China backing up its monetary policy tightening

Late last year, China announced that it was moving its monetary policy to "tight" from "prudent". You can read what the Red Cat Journal said earlier in this article on China's monetary policy tightening announcement. Now comes another hike in reserve requirements. This time, it is a 50 basis point rise to 15%, the highest level since 1984.

The Red Cat Journal can attest to the fact that the tighter monetary policy is already having an impact in the market. For one, readers of the Red Cat Journal have reported that property purchases in recent weeks and months have been held up by difficulties in obtaining mortgage financing. It appears banks have already started to tighten their belts under the threat of strict penalties should their loan growth exceed targets.

With the prospects of unwanted inflation rising and the possibility of excessive investment leading to an asset bubble, China is continuing moves to slow credit growth. Further rises in bank lending rates are also likely. China has seen what havoc rapid credit creation has caused in the U.S. and certainly hopes to avoid a similar fate.

However, tightening monetary policy may be complicated by two issues: the Renminbi (RMB) and a US economic downturn. The RMB has been rising at an accelerated rate in recent weeks which helps to ward off the threat of inflation. However, domestic interest rates, if they filter down to deposits, could attract more money into China, putting more pressure on the RMB to rise. That money could also find its way into the banking system, allowing banks to lend more, offsetting some of the impact of higher reserve requirements. However, because of China's strict capital controls, the risk of large scale inflows as a result of higher interest rates seems more theoretical than real.

The bigger risk is what appears to be a US economic downturn. With a US downturn, export growth in China is likely to slow. The negative impact of slowing export growth is currently a matter of hot debate with some arguing for a minimal impact and others arguing for a major negative impact. If it turns out to be the latter, China's tightening monetary policy could actually exacerbate a downturn that would have happened on its own. Whatever happens, the next year will be a fascinating one. The skill of China's technocrats will be put to the test. A successful navigation will only increase the world's confidence in the Chinese government. Let's not contemplate the alternative.