China is likely to raise interest rates, gradually, and keep the currency stable this year, and those moves will no doubt be accompanied by a gradual deflation of commodity and property prices.

Lower commodity prices would allow the central bank, the People's Bank of China, to raise interest rates gradually. That approach would offer the best chance for the global economy to achieve a soft landing.

Policy scenarios

China is facing the challenges of over-investment, insufficient energy resources and rising interest rates in the United States. Cost-push inflation and overcapacity-led deflation are also unfolding.

The massive amount of hot money in China leaves the nation vulnerable to the trend of rising interest rates in the United States. Raising interest rates slowly will gradually cool investment in China and deflate the bubble in the nation's real estate sector.

That approach offers the best chance for China's economy to achieve a soft landing.

However, China's politics have become more complicated in recent years. Now, it appears interest groups can effect national policy. Powerful lobby groups may push the nation's policies in a direction that is not optimal for the country - but is favorable to some.

In addition, many people desire the extension the economic cycle to 2008, when China will host the Olympics. Hence, if the economy decelerates quickly, which will occur if the central bank raises interest rates faster than expected, policy may shift unexpectedly.

The following are four major policy scenarios for 2005:

Keep the status quo

China essentially did not do much last year, and allowed the economy to go with the flow.

Talk last spring of tightening and a rate hike last October were not followed by consistent policy actions.

China's economy grew faster last year compared with 2003, as seen from the energy consumption, property investment and trade data. As a result, China faces the same challenges now as it did one year ago, except that the investment excess is greater.

Could this year turn out to be the same, which would mean no significant changes to either the interest rates or the currency? I expect a 25-per-cent probability.

China's economy, under such a scenario, would unfold how much excess capacity affects profitability, and how fast the central bank raises interest rates. For example, if property oversupply is exposed, falling property prices will quickly bring fixed investment to a halt.

If US inflation surprises on the upside, the Federal Reserve, or the Fed, would raise interest rates faster than expected. That would cause hot money to leave China, which would bring down property prices and slow fixed investment.

Under such a scenario, China would remain mostly a passive factor in the global economy, with emerging excess supply a potential shock. It serves as an amplifier for Alan Greenspan's monetary policy, mainly through speculation in the renminbi, the nation's currency, and Chinese property.

The fate of the US dollar depends on how fast the Fed raises interest rates. The global economic growth rate will be inversely correlated with the strength of the dollar.

Raise interest rates

Under this scenario, China will raise interest rates gradually to deflate the bubble in the real estate sector, slow fixed investment and deflate international speculation in the renminbi.

After China's economy has landed, demand for the renminbi will reflect reality and China will be able to float the exchange rate without fearing speculation will distort the value.

It is in China's interest to pursue this course, in my view. I give 50-per-cent odds to this scenario.

The Chinese economy will likely experience an orderly slowdown under this scenario. The prices of natural resources will cool, which will decrease inflationary pressure in China.

The slowdown in investment would contain the creation of excess capacity and improve financial stability.

When China cools its economy by raising interest rates, it will decrease speculation in the renminbi and help stabilize the US dollar. A stable US dollar and lower commodity prices will give China's central bank more time to raise interest rates.

It could create the best policy combination between China and the United States to achieve a soft landing globally.

Revalue the renminbi

Under either international political pressure or internal inflationary pressure, China may revalue its currency in line with market expectation - by 15 to 25 per cent.

Such an approach is likely to lead to a hard landing, as the massive amount of hot money flows out to realize profits. Commodity prices would fall sharply as a result, and the US dollar would strengthen.

China would immediately suffer deflation, as falling commodity prices and excess capacity would cause prices to decline. Since this scenario makes little sense for China overall, I give it a 10-per-cent probability.

The logic of "2005 Revaluation," in China Economic's January 11 edition, centred on two fundamental arguments: The need to respond to international pressure; and the need to shift towards consumption-led growth.

The former is a political argument that could not be dismissed with logic. However, as far as I can see, international pressure is dissipating this year. Outsourcing turned out to be insignificant in US elections last year. The appreciating yen has decreased pressure on Europe from a strong euro. Developing economies are now more concerned about China's growth prospects than the exchange rate.

Changing the growth model is a legitimate concern. China has relied on investment and exports to develop its economy. As its exports increase, this model becomes less potent. Consumption has to step up to sustain the fast development.

Revaluing the currency, in theory, will give greater purchasing power to households, by decreasing consumption prices. But I seriously doubt this will work.

China's consumption weakness is due to labour surplus that keeps wages down, and a low level of wealth due to a short history of market economics.

Revaluation would not solve either problem. In practical terms, many argue revaluation would make natural resources more affordable to the Chinese economy.

The argument makes some sense. First, the demand for natural resources is unnaturally high, due to cheap money, which generates low-return investments that demand natural resources. China should not support inefficient investment through revaluation.

Second, most investments in China destroy value due to bad decisions or management, not due to high prices of natural resources.

The export sector has high returns and creates most of the wealth in China. For example, rising land prices reflect China's export success. If China revalues to help value-destroying investments, economic efficiency would be further decreased.

Hence, financial reforms are far more important than revaluation.

Third, the best approach to help consumption is to return assets under government control to the people. These assets belong to the people in the first place, but are ending up in the pockets of insiders.

A higher currency value will only encourage more theft of State-owned assets by making them more valuable abroad, since the people who take State-owned assets are likely to take the money abroad eventually.

Allow the renminbi to appreciate slowly

This is a tantalizing strategy. I see many interests associated with the property industry are promoting it. The total volume of property under construction probably reached 1.5 billion square meters, or four times the sales, last year.

As interest rates rise, it will become difficult for all the properties under construction to be sold. Appreciating the currency bit by bit will tantalize foreign speculators and suck in more hot money, which will enable the property industry to unload its inventory.

If this scenario does unfold, I believe it will cause another wave of global speculation. Massive speculation will push the US dollar down and commodity prices up.

However, it will cause property construction to increase even more with another wave of hot money. Six months later, China will face more investment excess, and a hard landing might be inevitable.

Since this scenario only helps the property industry to unload its inventory, and no one else, I think it is unlikely to materialize. However, the property industry has become the most powerful lobby group in China, so I would not dismiss this scenario.

I assign a 15-per-cent probability.       

The Fed's policy should remain the dominant factor in how the global economy unfolds this year. If the Fed continues to raise US rates slowly, this will keep real interest rates low, the US dollar weak and financial markets bubbly.

While such a scenario may increase excesses and the pain of an eventual correction, it will also keep the global economy relatively strong this year.

If the United States sees an inflation shock, this will force the Fed to raise interest rates quickly, which will cause the global economy - and China - to decelerate quickly.

China's actions could change the course of the global economy.

If it raises interest rates gradually and keeps its exchange rate stable, the US dollar will stabilize, commodity prices will decline and the global economy might achieve a soft landing.

At the other extreme, if China adopts a strategy of appreciating its currency bit by bit, this might lead to further speculation and increase excesses in the global economy.

The global economy is experiencing over-consumption in the United States, over-investment in China and massive speculation in financial markets. In my opinion, the global economy will only achieve a soft landing if both China and the United States raise interest rates gradually.

(Business Weekly January 28, 2005)