Q+A: Where next for China policy after speedy end to 2010?

BEIJING Fri Jan 21, 2011 3:34am EST

BEIJING (Reuters) - China's growth accelerated in the fourth quarter and its inflation slowed less than expected, fuelling concerns that harsher policy tightening is needed to keep the galloping economy on an even keel.

With those worries weighing on global commodity prices and stock markets, here are some questions and answers about the outlook and risks for Chinese economic policy.

WHAT IS THE POLICY FOCUS NOW?

Despite vows to strike a balance between inflation and growth, the policy bias in China over the past year has been tilted toward supporting growth. The data that was published on Thursday should shift the focus toward inflation, though growth-hungry local officials will still resist that.

Annual growth was surprisingly strong in the fourth quarter at 9.8 percent, while inflation was stubborn in the year to December at 4.6 percent.

As recently as December, policymakers had shown reluctance to give anti-inflation efforts priority.

Zhang Ping, who leads the National Development and Reform Commission, China's top economic planning agency, said a shift in monetary policy to "prudent" from the previous "moderately loose" stance did not amount to "simple tightening."

But confidence that growth is now on a solid footing and warning signs that prices will climb faster in coming months should encourage more of a turn to fighting inflation.

Food and property price rises, the two main drivers of China's inflation, are showing no signs of abating. And there is evidence that inflation is slowly spreading to consumer goods.

HOW WILL CHINA TIGHTEN POLICY?

A slew of measures are likely including higher interest rates, tougher reserve requirements, faster currency appreciation as well as administrative measures such as bank lending restrictions, property market curbs and price controls.

Their total impact, however, is likely to be more gradual than heavy-handed.

In monetary policy, the central bank will rely mostly on required reserves, because they are seen as a softer alternative to interest rate increases and it can change the requirements without seeking cabinet-level approval.

Some analysts think the required reserve ratio could climb to as high as 23 percent by December, from a record 19.5 percent now.

On rates and the yuan, investors reckon authorities will be far less forceful. The market consensus is for interest rates to rise 50 basis points by the second half.

For the yuan, analysts believe gains will be capped at about 5 percent this year.

The China Securities Journal, an official newspaper, said on Friday that the next interest rate increase could come as soon as the Chinese New Year holiday in early February.

There has also been a debate about lending curbs, with the central bank pushing for a lower ceiling than other government agencies. But with the bank regulator pushing this week for a quick halt to off-balance-sheet lending, the indication at present is that Beijing is indeed pulling in the reins, aiming to cap new loans at about 90 percent of last year's total.

JUST HOW TIGHT HAS POLICY BECOME SO FAR?

The surprise jump in fourth-quarter growth was powerful evidence that China's tightening thus far has been far less severe than many in the market had anticipated.

To start with, the four increases in banks' required reserves since November are best viewed as a case of keeping liquidity steady rather than outright tightening.

China's central bank had to issue about 1.25 trillion yuan ($190 billion) in currency to buy all the foreign exchange that streamed into the county in the final quarter to keep the yuan stable. The four increases in required reserves together drained a roughly equivalent amount of cash from the economy.

Meanwhile, Beijing raised benchmark interest rates by a total of 50 basis points in the fourth quarter, trailing the 1.2 percentage point increase in annual inflation during that time, pushing real deposit rates deeper into negative territory.

China's administrative tightening has also been mild. Many had thought that Beijing would crack down on lending at the end of 2010, but instead it let banks glide past last year's credit target with an extra 450 billion yuan in loans.

WHAT ARE THE RISKS TO THE POLICY OUTLOOK?

Given the relatively light degree of tightening so far, the biggest risk is that a spike in inflation early in the year could force Beijing's hand, compelling it to act more aggressively than it had initially planned.

Concerns that the authorities could be falling behind in their battle with inflation were reflected in a series of upward revisions to inflation forecasts after Thursday's data. Deutsche Bank raised its full-year forecast to 5.0 percent from 4.4 percent. UBS increased its to 4.8 percent from 4.3 percent, while JPMorgan went to 4.6 percent from 4.3 percent.

Tellingly, all three also raised their 2011 growth forecasts to the 9.2-9.6 percent range. A hard landing, which some foreign investors have worried about, is not on the cards for now.

Despite signs of a coming rebound in inflation, the risk that prices could spiral out of control should not be overdone.

Money growth is still too fast in China, but the government has gone a long way to normalizing monetary conditions after the ultra-loose policy settings in 2009.

Increasing wages need to be set against increases in labor productivity. And over-capacity in many industrial sectors continues to suppress a spill-over of inflationary pressure to manufactured goods from food prices.

Non-food inflation only inched up in December, hitting an annual rate of 2.1 percent after 1.9 percent in November.

(Editing by Tomasz Janowski)

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