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The central government has embarked on a monetary tightening program to slow the nation's growth rate and fight inflation, using credit rationing as its main tool.
It's a policy that's compounding the nation's inefficient allocation of capital. It's also contributing to slower growth potential in China at a time when the nation's inflation rate is surging. Nominal GDP in China has been increasing at a 20 percent rate, and much of that is tied to inflation.
Inflation expectations have been rising even as policymakers raise interest rates: The People's Bank of China in early April raised the interest rate 25 bps. It was the fourth rate hike in the current tightening cycle.
But the aggregate increase for interest rates has been small. A 25 bps rate hike hardly makes a dent in what's actually a negative interest rate for the real economy.
Indeed, at this point, China's monetary policymakers are too far behind the curve. Inflation is entering crisis territory, as consumer prices for many products and services rise at double-digit rates. Signs of panic have appeared along with hoarding which, when it spreads, could trigger social a crisis.
Yet something else is happening. By shifting capital to inefficient users against the backdrop of negative real interest rates, China's economy is being pushed toward stagflation. Meanwhile, the public is afraid that the government wants to inflate away the value of their money.
What's prevented a full-blown crisis so far is a belief that the yuan will appreciate. If not for this assumption, capital flight from China would be rampant.
To change course, policy tightening must shift away from credit rationing and toward market mechanisms. Moreover, the interest rate must be lifted out of the negative column: It should be raised at least three percentage points to allay public fears. These changes are needed as soon as possible.
No One's Fool
Too many people in China's officialdom believe in the power of psychology, particularly in its ability to fight inflation. But inflation is not a psychological phenomenon; it's a monetary phenomenon. Excessive money supply leads to inflation. To contain inflation is to contain money supply at a growth rate in line with production. Even when psychology succeeds by, for example, convincing people that there's no inflation when in fact there is, the impact of these mind games does not last long. No one can fool all of the people all of the time.
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