Sunday, December 26, 2010

China Prepares To Fight Inflation

China has learned appropriate lessons from America's real estate bubble.  It is preparing a tighter monetary policy to avoid wrecking its economy:

The People’s Bank of China increased key one-year lending and deposit rates by 25 basis points on Christmas Day in its second move since mid-October. The change took effect yesterday.

Normally, raising interest rates is bad for stocks.  It increases companies' borrowing costs and tempts them to pay higher dividends to keep their earnings yields competitive with new bond issues.  China's stock market is reacting much more positively to this news than theory would allow:

China’s stocks rose and yuan forwards climbed to the highest level in five weeks after the central bank increased interest rates for a second time since October, bolstering speculation inflation will be contained.

Chinese stocks like the news because it signals that the government is committed to smart growth policies.  It also means the yuan will be more valuable, signaling to the currency markets that China will indeed let the yuan appreciate on its own terms. 

Will the U.S. follow suit with interest rate increases?  It's doubtful.  The U.S. needs a weaker dollar to keep its exports attractively priced.  That plus credit availability are supposed to keep GDP growth from stalling here.  The U.S. is unable to accept a sharp downturn as the bitter medicine for asset bubbles.  It may be forced upon us anyway.

Full disclosure:  Long FXI with covered calls and cash-covered short puts.