Chinese and US economies to diverge in 2011

Chinese and US economies to diverge in 2011

China and the US are oft en seen in the headlines disputing various issues ranging from political to economic matters.  However, their policies and goals have at times been aligned in an effort to stimulate global growth.

This year, though, we see a divergence in the policies of both countries due to the unique domestic situations they face.  Interest rates, GDP growth and inflationary worries are just a few to mention as central bankers and policy makers work to stabilize and spur growth in their respective nations.

The past two years in the US have been marked by monetary loosening through the process of quantitative easing (QE).  Beginning in November 2008, the US Federal Reserve began purchasing $600 billion of mortgage-backed securities (MBS). They continued this in March 2009 by spending $1,000 billion on agency MBS, bonds and some government debt in its first QE.

US equities gained 29.5 percent and the US dollar dropped 12.6 percent 12 months after the November 2008 announcement.  The impact of the first QE is obvious due to its success in driving up equities and growth during a time of stagnant activity.

Concerns over a double dip recession amidst a weakening domestic economy motivated US Federal Reserve Chairman Ben Bernanke to put growth back on the agenda with QE2.  On November 3, 2010, the US Fed announced that it would take further action through a second round of quantitative easing.

However, the real rally in US equities actually began in August last year when Bernanke first started making hints about QE2 in Jackson Hole, Wyoming.  Since the end of August 2010, the S&P500 rallied from 1,064 to a year-to-date high of 1,276 on January 5, 2011 representing just under a 20 percent increase during that time period.  The markets acted just as they should, with equities rising and treasury yields pushed down as a result of the Fed purchases.

New York Fed governors and other central bank members argued that monetary loosening through QE inflates balance sheets, boosts consumption, increases spending and in the end helps to grow US GDP.  It's clear that the $600 billion QE2 has helped rally stock markets in the US. The question is though: What happens afterwards?  At the end of June this year, QE2 will come to an end with the last $90 billion purchase of treasuries.  For this reason, the economic situation in the US should outpace emerging markets – including China – with good growth seen in the first half of 2011.

In China, inflation is the main concern.  Rising CPI and food prices have headlined news stories recently.  The Central Government's priority will be to rein in inflation and achieve price stability to maintain social harmony.  According to Bloomberg data, food prices in China's CPI (November 2010) rose 11.6 percent (compared with 10.1 percent in October, and in percentage terms increased 15.84 percent).  This upward trend exists today and inflation expectations are still high.

In Algeria, riots occurred in January as rampant inflation and political uncertainty persisted.  Food prices increased sharply, making basic necessities unaffordable for many Algerian citizens and culminating in a 9 percent plunge in the country’s stock market on January 10, 2011. These are the type of situations China will work hard to avoid.

A main focus for Chinese policy makers should be to maintain high growth in the economy in order to cover increased inflation.  Higher income and wages plus some price controls can help cool down inflation and support economic growth.

In the end, China will succeed in lowering inflation and stabilizing prices.  After the Lunar New Year in February, prices should come down and indications of controlled inflation should appear.  Unlike last year, China should see good growth in the second half of this year as important events such as the National Day (October 1, 2011) will mark dates for the Chinese to have its most problematic issues under control.

Price instability could mean social unrest and this is what China and its central bankers will be fighting strongly against. Sentiment should smooth out as an increase in labor prices should also help partially off set living costs.  For China, strong growth, slightly higher inflation, and steady growth in wages will be the main drivers of its economy.