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Eye on the Market | July 11, 2011 J.P Morgan Topics: Portfolios, US corporate profits and the Twilight of the Gods (in the US, Europe, China and the IEA) Twilight of the Gods part 3: Why is everyone assuming that the next Chinese tightening is the last one? Every time China tightened monetary policy this year, most China research maintained that the tightening cycle is close to its end. Perhaps; Premier Wen has stated that the country’s efforts to control inflation have worked, that price stability is in an acceptable range, and that it will drop steadily from here. But last week’s headline inflation release of 6.4% hit a three year high, and it is not clear to us that China is about to end its various inflation control policy measures. In favor of Wen’s argument, food inflation has been a large contributor, some of which should be transitory. Blue-ear pig virus (PRRS) killed hundreds of thousands of pigs in 2010, which affected this year’s supply (2006 was worse). As shown below, pork prices have soared, but shou/d come down if the supply situation normalizes. [Note: a “Strategic Pork Reserve” can be released to mitigate price increases]. However, according to the Food and Agriculture Organization’, new virulent strains of the virus have a fatality rate of 20% (even higher for piglets), and what is considered a temporary supply shock may be more permanent. Chinese pig facilities have the highest animal densities in the world, contributing to the spread of disease to 25 of China’s 33 provinces. Antibiotics have proven ineffective, and once one pig gets the disease, it tends to spread to the entire herd in 7-10 days. China has vaccinated 100 million of its 500 million pigs, but existing vaccines do not prevent infection, they only slow the rate of transmission to other pigs. China headline inflation Chinese wholesale pork price Percent change, yoy RMB per kilogram 10% 26 aoe, 24 6% 20 4 Begining of 45% 1g 4PRRS outbreak 16 2% 14 | O% 12 -2% 10 2005 2006 2007 2008 2009 2010 2011 8 2006 2007 2008 2009 2010 2011 Source: China Ministry of Commerce. A separate issue is that China is doing a lot more to control the supply of money than the cost of money. As shown below, there have been a lot more increases in bank reserve requirements than interest rate increases. Deposit rates are still negative in real terms, and bank reserve requirements only affect banks, and not the shadow banking system, which is growing in China. Source: Natianal Bureau of Statistics of China China reserve requirement ratio for large banks China one-year deposit rate still negative in real terms Percent Percent, year on year aot 10% 21% 0, 19% iad 17% 6% CPI 15% 4% 13% Deposit rate 11% 2% 9% 7% -2% 5% 2005 2006 2007 2008 2009 2010 2011 2005 2006 2007 2008 2009 2010 2011 Source: People’s Bank of China. Source: People's Bank of China, National Bureau of Statistics. 0% Forward-looking manufacturing surveys have declined and interbank lending rates (Shibor) have surged, so it’s clear that the tightening steps are working. But private sector credit is still growing in China, and real estate prices are still nsing. The bottom line is that the substantial stimulus provided by Chinese and other Asian policymakers in the wake of the recession has not yet been adequately withdrawn, and that more steps will need to be taken to do so. > “Porcine reproductive and respiratory syndrome (PRRS) virulence jumps and persistent circulation in Southeast Asia”, Food and Agriculture Organization Emergency Prevention System, Issue number 5, 2011. 4 HOUSE_OVERSIGHT_030811