China Tightens Monetary Policy

Last month, I wrote about a growing real estate bubble in China and pondered how the Chinese government would respond. In recent weeks we're starting to get a glimpse of its springing to action. Its latest moves are more aggressive: it has increased the commercial banks' reserve requirements and raised rates on government debt to make it more attractive to investors. These actions contract monetary supply and should help to slow its wild economic growth, but just a little. It appears to be a smart move.

Increasing banks' reserve requirements essentially constrains their lending. The higher the reserve requirement, the more of a bank's capital is forbidden from being used to make new loans. With less money to lend, less credit is available, and monetary supply contracts. The Wall Street Journal reports:

Starting next Monday, most commercial banks will be required to put 16% of their deposits on reserve and not lend the money, an increase of a half percentage point. In recent years, that reserve requirement rate has emerged as a primary tool for the central bank to fine tune monetary policy.

A half point isn't drastic, but also isn't insignificant. Usually, when central banks raise rates, they do so gradually. So this step is meaningful, not so much because of its magnitude, but because of the signals it sends: China is worried about excess monetary supply and is beginning to apply a strategy to rein it in. And that's not all:

Also on Tuesday, the central bank raised the yield it pays on its one-year bills, a move also designed to siphon cash out of the financial system by making the debt securities more attractive for banks to buy.

By making this debt more attractive, investor will shift more money into the less risky assets. That takes money out of the credit markets and freezes it in government bonds. Again, monetary supply declines.

Central bank moves like this are always highly contentious. For example, if the U.S. Federal Reserve did this kind of thing right now, then that could be extremely dangerous: contracting monetary supply at a time when an economy is struggling to recover from a deep recession could throw it back into the trough. But China's economy is in much better shape right now that the U.S.'s economy. Its real estate prices are appreciating; it's receiving a lot of foreign investment; and its exports appear to have recovered. So while it's impossible to know if the central bank's timing was perfect, there's definitely a strong argument that its move makes sense.

In fact, it seems particularly warranted in light of the real estate bubble that I mentioned last month. One of the criticisms of the U.S. Fed is that it failed to draw in monetary supply during the housing boom, causing the real estate market to overheat. Clearly, China doesn't want to repeat our mistakes.

The other fear, of course, is inflation. China wants to ensure it isn't a problem. The WSJ says:

At this point, inflation is under control, although the consumer price index turned positive for the first time in November and rumors are widespread the December number will show a jump.

Economists say headline inflation rates in China are likely to rise rapidly in the next few months, even if only because current prices are being compared to the extremely-depressed levels of early 2009.

Again, in light of that, tightening credit makes a lot of sense.

As usual, investors will be less than amused by this monetary restraint. When a central bank decides to take action like this, it usually means that the party is over for the bulls. So look for Chinese equities to take a hit when the market opens (the announcement was made after market close yesterday). But don't take the market's reaction to be a meaningful verdict on whether the central bank's move was wise -- just reflective of its crankiness that it probably can't expect as irrationally high returns through 2010 from investment in China if its central bank continues down this path.