China still isn't serious about inflation and that's an increasing danger

01/14/2011 3:17 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Once more in to the breach, dear friends, once more.

The People’s Bank of China yesterday increased the reserve requirements for China’s banks for the fourth time in two months. The 0.5 percentage point increase brings the reserve ratio for China’s biggest banks to a whopping 19%.

The theory is that if banks have to keep more money on reserve, they’ll have less to lend. And that will rein in the growth in the money supply that’s feeding into inflation that hit 5.1% in November.

That theory didn’t hold up too well in 2010 as, despite three end-of-the-year reserve ratio increases, China’s banks made 481 billion yuan in new loans in December. That pushed the total of new bank loans for 2010 to 7.95 trillion yuan, well over the official 7.5 trillion target.

The problem is that without more increases in the benchmark bank lending and savings interest rates, money is just too cheap in China. The benchmark one-year lending rate is still just 5.81% even after two interest rate increases in 2010. With inflation running at a 5.1% annual rate that means the real cost of borrowing is just 0.8%.

What company wouldn’t take a loan at that interest rate? What company can’t find something to invest in that earns more than 0.8%? If not it’s own business, then real estate or the stock market?

Another increase in the reserve ratio probably does more damage than good at this point. The more of these half-measures the government in Beijing tries and that fail to stem inflation, the more convinced the financial markets as a whole get that big steps—benchmark interest rate increases of another 1.5 to 2 percentage points are getting mentioned—will be necessary. And that means investors are starting to talk about the government being forced into dramatic moves that could actually crash economic growth.

At least that’s the fear at this point.

The Shanghai Composite index is now down 13% in the last 12 months.

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