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China's New Year's Resolution: Don't Fight Inflation With Interest Rates

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Soft interest rate movement is proving ineffective in controlling China's rampant inflation.

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Chinese Lunar New Year's is a time of generous giving. And while it wasn't presented in the traditional red envelope, the government handed it's people a gift nearly all Chinese were hoping for; a fight against inflation.

At the conclusion of the seven-day festival yesterday, China raised deposit and lending rates 25 basis points. This marked the third rate hike in four months.

Unfortunately, the government committed a huge New Year's faux pas, offering a gift that isn't as valuable as it may first appear.

As a Shanghai resident, I can attest to the torrent of inflation. In fact, it's noticeable in daily life so much that it's discussed on a daily basis. I sat down at my favorite sushi shack the other day and prices had increased a good 20% to 30%. A RMB 3 plate of dumplings at my lunch spot climbed to RMB 4; a 25% increase in one felt swoop. Certain veggies have risen upwards of 60%. Western restaurants with premium priced menus are cutting their portions dramatically to avoid raising prices. I was recently served a salad that arrived at roughly half of the typical portion size.

So why do I feel snubbed by the government?

Because the rate hike won't put a dent in the inflation problem. While appearing to be a nice gesture, it's no different than giving a beautifully wrapped box that turns out to be empty once opened.

It's a mere publicity stunt to calm a population outraged about inflation. It allows China to act as if it's taking the bull by the horns to combat rapidly rising prices when it's really not.

Let's take a look why.

First of all, borrowing rates don't influence Chinese consumers like they do in the US. Leverage is a fresh concept. They don't rack up huge Mastercard (MA) or Visa (V) bills on frivolous shopping and then whittle down the balance on a high-interest, minimum payment plan. China remains a cash economy. So an increase in interest rates won't impact a nation of consumers that, for the most part, doesn't pay interest on purchases.

And as I pointed out last week, demand in China is seemingly inelastic. If car registration fees amounting to thousands of dollars, and New Year's travel costs rising to double or triple normal fares doesn't curb demand, it's hard to imagine a slightly higher interest rate bothering consumers in the event they do tap a credit line.

Next, we have the housing market factor. Even if developers are facing higher borrowing costs and home-buyers are confronted with more expensive mortgage payments (fixed rate mortgages aren't available in China), there is little to no deterrence from building and buying due to the persistent rise in home value.

Despite bubble warnings, housing prices rose 20% in 2010 and 9.4% year over year in the first month of 2011. Investors chasing after those returns won't think twice about their purchase on rate hikes that pale in comparison to return potential.

Moving on, we arrive at the fact that Chinese bank loans are predominately mortgages. The remaining are to state-owned enterprises that, for obvious reasons, aren't affected by higher rates. Small to medium business lending is nonexistent. The tight-knit family culture comes into play when businesses are built, meaning money is raised from relatives and friends, not banks. (Highly unlikely that Uncle Cheng is going to adjust his interest rate to the new official lending rate.)

This concept trickles into the mortgage area as well. In response to rate hikes, young home buyers will seek out the cash rich among their guanxi (a term for the iron clad social network the Chinese pride) for borrowing purposes.

Those who don't run in a cash rich circle will be burdened by the rate hike. And these are the individuals who likely fall into the middle-class; the exact group of people China can't afford to put in a financially strapping situation.

Lastly, let's get real here. Overall inflation in November and December was 5.1% and 4.6% respectively. The Bank of Communication announced inflation will rise above 6% by the middle of 2011. A few measly 25 basis point rate hikes isn't going to cut it; it surely hasn't made a different thus far.

On the flipside, rate increases aren't only ineffective, but may also yield negative results. Higher rates attract speculative, foreign money. China already has more liquidity than it needs.

Persistently high inflation has the potential to seriously damage the Chinese economy. Companies are reconsidering China as their manufacturing hub. Coach (COH), for example, announced it will shift its China output to less than 50% from its current 80% as other Asian nations can offer far more competitive pricing. And unrest among China's enormous lower class population is rapidly building.

The Chinese government needs to find a solution to the problem, be it currency fluctuation, allowing more Chinese money to flow overseas or some other innovative mechanism. But the interest rate game isn't going to win this battle.

Xin nian kuai le (Happy New Year's).


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