Over-tightening may dent future economic growth

China's GDP grew 9.7 percent in the first quarter while inflation jumped to a 32-month high of 5.4 percent in March. Both growth rates beat market forecasts and appear to suggest that the tightening polices adopted by the Chinese government since should be sustained and even furthered.

But my worry is that if austerity measures are stepped up in the months to come, it may lead to an over-tightening.

I don't think there is much leeway for further rate moves. The benchmark lending rates have already reached 6.31 percent, very near to 6.5 percent, a level that many analysts have believed to be comfortable to maintain a balance between economic growth and the fight of inflation.

In addition, considering the fact that China registered a quarterly trade deficit and that domestic consumption growth was not usually high, we can come to the conclusion that the economic growth in the first quarter was mainly boosted by fixed-asset investment, many of which came as the government spending.

This showed that the economy, especially the private sector, is not as robust as it appeared to be.

A combination of factors such as skyrocketing costs of raw materials, labor, logistics, production and financing will hit private businesses hard in coming months, posing a potential threat to the economic growth. That is something policymakers should attend to. In fact, top policymakers have also been aware of the risk of over-tightening policies.

At a State Council meeting on April 13, a meeting held obviously to discuss the first-quarter economic situation, policymakers proposed to "increase the share of direct financing, fulfill the reasonable funding demand of the real economy and boost commodity housing supply". The call was a confirmation of the signs of loosening of monetary conditions in March.

During the month, policymakers allowed a higher level of lending by banks. To be precise, new yuan-denominated loans stood at 679.4 billion yuan (72.3 billion euros) in March, while the country's broad money supply (M2) rose 16.6 percent from a year earlier to 75.8 trillion yuan. The figure exceeds the whole-year target of 16 percent set by the People's Bank of China at the beginning of this year.

Another factor could lead to an over-tightening is the "lagging effects". It usually takes six months for monetary policies to take effect, any new tightening measures put in place by now may be overdone and will put a dent on the growth later this year or early next year.

That worry was spelt out in Premier Wen Jiabao's speech at the State Council meeting. The premier said the government needed to "fully assess the time lagging effect of monetary policies and avoid significant negative impact from over-tightening in the future". This shows that leaders had been aware of the harm of overdone policies, a mistake it has committed in previous credit tightening and loosening circles.

Apparently, top Chinese policymakers are working hard to strike a balance. On one hand, they want to curb inflation and prevent the economy from getting overheated. On the other hand, they wish to keep the economy expanding at a fast and stable pace so that employment can be guaranteed.

Policymakers will be more willing to use quantitative and administrative measures, whose effects are direct and have less impact on the overall economy, instead of qualitative tools.

Another interest rate hike is likely in the second quarter, as fighting inflation is still the top priority of the Chinese government. But it may pause the rate moves and start to gauge the effect of the tightening policies before they make further decisions.

Quantitative tools, such as increasing required reserve ratio (RRR) for banks and selling central bank bills, will be used more often as the government thinks they are effective to mop up excess liquidity and avoid hitting hard the overall economy. In fact the government has increased the RRR with effect from April 21, the 10th increase since the beginning of 2010.

The pace of appreciation of the yuan will be quickened because policymakers believe it is another good tool that can help tame inflation but avoid affecting the overall economy.

When the tightening circle will be over really depends on economic data in the coming months. If inflation shows signs of abating, it is very likely that the Chinese government will stop implementing further austerity policies, and a brake of the tightening is likely to come at the beginning of the third quarter.

The author is a financial analyst with a multinational insurance company in Shanghai.