Will China further worsen the economic situation?

China’s inflation has eased to 4.9%  in August 2008, the slowest pace since June 2007.  This was after a series of rate hikes were done to control inflation. This news came on 10 Sep 2008 and  I immediately thought what if China eases its rates now?

Easing of rates in China would be a lot different than those in other advanced economies. Most developed economies are facing severe distress in financial markets and this is expected to hit their real economies as well. The real economy has stood up well so far but it can’t hold on if financial markets continue to deteriorate.

In China’s case if it lowers interest rates, it will again lead to a higher demand for food commodities and oil. This will lead to higher global prices and once again we have a global inflation problem.

Just to recall, inflation has been a global phenomenon for a while now, but Central Banks were not willing to act (read my paper here) The developed economies’ central bankers were blaming the recent rise in inflation on developing economies and expected latter to raise rates (IMF also joined in playing the same game).

They said as developing economies have grown, their consumption levels have increased leading to rise in prices  of food and oil prices. So, the onus was on developing economies to hike interest rates and bring the prices down. As these prices are global in nature, it will lower inflation in developed economies as well. In other words, the developed economies’ Central Banks can continue to manage their financial markets and growth and let inflation be managed by developing economies.

As I thought through this, now China has lowered its interest rates (see Reuters release as well):

China’s central bank said Monday it would cut the one-year benchmark lending rate by 0.27 percentage point from Tuesday and cut the reserve requirement ratio for smaller financial institutions from Sept. 25 to boost economic growth.

China’s benchmark deposit interest rate will remain unchanged, the PBOC said in a statement posted on its Web site.

It is actually pretty confusing. China has three policy rates –  1 year Lending rate, 1 year deposit rate and the reserve ratio (which is like the Cash reserve Ratio of the Banks).

So lending rate has been reduced for all the banks from 7.47% to 7.20% . The Reserve requirement has been reduced for all banks except  five biggest banks and the Postal Savings Bank by 1 percentage point. The 1 year deposit rate is unchanged at 4.14%. Further:

The PBOC said the aim of the easing was to maintain fast and stable economic growth.

It might appear from the statement that China’s growth rate is slipping. Lets see the data.

The recent data shows China’s industrial output grew by 12.8% in August which is lower than July – 13.7% and lower than August 2007 – 17.5%. The GDP is expected to increase by 9% in 2008 compared to 11.9% in 2007. The recent figures are surely lower than previous figures but still are much higher given global conditions. 

Moreover, the recent inflation and industrial output figures are just for August and we are yet to see a declining trend. It could just be a blip. But as the rates have been lowered, we might just expect the growth to pick up again and higher food and oil prices in future.

This will surely test the developed economies and their central bankers. They are banking on developing economies (esp large ones like India, China etc) to increase their interest rates. However, their expectations might just turn pretty sour. They would just hope that China’s Central Bank does not lower the rate further.

Some might say that China’s economy might not really expand as it is an export driven economy. With developed economies down, China will not find any takers for its exports. Agreed but this just turns the entire problem on its head. 

This just implies, the developed economies central banks’ would hope that their economy does not pick up soon.  Because if it does, so would China’s exports followed by rise in incomes and then in prices of food and oil. This would lead to higher inflation again putting Central Banks in a dilemma.

Pretty troublesome times for sure.

Addendum:

As I write this, the yields in the Indian G-sec market eases further. Participants joke saying it is because of the rate cut in China. 🙂

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3 Responses to “Will China further worsen the economic situation?”

  1. Deepti Goel Says:

    maybe we should regress our G sec rates on chinese interest rates…keep it in mind…

  2. Interest Rates » Will China further worsen the economic situation? Says:

    […] Read the rest of this great post here […]

  3. America and China and India, Oh My! Says:

    […] Some might say that China’s economy might not really expand as it is an export driven economy. With developed economies down, China will not find any takers for its exports. Agreed, but this just turns the entire problem on its head. Source: Mostly Economics […]

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