World Economy

Jul 20, 2011

China should continue to withdraw stimulus in part to combat risks of higher-than-expected inflation.

The International Monetary Fund on Wednesday said China should continue to withdraw stimulus in part to combat risks of higher-than-expected inflation.

In its annual review of China’s economy, the IMF directors “saw room for further tightening of monetary conditions” and suggested “greater reliance on interest rates and nominal exchange rate appreciation.”

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This year, the People’s Bank of China has increased loan and deposit rates in three quarter-point moves.

In addition to possible inflation risks from food supply shocks, the IMF staff said China also faced the risk of a possible property bubble and a decline in credit quality in the lending undertaken to protect the economy from the financial crisis.

“Our view is that inflation is close to peaking in the next month or two, and we believe by the end of this year, inflation will start moving on to a downward trend,” said Nigel Chalk, a senior advisor in the IMF’s Asia and Pacific department, during a conference to discuss the report.

The IMF said consumer price inflation would average 4.7% in 2011 and then moderate to 3.3% next year.

The IMF directors welcomed steps by China to cool down property price inflation.

“The administrative measures that the government has been taken over the past year or two have been effective, they seem to have calmed down things in the real estate sector,” Chalk said.

But any “durable” solution to property bubbles would need to involve “a significantly higher cost of capital, financial development and higher real estate taxation,” the IMF directors said.

“Certain cities, particularly some of the largest cities, do look bubbly from a price perspective,” Chalk said.

Chinese consumers are impressive savers but putting money in the bank is not attractive given the low interest paid for deposits. There are few non-bank alternatives for savings and there is also no taxation of real estate in China.

“As long as those factors are in place, we think the system is going to have a strong propensity toward bubbles. The government will have to continue to step in from time to time,” Chalk said.

The IMF board repeated its recommendation that China should allow its currency, the yuan, to strengthen further.

The currency USDCNY -0.13% has appreciated by 5.5% against the dollar over the past year.

“In order to get household income rising as a share of GDP, which is an important part of rebalancing...a stronger currency would be needed,” Chalk said.

A stronger currency would also trigger an expansion of the domestic service economy, he added.

The IMF staff said it was time for China to immediately embark on a path to liberalize the financial system.

The first step is to allow the currency to strengthen, and then the central bank can begin to absorb the “significant liquidity overhand” that is currently present. The central bank would have to adopt a new framework for monetary policy decision making.

This would be followed by strengthened regulation, development of nonbank channels for credit, interest rate liberalization and finally capital account liberalization.

“This is a risky undertaking. It needs to be managed very carefully. It needs to be sequenced correctly,” Chalk said.

China’s representative at the IMF, Jinxiong He, had the rare opportunity to rebut the report. He disagreed sharply with the suggestion that the yuan was below fundamentals, saying the staff analysis is based on a flawed benchmark.

The Chinese official also complained that the IMF did not mention that the U.S. Federal Reserve’s quantitative easing had fueled inflationary pressures and constrained options regarding the policy mix.

by erectusplus at 8:33 PM |