China Tries to Turn Down the Heat

A move to widen the currency trading band and hike interest and reserve rates is designed to cool the raging economy

China's $2.6 trillion economy has been throwing off alarming heat flashes for months now. Ordinary Chinese have yanked some $9 billion in bank savings this year to join the merriment at the Shanghai Stock Exchange, where the composite index has shot up about 50% so far, following a 130% gain in 2006. The smaller Shenzhen bourse is up roughly 100%.

It's party time on the mainland as money supply and loan growth rollick along at double-digit rates. Meanwhile, the country's export sector is smoking, and China is likely to make economic history for a developing economy when it reports a current account surplus this year approaching $400 billion, a mind-blowing number. China's gross domestic product also blew by market estimates and grew at an 11.1% annual rate during the first quarter.

"Do something—anything—"to cool things off has been near universal advice from economists and policymakers abroad. China responded after the markets closed on May 18 with a three-pronged approach to wrestle this beast to the ground. Most important, it widened from 0.3% to 0.5% the trading band within which the yuan is allowed to fluctuate on a daily basis against the dollar.

Skeptical China Watchers

The People's Bank of China also, as expected, raised interest rates. A key one-year loan benchmark goes up to 6.57% (from 6.39%), and the one-year deposit will be nudged up to 3.06% from 2.79%.

This makes the fourth round of credit tightening the central bank has executed since the late spring of 2006. It has also repeatedly raised the reserve requirements of cash that mainland lenders must park with the central bank.

In a statement posted on its Web site, the central bank described the move as a natural progression in the country's long-term goal of liberalizing its foreign currency market. "People's Bank has enacted a series of policies to develop the foreign currency market," the statement said. "At the same time, the Chinese economy has been developing rapidly and stably, financial reform has also made improvements."

Well, that's one take. The timing of these moves will hardly go unnoticed to skeptical China watchers. After all, Chinese Vice-Premier Wu Yi is leading a trade diplomatic mission to Washington beginning May 22. She'll be meeting with U.S. Treasury Secretary Henry Paulson to discuss trade imbalances, currency policy, intellectual property rights protection, and other issues that have turned relations acrimonious on economic matters.

Fear of a Bubble

"The increase in the trading band is obviously directed at the U.S.," says Andy Rothman in Shanghai, the China macro strategist at CLSA Asia Pacific Markets. However, "the move is so small that it won't generate any goodwill in Washington." The goal, he says, is not so much to slow down the economy but prevent it from overheating.

Yet there is more to the move than pre-summit theatrics. Beijing officialdom is genuinely anxious about the social blowback from a stock market meltdown (there are 70 million traders in China) or worse, a boom-then-bust economic scenario. Premier Wen Jiabao and PBOC Governor Zhou Xiaochuan have both expressed public concern about a potential equity market bubble in recent days.

In fact, Standard Chartered Senior Economist Stephen Green thinks the primary intent of the moves is to defuse the stock markets. And in a research note circulated soon after the PBOC announcement, he told clients: "We expect the market to fall next week—and if it proves resistant, Beijing will continue with a thousand small cuts until it does."

Big Incentives Remain

So will these moves do much to cool off China's hyper-growth? They certainly show that Beijing is serious and willing to take action. However, China's interest rates are still awfully low if you factor in inflation running about 3%. That means real interest rates are a bit over 3% in an economy still setting land-speed records.

On top of that, there is so much excess cash in China from export earnings, speculative inflows into real estate, and foreign direct investment that banks will still have a big incentive to lend and companies to borrow. Individual stock investors will still be tempted to bet on stocks, given the obvious math that a 3% inflation rate and 3.06% return on bank deposits is not the way to get rich in a hurry.

The widening of the trading band—though a step in the right direction—isn't going to have much impact on China's exploding trade numbers. On May 11, Green forecast that China's trade surplus would rocket up to $370 billion this year, vs. $217 billion in 2006.

Meanwhile the current account surplus, the widest measure of trade and capital flows, would hit $400 billion. That would compare with $249 billion last year.

Starting Somewhere

The reality is that the rest of the world will have to tolerate some large trade numbers during the rest of this decade and at the same time persuade Chinese leaders to stay on a course of phased-in reform of currency policy, full interest rate liberalization, and the lifting of capital controls. Beijing also has to shore up its social welfare programs so ordinary Chinese can feel more secure about their retirement and health care and perhaps spend more.

In the great scheme of things, today's moves were baby steps in that direction. Think of them as a minor scene in a marathon multi-act play. This economic drama is by no means finished.