China’s tightening shows global rebalancing at work

BEIJING: The inflationary pressures that prompted China to raise interest rates for the third time in four months are evidence that the imbalances destabilizing the global economy are slowly but surely being ironed out. 

China’s current account surplus, though shrinking, will not melt away overnight. Finance ministers from the Group of 20 major economies who are meeting next week are still likely to urge China to let the yuan’s nominal exchange rate rise faster. 

But economists said the same inflationary forces that triggered Tuesday’s quarter-point rise in interest rates by the People’s Bank of China were inexorably hastening the shift towards consumption and away from exports that the United States and Europe have long urged. 

“This broader story of rising inflation in China contributes to global rebalancing ,” said Ashley Davies, an economist with Commerzbank in Singapore. “China is getting more expensive relative to the West.” 

An unprecedented surge in money and credit growth in 2009 to fight the downturn induced by the global financial crisis is the root cause of China’s rising inflation. 

The economy is now growing too fast for comfort, helping to push up global energy, food and commodity prices that in turn are feeding back into domestic inflation. 

In addition, wages, which have long risen at a double-digit pace, are climbing ever faster: employers are having to compete for a shrinking pool of young migrant workers willing to quit the family farm and toil long hours in often Dickensian conditions a long way from home. 

So much, so familiar. China has suffered worse bouts of inflation in the recent past, notably in early 2008. 

What is new is that manufacturers appear to be finding it increasingly tough to increase productivity faster than wages. 

“It’s not just the inflation rate. It’s what’s happening to wages and productivity that is probably the key,” said Michael Buchanan, chief non-Japan Asia economist with Goldman Sachs in Hong Kong. 

 Exporters can absorb a rise in unit labor costs relative to those of their competitors only for so long. Eventually profit margins disappear and firms switch production to the domestic market or move to a country where costs are cheaper. 

“Up until quite recently, even when you saw strong nominal wage growth, productivity growth was even stronger,” Buchanan said. “More recently, that may no longer be the case.” 

So buoyant wages, apart from providing fuel for domestic consumption, should further erode China’s current account surplus, which fell to a five-year low in 2010 of 5.2% of GDP from 6.0% in 2009. 

“It’s a good thing for the world and for China if you do see wage growth outstrip productivity growth going forward,” Buchanan said. 

Economic theory dictates that a huge external surplus is ultimately corrected either by a rise in the nominal exchange rate or by inflation, which causes the all-important real exchange rate to climb. 

In China’s case, both processes are at work but the latter is predominating. Because China has much higher inflation than the United States, the yuan’s real exchange rate has climbed by much more than its 3.6 percent nominal appreciation since June. 

Alaistair Chan, an economist with Moody’s Analytics in Sydney, said inflation differentials were effecting an adjustment that the Chinese government, by capping the yuan’s nominal rate, was preventing. 

“Evidence suggests that rising prices in China are beginning to deter some large U.S. buyers,” Chan said in a report. 

Tellingly, the cost of goods imported into the United States from China rose 0.9% in the fourth quarter after holding broadly steady for the previous 18 months. 

As for the immediate consequences for Asia of Tuesday’s rate rise, Johanna Chua, chief Asia-Pacific economist at Citi based in Hong Kong, said it would allay anxiety that China was falling too far behind in its efforts to stop the economy boiling over. 

“Obviously people are still worried about inflation, but the fact that China continues to tighten could at least avert the risk of overheating later on,” she said. 

Beijing’s demonstrable concern about inflation argued in favor of permitting a faster rise in the yuan, also known as the renminbi (RMB), she said. 

“Moving the RMB would give other countries in the region a little more leeway. In fact a lot of currencies in the region have already started to move,” Chua added, citing the rupiah and the won. 

Both Chua and Davies at Commerzbank said China’s rate move increased the chances that the Bank of Korea would follow suit at its rate-setting meeting on Friday. 

Asian policymakers are preoccupied by their countries’ relative competitiveness against China, Davies said. 

“So if this interest rate hike facilitates further currency appreciation by China, then that would mean a greater likelihood of rate hikes by other central banks in the region,” he said. 

But Buchanan argued that other factors would count for more in policy deliberations: capital inflows that were a big worry in late 2010 have dwindled, allaying central bank fears that higher rates would suck in hot money; inflationary pressures have continued to build; and confidence in the U.S. economic outlook has strengthened. 

“All of that is much more important to the case for tightening in the region in comparison to the rate hike we saw yesterday,” Buchanan said.