Inflation tests China's grip on key economic levers

By Alan Wheatley and Zhou Xin - Analysis

BEIJING (Reuters) - China has long defied the conventional wisdom that state controls over the economy are doomed to fail, but could 2008 be the year its luck runs out?

After a leap in money and credit growth in January, some economists are seriously questioning how long the government can keep holding interest rates and the yuan below market-clearing levels without fuelling inflation, already at an 11-year high.

China's policy makers have pulled on an array of levers with consummate skill in recent times to constrain bank lending, corral the yuan, guide interest rates and regulate investment.

They have been rewarded with five years of double-digit economic growth and, until lately, low inflation. It would be foolish to write off the chances of continued success.

But circumstances are now changing as surging food prices propel inflation, demanding tighter monetary policy to keep real interest rates positive.

Yet with U.S. interest rates falling fast, that would widen yield differentials and make it even more tempting for investors to sidestep China's capital controls and pour into the yuan.

That in turn would provide fresh fuel for the money and credit growth that risks transforming China's inflation from a food phenomenon into a broad-based threat to economic stability.

Paul Cavey, an economist at Macquarie Securities in Hong Kong, said the changed environment meant China's reliance on administrative controls to steer the economy was unsustainable.

"If the Fed wasn't cutting rates so aggressively and if global commodities and domestic food prices hadn't become such an issue, China could probably hang on for longer," he said.

"But I suspect that those two things are enough to quite substantially erode the effectiveness of administrative measures, and that's probably what we'll see play out over the course of the next 12-18 months," he said.

OUT OF CONTROL

The result, Cavey said, would be an unwanted jump in credit growth, to around 20 percent or so a year from 16-17 percent now.

Banks are keen to lend, while borrowing was a "no brainer" for firms because real interest rates were close to zero compared with nominal GDP growth or return on equity of 16-17 percent.

"Any time in history when a government imposes administrative measures, they work for a period of time. But if the financial incentives are such that people want to get around those restrictions, generally they find a way to do so," he said.

The controls certainly show signs of fraying. After bowing to Beijing's orders and making just 48.5 billion yuan of new loans in December, banks lent out 803.6 billion yuan in January -- 62 percent of the quota they were given for the whole first quarter.