Inflation is making headlines around the world, and China is no exception. In between reports of the latest restrictions on property purchases in various cities, local media have been carrying stories about drought in the wheat-growing areas of Shandong and Henan.

 

Consumer price inflation accelerated to 4.9% year-on-year in January. Households are bracing for higher prices, and consumer confidence is taking a hit. Given that China's inflation is domestically produced, the onus is on the government to deal with the problem. Two potential flashpoints for public anger are food and housing, and the government has been micromanaging both with some success.

 

The People’s Bank of China has accelerated its tightening campaign, although there is some way to go until policy can be considered restrictive. The first quarter could mark an “intensive adjustment” in policy, according to a PBoC board member. The required reserve ratio has been raised to 19.5% for big banks and 17.5% for small banks.

 

The reality is a little murkier because the PBoC has been setting different ratios for many banks and issuing so-called punishment bonds to banks it believes are lending too much. The difficulties in using reserve ratios to tame inflation – ratios are at record highs even as inflation continues heading up – mean that the PBoC may be turning to interest rates.

 

Another rate hike in the first quarter is expected, as well as an additional increase in the second quarter.

 

The PBoC may have a somewhat freer hand now that the threat of speculative inflows appears to have been overstated and the market has accepted a slow pace of yuan appreciation, although there are still reasons to suggest that the PBoC will tread slowly. Higher interest rates are likely to create problems down the road, as many loans begin underperforming.

 

If China’s experience during the 1997 Asian financial crisis is any guide, 20% of new loans could turn bad. This ratio would be higher if interest costs were higher. Raising interest rates will also increase the cost borne by the PBoC through higher interest payments on bonds it issues as part of its foreign exchange intervention sterilisation operations. Traditionally, this has been offset by payments on its U.S. Treasury foreign reserve pile, but the negative spread between U.S. and Chinese interest rates now makes this insufficient.

 

The National Bureau of Statistics recently changed the way it calculates property prices, discontinuing the popular index of 70 cities in favour of releasing data on each city individually. The change makes it difficult to see trends in the property market, but price gains in individual cities nevertheless indicate still-buoyant activity. Another gauge of strong property market activity is that new regulations are coming thick and fast, the latest being restrictions on purchases in Shanghai and Guangzhou, which follow rules announced for Beijing.

 

Shanghai and Chongqing also began the year with a trial of a yearly property tax which, if successful, will help diversify government revenues away from the selling of land. But in the near term, this may be bad for inflation as anecdotes suggest that many owners are raising rents to make up the losses.