China's New Years Resolution: Don't Fight Inflation With Interest Rates

By Kristin Graham Chinese Lunar New Years is a time of generous giving. And while it wasn't presented in the traditional red envelope, the government handed it's people a gift nearly all Chinese were hoping for; a fight against inflation. At the conclusion of the seven-day festival yesterday, China raised deposit and lending rates 25 basis points. This marked the third rate hike in four months.

(To see Todd Harrison's article on whether the NYSE symbolizes America's role in finance, click here.)

Unfortunately, the government committed a huge New Years faux pas, offering a gift that isn't as valuable as it may first appear. As a Shanghai resident, I can attest to the torrent of inflation. In fact, it's noticeable in daily life so much that it's discussed on a daily basis. I sat down at my favorite sushi shack the other day and prices had increased a good 20% to 30%. A RMB 3 plate of dumplings at my lunch spot climbed to RMB 4; a 25% increase in one felt swoop. Certain veggies have risen upwards of 60%. Western restaurants with premium priced menus are cutting their portions dramatically to avoid raising prices. I was recently served a salad that arrived at roughly half of the typical portion size. So why do I feel snubbed by the government?

(To read Jeffrey Cooper's piece on when and why a market correction will occur, click here.)

Because the rate hike won't put a dent in the inflation problem. While appearing to be a nice gesture, it's no different than giving a beautifully wrapped box that turns out to be empty once opened. It's a mere publicity stunt to calm a population outraged about inflation. It allows China to act as if it's taking the bull by the horns to combat rapidly rising prices when it's really not. Let's take a look why. First of all, borrowing rates don't influence Chinese consumers like they do in the US. Leverage is a fresh concept. They don't rack up huge Mastercard (MA) or Visa ( V) bills on frivolous shopping and then whittle down the balance on a high-interest, minimum payment plan. China remains a cash economy. So an increase in interest rates won't impact a nation of consumers that, for the most part, doesn't pay interest on purchases.

(To view Chris Vermeulen's thoughts on why the Gold Miners Index should send a warning to traders, click here.)

And as I pointed out last week, demand in China is seemingly inelastic. If car registration fees amounting to thousands of dollars, and New Years travel costs rising to double or triple normal fares doesn't curb demand, it's hard to imagine a slightly higher interest rate bothering consumers in the event they do tap a credit line. Next, we have the housing market factor. Even if developers are facing higher borrowing costs and home-buyers are confronted with more expensive mortgage payments (fixed rate mortgages aren't available in China), there is little to no deterrence from building and buying due to the persistent rise in home value. Despite bubble warnings, housing prices rose 20% in 2010 and 9.4% year over year in the first month of 2011. Investors chasing after those returns won't think twice about their purchase on rate hikes that pale in comparison to return potential. Moving on, we arrive at the fact that Chinese bank loans are predominately mortgages. The remaining are to state-owned enterprises that, for obvious reasons, aren't affected by higher rates. Small to medium business lending is nonexistent. The tight-knit family culture comes into play when businesses are built, meaning money is raised from relatives and friends, not banks. (Highly unlikely that Uncle Cheng is going to adjust his interest rate to the new official lending rate.)

To read the rest, head over to Minyanville.