All eyes on CPI to gauge future monetary moves

By Sun Lijian (China Daily)
Updated: 2007-06-25 08:34

The consumer price index (CPI) last month attracted wide public and government attention.

Its growth of 3.4 percent, though a record high for two years, and the third monthly rise in a row of over 3 percent, was still within market expectations.

The unusual interest was due to several factors.

The market, especially the securities market, is trying to figure out future moves by the monetary authorities, and the CPI, the key indicator of inflation, is obviously an important factor in any decision.

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The government may also be under pressure. The CPI in rural areas is climbing more quickly than in the cities. With the rural population lagging far behind their urban cousins in disposable income, the more dramatic growth in the prices of necessities may further lower the living standard of the rural population.

Admittedly, the current CPI growth is primarily driven by the rise in prices of pork and grain. However, there is a possibility prices of more commodities could be pushed upward, signaling runaway inflation.

With the banking sector controlling the majority of the country's financial assets, the difference between the inflation rate and the interest rate is a decisive factor in money flows between banks and the capital market. When the CPI growth is close to the interest rate, more people could move their savings from deposit accounts to securities.

The already excessive liquidity troubling the economy would be even harder to contain.

Under such circumstances, it is only natural for authorities to tighten the monetary policy. With higher interest rates and deposit reserve requirements, the central bank has quite a few tools at its disposal.

Given the time gap between launching a tightening policy and it effects on the economy, the earlier it is launched the more effective it will be.

However, tightening the monetary policy could cost China a lot more than it would other countries because of China's heavy reliance on foreign trade and foreign direct investment.

Both the market and businesses are seeing abundant liquidity, consumers have a strong desire to buy or invest and the country's exports are primarily driven by products from foreign-invested processing manufacturers. So tightening monetary policy will have a limited effect on domestic demand and inflation prevention.

Furthermore, export-orientated manufacturers are capable of making up their costs as a result of higher interest rates by selling more items at more expensive prices. Thus, increasing the trade surplus and liquidity.

China is in the middle of a reform scheme involving the renminbi's exchange rate against other currencies. The difference in renminbi interest rates against other currencies is a source of profit for investors on the international money market.

If the monetary policy is tightened and the interest rate raised in China, in other words, if the interest rate gap changes, or even if there is a possibility of such a change, the Chinese monetary authorities would face huge pressure to maintain the renminbi exchange rate and the smooth development of the reform itself.

Different from the United States and European countries, China needs reasonable economic growth, to help curb unemployment caused by economic transition, and maintain relatively low inflation. It is not easy to kill two birds with one stone.

It is not feasible to indulge inflation by keeping the monetary policy as it stands for the fear of hurting economic growth.

Therefore, the central bank of China is facing a much more difficult task of containing inflation compared to its counterparts in other countries.

The policymakers may have to resort to a complex set of tools to ensure economic soundness against the problems.

Premier Wen Jiabao and his colleagues drafted a series of countermeasures at a recent meeting of the State Council. And the measures are correct in tackling inflation in all possible aspects.

Farmers and cattlemen are being offered special subsidies and favorable treatment by the government so that they can stay in business.

Measures are also being taken to reduce the trade surplus, so inflation does not get worse by the attendant liquidity. Export tax rebate rates have been cut, some are no longer eligible for tax rebates, and import tariffs have been lowered.

Liquidity is being diverted into more financial products and the capital market, so that inflation pressure on the commodity market is eased.

These measures will help achieve the dual target of containing inflation and ensuring reasonable economic growth.

(For more biz stories, please visit Industry Updates)