Bitten by two runaway tigers

We should all be watching very closely the efforts of the Chinese and Indian authorities to bring their rampaging economies under control, because our economic outlook depends heavily on how well they manage this hugely difficult task.

India, which is currently enjoying double digit growth in its industrial output, is faced with the problem of surging inflation, with the country's wholesale price index – the main measure of inflation – rising by 9.9 per cent in March.

To curb inflation, the Indian central bank has just announced that it will raise interest rates for a second consecutive month, pushing its key lending rate to 5.25 per cent. The central bank has also nudged up its cash reserve rate – the level of reserves that banks are required to lodge with it – to 6 per cent.

Indian inflationary pressures are being fuelled by food prices, which have been rising at 15-20 per cent a year. These sharp rises reflect the fact that last year's rains were the worst in 37 years, and there are widespread hopes that good monsoon rains in coming months will boost agriculture production, and reduce pressure on food prices. Strong agricultural production would also help the economy reach the Indian government's goal of 9-10 per cent economic growth this year.

But even if pressures on food prices abate, there will still be huge inflationary pressures from the rising cost of oil and other commodities, and from the reintroduction of import duties that were temporarily suspended in the wake of the financial crisis.

As a result, the Indian central bank has little choice but to raise rates. The problem is that it is doing so at a time when the Indian government fiscal stimulus, introduced in the wake of the financial crisis, is being wound down. The risk is that by raising rates, the central bank snuffs out recovery in the private sector.

And some contend that the Indian central bank has let the inflation genie out of the bottle. As a result, they argue, the central bank will need to tighten rates much more aggressively if it is to have any chance of reining in inflation. The experience in most countries is that central banks have to apply the monetary brakes very heavily to bring inflation under control, and this risks plunging the economy into a deep and prolonged recession.

Meanwhile, the Chinese authorities are confronted with an economy that grew at a 11.9 per cent annual clip in the first three months of the year, the fastest pace since 2007.

Much of this economic rebound has been driven by the property sector. But there are now worries that China is in the grip of a property price bubble, particularly in wealthy coastal cities such as Beijing, Shanghai, and Shenzhen. Property prices in 70 of China's major cities surged by 11.7 per cent in March from a year earlier, the fastest pace since China began issuing the data in July 2005. Overall, Chinese property sales in the first quarter of the year rose by a spectacular 35.8 per cent.

The Chinese authorities are trying to rein-in this runaway growth by instructing banks to cut back on lending, and tightening the rules regarding lending on housing.

China has just announced tougher restrictions on pre-sales of developments by property firms, to stem speculation, and ease surging home prices. Developers have to get government approval before they're allowed to take deposits for unfinished properties.

And Beijing has further increased the deposits that home buyers must put down for home loans. Buyers of larger first homes need a 30 per cent minimum deposit, while buyers of second homes must stump up with a 50 per cent deposit. In addition, banks have been instructed to "greatly increase” the interest rates they charge on borrowers who own more than two properties.

More generally, Beijing has tried to take steam out of its economy by instructing banks to cut back on their lending. Banks have been instructed to lend 7.5 trillion yuan ($US1.1 trillion) this year, down from 9.59 trillion yuan ($1.4 trillion) in 2009. And there are indications that Chinese banks are complying with instructions, with banks lending a total of 2.6 trillion yuan ($380 billion) in the first quarter of the year.

The problem is that a 20 per cent plunge in bank lending could result in a sharp drop in China's economic activity, particularly as it comes at a time when the effects of the massive Chinese fiscal stimulus are waning.

Both the Chinese and Indian governments face massive challenges in bringing their runaway economies to heel. In the case of India, the central banks has no choice but to continue tightening to bring inflation under control, while the Chinese authorities are faced with the dilemma of how to control a property bubble.

Australia has little option but to watch on, and hope the economic gods are kind.