For the second time in the last few months, China’s Central Bank has raised its rates to fight internal inflation. The new rate goes into effect Sunday.  Here is an English version of their announcement.

The surprise action taken when almost no one would be around to notice, verses waiting until the start of the new year gives the Bank a chance to cause a further tightening as some investments reset their base rates at the beginning of the new year. This gives all of those loans a higher internal rate for the next year.

“This rate hike demonstrates Chinese authorities’ determination to keep inflation under control up front, or front-loaded tightening,” said Qing Wang, chief China economist at Morgan Stanley in Hong Kong.

“Compared to rate hikes in the beginning of next year, a rate hike before year-end will have a more tightening impact, as the interest rates on the medium- and long-term loans and deposits are reset at the beginning of each year according to the base rates.”

Once expectations of inflation are ingrained into an economy, and currently China shows all signs of that event, it takes a Vockler type event to kill it.  While China is attempting to do this, with out slowing or stalling its economy, the world is starting place bets on the outcome.

“We expected a rate hike by the end of the year, though Christmas Day is something of a surprise — a rate hike is not normally on the wish-list for Santa Claus, but in China’s case this is a prudent move,” said Brian Jackson, economist with Royal Bank of Canada in Hong Kong.

“We think it is increasingly clear that using quantitative measures, such as reserve ratios, to rein in liquidity and credit has not been enough, and that adjusting the price of credit — that is, interest rates — is needed to get price pressures under control.”

While China can handle a slowing down of its economy, can it actually handle the types of actions necessary to both reign in growth, while killing inflationary reality, and still growing at a rate to obsorb the jobless in China?

I personally don’t expect that they do.  A command economy is great for getting projects started, it is not so good at slowing down a run away train.  There are to many people who are still on the old play book, or have fully committed to generating the growth that can not survive the slow down effect.

It is always easier to go “All In”, then it is to get “all out” and still keep your risk capital.  This is the issue Chinese governments below the central planners now have to deal with.  In a few years, the cost of allowing the misallocation of capital to grow to the level it has,  is going to impact the long term stability of China Inc.

This is basic capital allocation issues, and obviously China has expanded its economy year over year,  until these aspects have been given a chance to get fully ingrained. The black swan of China is when it cant service its internal loan portfolios due to lack of cash flow and lack of new capital to leverage up, with a slow down in demand for products.

Every growth economy has hit this wall.  The US in the 1930’s, the Japanese in the late 80’s to early 90’s when a square foot of property in Tokyo was worth $1 million US dollars or some silly quote.  The case I am remembering was a sushi shop with 32 sq ft of space and a price tag that should make a professional blush.

Boom Bubble Bust always pop.  Its just a matter of when, and what happens after that.  China appears to be doing what it has to to slow down, I am not sure they grasp how hard it will be to both slow down and maintain growth.

Disclosure: Long Popcorn

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