China is likely to keep tightening monetary policy over the rest of 2007, but some economists believe the central bank will slow the tempo of interest rate increases as the outlook for exports darkens and inflation prospects improve.
The fourth rise in rates so far this year, announced late on Tuesday, showed China to be focused on the risk of domestic overheating, rising inflationary expectations and the need to corral a record-breaking stock market rally.
Capital controls mean that China need not worry about contagion from a spreading global credit squeeze. Analysts say Chinese banks' exposure to poor-quality U.S. mortgages is low.
But Mingchun Sun with Lehman Brothers in Hong Kong said China needs to be alert to the risk that the global economy will flag in coming quarters because of the turmoil in financial markets.
"With exports accounting for 43% of GDP, a sharp slowdown in global economic growth could pose a significant threat to China's growth in 2008, exacerbating the massive overcapacity problem already in existence," he said in a research report.
"While China is now experiencing high inflation, we judge that deflation pressure could re-emerge in 2008 if export growth slows sharply as a result of a sharper-than-expected downturn in the global economy," he added.
Consumer inflation surged to a 10-year high of 5.6% in July, but Sun thinks the rate is close to its peak. As a result, he expects the People's Bank of China to stand pat for the rest of the year.
Goldman Sachs is sticking to its forecast of 12.3% growth in gross domestic product in 2007 and 10.9% in 2008 but agrees that Chinese macro policy will turn cautious if the U.S. economy turns down.
"If growth momentum is undermined as a result of the U.S. weakness, economic policies in China would likely ease up, and the risks for policy errors of over-tightening in an adverse global environment should be limited, especially considering the reluctance to tighten policy by the authorities this year," Hong Liang and Helen Qiao told clients on Wednesday.
In announcing the latest rate rise, the PBOC cited a need to anchor inflationary expectations. Reports of food price increases being transmitted to other parts of the economy have unnerved a government ultra-sensitive to the risk of unrest over inflation.
"Expect another rate move as soon as September if August inflation remains high and signs of a meaningful slowdown do not appear," said Tao Wang, head of Greater China economics at Bank of America.
But Qu Hongbin with HSBC in Hong Kong said that, except for the unlikely event of a surge in inflation to 7% - 8%, Beijing would not slam on the policy brakes.
Indeed, with a possible cut in U.S. rates looming, China is more likely to opt for quantitative tightening measures for the rest of the year, Qu said.
These could include another two or three increases in banks' required reserves, new curbs on bank lending to property and some other industries and tighter controls on capital inflows not related to foreign direct investment.
"Forthcoming political events aside, Beijing leaders will have to carefully strike a balance between the need to create 10 million new jobs each year to absorb rural surplus labor and controlling inflation," Qu said, alluding to the five-yearly congress of the ruling Communist party expected in October.
Ha Jiming, chief economist at China International Capital Corp, advocated a stronger yuan, which he said would bear down on inflation and ease friction with China's trading partners.
"It's not enough to rely on interest rate increases to curb overly fast investment and economic growth," he said. "Looking into the future, we think there's still a possibility of small rises in interest rates," Ha said. "But China is unlikely to raise interest rates by a large margin."