China CPI inflation was up 6.5% yoy in August, prompting further rate hikes and more imports of food from the rest of the world
China reported CPI inflation of 6.5% year on year in August, compared to 5.6% yoy in the previous month. The market expectation was for 5.9%, and the actual data was an upside surprise. The last time CPI inflation reached over 6.5% was back in December 1996. China’s inflation has hit our target set for mid-2008 nine months ahead of time. We expect inflation to continue rising in the coming months, but probably at a slower pace due to a higher statistical base. Nevertheless, we think the pressure on inflation is still pointing to the upside. Over the next 12 months, we believe rising inflationary expectations will replace food inflation as the main driver of price hikes, and that wages and service prices will go up, driving non-food inflation higher.
With the inflationary situation continuing to deteriorate, we expect local interest rates to go up more aggressively. Higher interest rates, however, was are intended to keep up with rising inflation in order to maintain a neutral monetary policy stance. We therefore do not view the current rate hikes as tightening, but rather a normalization of monetary policy. We recognize that rate hikes will not ease the strain in food supply, but not raising will likely to lead to grave consequences, as negative real interest rates will continue to erode the value of bank deposits and prompt capital to flow into the property and stock markets, causing asset price inflation. The real interest rate has now fallen to -2.9% yoy.
While the monetary stance of the economy is deteriorating (i.e., there is rising consumer and asset price inflation), we maintain our view that the situation in the real economy continues to improve. July’s industrial production and fixed investment growth data have shown a moderation from their peak in Q2, for the first time in three months. New loan issuance also slowed during May to July when compared to its level in the previous three months. Moreover, the forward looking PMI index in August has also suggested a moderation in the pace of growth and a mid-cycle slowdown in infrastructure investment. We expect August’s macro economic data, to be released this week and next week, to show a moderation in growth momentum as well.
In view of the moderation in the real economy, we expect the government to refrain from initiating drastic austerity measures similar to those in 2004, despite the continuing rise in interest rates. Measured tightening policies in specific areas of the economy, such the property sector, are possible, however. In the event of a clear sign of a slowdown in the real economy, along with a slowdown in global growth led by the US economy, however, we would not rule out the possibility that the government will make corresponding adjustments to its administrative controls over loan and credit growth.
We now expect two more rate hikes in 2007. We expect the PBoC to tighten again over the next two weeks, followed by another rate hike after the Communist Party’s Congress in October. We now expect the one-year deposit rate to be raised by 81bps (to 4.41%) and the one-year lending rate to be raised by 54bps (to 7.56%) by the end of 2007. We also expect one more 50 bps reserve requirement ratio hike (to 13%) in 2007. Further government actions aimed at stabilizing the surging prices are also expected to be launched. In 2008, we expect the normalization to be followed by a 108bps hike in the deposit rate (to 5.49%) and a 81bps hike in the lending rate (to 8.37%), together with three more reserve requirement ratio hikes (to 14.5%) and the complete removal of interest income tax, currently at 5%.
We expect the government to increase imports of food from the international market to ease the domestic supply bottleneck. In August, food prices continued to surge, rising by 18.2% yoy. Meat and poultry prices jumped 49% yoy, while growth in grain prices remained rapid at 6.4% yoy. We expect the government to increase its imports of meat and grain in the global market in order to ease the supply bottleneck. The Ministry of Commerce has make known its intention to raise imports of pork to 100,000 metric tons this year, more than quadruple the level of last year. This is likely to be followed by increased imports of grain, such as wheat, from the rest of the world. We think this would tilt the balance of supply of demand in the global market and have major implications for international prices of agricultural products.
