed down by the government as a cooling move; but many of these are partially listed and owe the Ministry of Finance significant dividends, and therefore need to remain profitable, at least on paper and with the use of creative accounting. The banks themselves are also SOEs and find themselves in the same boat and have no choice but to move ahead at full throttle, making bubble inflation a self-fulfilling prophecy. There is also the matter of the lack of sophistication of capital markets in China, meaning that property is one of the few investible asset classes, both for individuals and for corporates, leading to serious asset inflation.

Chinese banks’ over-reliance on lending is a serious concern—and although they are building up fee streams, the growth in lending has been so enormous that fee-earning businesses just can’t catch up. The majority of the lending that the big banks are making appears to be towards infrastructure projects that don’t have any near-term cash flow, and inflation and economic slowdown, as well as a tightening of the money tap, will all hit these hard sooner rather than later.

The new reserve ratios, however, do appear to be limited to the largest banks, meaning that smaller banks that lend to SMEs are exempt. Their cost of funds may be higher, but these SME-focused banks should be able to lend out more funds relative to their larger peers. But it could also play out another way - large SOEs that find the big banks no longer able to deploy as much capital may borrow from small banks instead and negotiate hard for good rates from small and medium-sized banks, cutting off the SMEs completely.

And there be dragons.

Categories: China, Regulation, Risk and Regulation
Keywords: Inflation, People’s Bank Of China, State-Owned Enterprises
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