Talk of Inflation Spike Puts China Markets on Edge

Speculation is swirling that data on Thursday could show a spike in June inflation that would increase the chances of a fresh round of policy tightening, according to economists and market participants.

A Reuters poll of economists last week pointed to a modest pick-up in annual consumer price inflation to 3.5% from 3.4% in May, but the whisper in Chinese markets is for a figure as high as 4.5%.

Such rumors sometimes turn out to be spot on; other times, they are wide of the mark. The figures will be issued on Thursday alongside second-quarter gross domestic product data.

"The CPI will definitely be above 4 percent for June," said Li Huiyong, an economist at Shenyin & Wanguo Securities in Shanghai. "That would make the problem of low interest rates even more striking. As a result, there'd be more pressure for higher rates to accelerate the process of the central bank's rate normalization," he said.

With one-year certificates of deposit paying 3.06%, real interest rates are already in negative territory, especially because interest income is taxed at 20%.

This gives businesses an incentive to borrow to invest even faster, especially as profits are growing strongly, and is encouraging savers to take money out of the bank and punt on the red-hot stock market.

Cutting or scrapping withholding tax would be one policy option in addition to raising interest rates, which last went up on May 18, economists said. Two economists, who declined to be identified, said they expected June's CPI to rise 4.4%. Goldman Sachs is forecasting 4.5%.

Taking Stock

Rapid rises in the price of pork, edible oils, raw milk and corn in the past month made an increase of more than 4% highly likely, Jun Ma, Deutsche Bank's chief China economist, said in a note to clients.

"This implies a higher likelihood of a reduction in interest rate tax and/or another increase in benchmark interest rates in the near term," he said.

Wen Bin, an analyst at Bank of China in Beijing, said a rate rise could happen soon after the release of Thursday's figures.

Further fuelling speculation that a policy response is imminent, two officials said Premier Wen Jiabao was due to chair a meeting of the State Council, China's cabinet, on Wednesday to take stock of the economy.

The State Council is the final decision maker in China and it often issues policy statements, though not announcements of policy tightening, following such economic reviews.

Wen said on June 13 that China needed to moderately tighten monetary policy. His strong words were echoed on Tuesday by a sub-committee of China's rubber-stamp parliament, which said the economy was at risk of overheating.

The GDP report is likely to show that the economy in the second quarter expanded almost as fast as the first-quarter pace of 11.1%.

Not everybody believes tighter policy is inevitable. Core inflation, stripping out volatile food prices, remains low at around 1%.

Mingchun Sun of Lehman Brothers in Hong Kong raised his 2007 inflation forecast last week to 3.0% from 2.8% but said in a report that he expected the central bank to keep interest rates on hold for the rest of the year.

Beijing has raised rates four times since April 2006 and raised the proportion of deposits that banks have to park at the central bank on eight occasions in the past 13 months.

Li at Shenyin & Wanguo Securities said inflation of more than 4% would be intolerably high for the authorities and could trigger a flurry of steps in addition to higher interest rates.

"All the options open to the government could be used in the next two months, including bank reserve requirement ratios, issuance of special treasury bonds and some administrative controls," he said.