China's shift in its monetary policy

Recent press conference by Hu Jintao, stressing the need for growth,marked an important shift in direction of Chinese monetary policy. Inflation is still a big concern but balanced that with a call for continued growth. He said in this remarks, “We must maintain steady, relatively fast development and control excessive price rises as the priority tasks of macro adjustment.” Some of the policies adopted for fighting inflation will be shifted to support growth.

This shift does not come as a surprise to me, as Central government is facing intensive pressure from the governors from provinces in Eastern and Southern China, where exporting industry accounts for a large share of the economy, have been blaming the currency policy and pressuring central government for a change. Chinese exporting industry, especially those with low value-add industry, has been under pressure due to inflation in raw material,energy and wage, rising RMB and tightened credit market. During the first half of 2008, textile export to United States from Guangdong Provice dropped 31.3% to USD 10.8B (according to Caijing.com). Given the 7% rise in RMB, the export of textile dropped 38% in RMB term. As industries like textile are labor intensive, softness in these sectors put pressure on local employment. The labor markets in Eastern provinces like Jiangsu and Zhejinag are seeing softness the first time since 2002. As the smaller and weaker companies are shutting their doors, a potentially devastating crisis is the corporate debt that is often cross guaranteed. When a company, usually small or financially weak, failed to qualify a loan from bank, they often get a debt guarantee from major buyer or sister companies with same major share holder. Meanwhile the guarantor often obtains debt guarantee from a third company. Because the guarantor and guaranteed company are often financially linked (supplier/customer or business partner), the financial distress of one party might severely damage that of the other. The initiation of default on a small scale could trigger a chain reaction.

The inflation fighting school in the communism party, lead my prime minister Wen Jiabao, is losing their voice in central government, as the rapid rise in RMB and tight lending policy in the first half of this year did not cool the inflation down as effective as some expected. Meanwhile sluggish exporting business in South and East China as the consequence of inflation fighting policy raised enormous pressure from angry and nervous politicians and business people in those area. I believe the central government is forced to adapt the relaxed policy as least for the near term. As the inflation is far from being well-controlled, I doubt such policy will be beneficial to Chinese economy. I predict the RMB will like to appreciate much slower in for short period than it did in the first half of this year, PPI will face upward pressure and stay about 10%. The government will exert more pricing control of key input material (energy, electricity, fertilizer and etc) will be extended. I do not think such price control will survive for a long period, as the supply of these raw material will drop and the price on the black market will rise further (this is already happening in coal market). The government will eventually recognize their failure in fight against the market trend and relaxes or gives up the price control. The raw material sector, coal in particular, and home building sector are likely to benefit from this policy. On the other hand, banks will likely to take more risk and weaken their balance sheet, which makes them extremely dangerous when the government shift back to tight monetary policy if inflation gets out of control.