Chinese Premier Wen Jiabao has signalled that China intends to stick with its existing policies as it tries to clamp down on rising inflationary pressures, but analysts are increasingly questioning whether China will succeed unless it allows its exchange rate to rise more rapidly.
"We must slow price increases, but we also must avoid causing big fluctuations in growth,” Wen said in a statement issued yesterday after he met officials and business leaders.
His statement comes after figures released on the weekend showed that China’s consumer price inflation index in June surged by 6.4 per cent from a year earlier, its fastest rate in three years. Soaring food prices – up 14.4 per cent in the month compared with a year earlier – were blamed for much of the latest increase, but analysts worried that non-food prices were also up 3 per cent, which showed that price pressures were becoming more widespread.
Although Wen said that China planned to keep its "overall direction of policy” unchanged, queries are increasingly being raised as to whether China can keep a lid on inflation without allowing the yuan to rise more swiftly. Despite fierce criticism from the United States, which claims that China’s undervalued currency gives it an unfair advantage in international markets, the yuan has climbed by only 2 per cent against the US dollar this year, and has actually fallen against other major currencies.
In a bid to control inflation, China’s central bank has raised interest rates five times since last October, and has increased banks’ reserve requirements (the amount of money that the banks are required to hold on deposit with the central bank) nine times since November. The People’s Bank of China has also stepped up its administrative controls on the banks by setting lending limits for individual banks, and scrutinising their lending practices.
But the Chinese central bank is facing an uphill struggle to mop up the flood of liquidity flowing into the country. Figures released yesterday showed that China accumulated a further $153 billion of foreign exchange reserves in the three months to June, bringing its total reserves to $3.2 trillion. In order to keep China’s exchange rate steady, China’s central bank prints new yuan and buys all the foreign exchange that comes streaming into the country.
However, this adds to China’s money supply, and fuels inflationary pressures. In order to remove this increased liquidity, the central bank then has to either sell bills (which takes some money out of the banking system), or order banks to set aside an even higher chunk of their deposits as required reserves. The central bank is aware that if it sells more bills, it could push up interest rates, and cause even more money to come flooding into the economy. Further, it must pay interest on the bills, making this option increasingly expensive. As a result, most analysts expect that the People’s Bank of China will resort to further hikes in the reserve requirement ratio in a bid to mop up the liquidity.
But analysts are becoming increasingly worried that China’s insistence on maintaining a virtually fixed exchange rate will inevitably hamper its anti-inflation efforts. They argue that more needs to be done in an economy experiencing strong growth (figures released later today are expected to show that China’s economy grew 9.4 per cent in the second quarter), and which has strong domestic monetary growth and massive capital inflows.
Inevitably, they say, China will at some point have to stop relying on further increases in the reserve ratio as an inflation-fighting tool. Last month, China lifted the reserve ratio requirement by a further half a percentage point to a record 21.5 per cent for the country’s biggest banks. Analysts note that further rises in the reserve ratio penalise the banks even more, and will only encourage both lenders and borrowers to seek out new ways to sidestep the official banking system.
At some point, they say, China will have to make a tough decision. Either it will have to allow its exchange rate to rise further and faster, or it will have to accept that its inflation rate will move inexorably higher.