Monday, April 18, 2011

How to Play The Gap Between Chinese and U.S. Interest Rate Policy

The U.S. and China are the world’s two largest economies. So when they pursue radically different policies towards setting interest rates, investors should expect threats and opportunities.  At the core of the different interest rate policies is a fundamentally different concept of inflation and how to control it.  The U.S. ignores inflation that pains consumers – such as rising food and energy prices – and fears most deeply the inflation that cuts into corporate profits – rising wages. By contrast, Chinese leaders fear consumer inflation because they believe that if China's citizens can’t afford the basics of life, they will protest in the streets. 

With wages dropping in the U.S., the Fed is determined to keep interest rates near zero. By contrast, in China, the government is raising interest rates and bank reserve requirements -- four times in the last year or so -- to try to cut off the flow of debt that drives up prices. How can investors profit from these different policies? The best way for an American might be to open a savings account at Bank of China.

China's consumer inflation appears to be climbing. According to the New York Times, China's reported consumer price index rose 5.4% in March 2011, although food inflation there has been estimated at 14% while the price of gasoline there has risen 10% to $4.50 a gallon since the end of 2009. Meanwhile, real estate prices in China are 25 times the median income (about five times the comparable U.S. ratio) and keep rising -- an average Beijing apartment goes for $500,000.

China has taken several steps over the last year to try to curb inflation -- including raising interest rates and reserve requirements -- the amount of cash that banks have to set aside relative to their loan balances. And Monday it raised those reserve requirements again to 20.5%.

The U.S. does not take these consumer price increases into account when setting interest rates. Ben Bernanke sees inflation at a relatively modest 1.2% -- he does not take into account the $0.87 a gallon spike in gasoline prices over the last year when it comes to setting interest rates. With unit labor costs down 1.5% in 2010 and the median family income down 8.1% in the last decade, he has no fear of rising wages and by his definition of inflation, no need to raise interest rates to stop it. Moreover, with the unemployment rate still 8.8% and 13.5 million people looking for jobs, prospects are poor for higher wages in the U.S.

This raises an important question about whether interest rate increases actually control inflation. The short-answer in the case of China is that its efforts to control inflation have failed. But they might work in the longer term if they cut off the loose money that makes it possible for people to buy things that they otherwise could not afford. So far, China has been afraid of raising interest rates so much that. So far, China has been afraid of raising interest rates so much that they brake its 9.7% annual growth rate – a slowdown that could have nasty political side effects.

What is an investor to do? One obvious possibility is to put your money in a Chinese bank which you can do at Bank of China if you visit New York City or Los Angeles. Deposit rates there are 3.25% -- a far cry from the 0.52% you're earning now in a typical checking account. This could be a safe trade as long as the dollar and the yuan maintain a fairly stable relationship -- although the dollar has been weakening slightly relative to the yuan in the last year.

Another possibility is to buy commodities exchange traded funds (ETFs) which would let you take advantage of rising prices -- particularly for food-related commodities. Here's a menu of nine such ETFs that might be worth investigating. But if you invest in them -- be aware of the risk that commodities prices can go down fast. For example, in July 2008, the price of oil was $147 a barrel -- it ended that year at $33 thanks largely to the financial crisis that peaked that fall.

Regardless of the trajectory of these investment ideas, the differences in interest rate policies between the U.S. and China are likely to affect your net worth in the year ahead.


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