China tightening could undo risk markets: James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own)

HUNTSVILLE, Alabama - The key decision for global markets in 2010 will very likely not be made in Washington but Beijing, where emerging inflation and a property bubble may push China to begin reining in expansionary policies earlier than will suit the developed world.

After returning to a breakneck pace of growth with amazing speed, there are already signs that China is weighing steps to curtail the bank lending that has been a huge source of stimulus, helping to drive property and other asset prices sharply higher.

We emphasize the role of the reserve-requirement ratio, although the ratio was internationally seen as useless for years and it was thought central banks could abandon the tool, Chinese central bank Governor Zhou Xiaochuan said at a Beijing conference on Tuesday.

Besides benchmark interest rates, we also put emphasis on managing the gap between deposit and lending rates, Zhou said.

Put simply, that implies that China may take steps to limit the amount of money banks are allowed to lend and to drive the margins between what they pay in interest and what they charge higher, both steps which will cool growth and speculation.

China's central bank on Wednesday followed up by promising to exercise tighter control over bank lending next year while reaffirming a long-standing pledge to maintain appropriately loose monetary policy.

Even if you don't own a million dollar apartment investment in Shanghai -- kept empty of course because cash flows are for the little people - this could spell trouble.

Zhou today signaled the end of the global market bounce that has been in progress since the end of last winter, Lombard Street Research economist Charles Dumas wrote in a note to clients.

The only major addition of liquidity in the world economy over the past year has been in China. That is about to be withdrawn. Risk assets look like an unwise place to be in early 2010, especially commodity futures and the government bonds of countries with large deficits and/or debts. For risky investments worldwide, this could mark a turning point from 2009's massive rally.

China's banks will lend about $1.4 trillion in 2009, roughly double 2008's allocation. Official estimates put inflation at a tepid 0.6 percent for the year to November, but this is in contrast to media reports about bulk-buying by Chinese consumers concerned about a rapid rise in the price of staple foods.

THE POWER OF NARRATIVE

Reflationary efforts in China have almost certainly had a positive impact on global economic conditions, possibly affecting market prices for securities more than fundamental demand. On the broadest measure, money supply in China is growing at an astonishing 30 percent annual clip, more or less double its usual rate of growth this decade.

By Lombard Research's reckoning, China has been doing the heavy lifting. Even with a range of extraordinary policies such as quantitative easing, combined money growth in the United States, euro zone, Japan and Britain is barely positive. But adding in China's efforts, this rises to a more normal 6 percent range.

But China could be cutting back -- through loan controls, interest rates and ultimately by allowing the yuan to rise in value -- just as other sources of liquidity such as the U.S. quantitative easing program are withdrawn. Perhaps this is all part of the grand plan, and perhaps the rise in asset prices over the past nine months will be confirmed by a self-sustaining recovery even without further growth in stimulus.

There are at least three other possibilities. First, it may be that tighter policy in China retards a recovery and hurts asset prices. But there is also a chance that China genuinely needs tighter policy but the United States, Europe and Britain do not.

If so, further signs that China is serious about addressing its nascent property bubble and inflation should be quite nasty news for equities and other risky assets. Finally, there is the possibility that China is the bellwether for inflationary issues that will crop up elsewhere soon, though this seems a long shot.

Risk assets could get hit if it looks like the Fed's hand is being forced regardless of what the U.S. central bank does about interest rates and its exit plan. Withdrawing monetary stimulus will hurt, but what might hurt even worse is if the Fed were forced to extend measures to the point at which it starts looking desperate rather than masterful.

We are operating under a common narrative in markets: that the authorities are both willing and able to do what it takes. This may or may not be true, but it gains tremendous force simply because people subscribe to it.

China may make this simple narrative quite a bit more complicated.