The central bank of China raised interest rates again last week and followed that by increasing the reserve requirement for the country's banks this week. This has been a fairly consistent pattern by the People's Bank of China over the last four months. The signs of creeping inflation and speculative activity in the property markets are clearly higher than the authorities' comfort level. Consequently, monetary policy is in the midst of "catching up" to economic activity.

The one year lending rate in China today stands at 6%, which is well below that of nominal GDP growth. That has elevated concerns that the tendency to have kept rates too low for too long, has caused overheating conditions that may be difficult to reign in though simple policy tools. A central theme in China's recently released five-year plan is to expand domestic consumption. Keeping interest rates low is a means by which to facilitate that goal. However, it may also lead to asset inflation and possible market distortions that render the low interest rate policy counterproductive.

The risk of China tightening monetary conditions, which is true for any country whose central bank is using conventional policies to manage growth and interest rates, is that it works with a lag. Therefore, it will not be known for months if enough or even too much has been done to stem business activity and inflationary pressures. Should policy be applied heavy handedly, it could thwart economic activity enough to scare Chinese officials into a possible stop-go blunder.

January's reading on headline inflation of just below 5% was modestly lower than the month before. Food prices dominate the reading and they rose 10%. Backing out food costs, however, leaves an inflation rate of 2.6%, a seemingly manageable level but still a multi-year high. Contributing to the non-food inflation was increasing residential costs, a factor that the People's Bank of China is finding worrisome.

For investors in the country's stock market, the roughly 15% decline since November has been painful to experience and difficult to reconcile given the low double-digit pace of GDP. The key to foreseeing a turnaround for the Chinese equity markets is tangible data to suggest a meaningful slowdown in the economy and property market is occurring. That would allow policymakers to release the brake and reduce the threat that over tightening might cause a hard landing. These developments could take place in the coming quarters. Until then, the conflict between policy and growth will mean further turbulence for investors.

We expect that later this year the effects of policy tightening will have been sufficient to take the froth out of the Chinese economy. That will not only persuade authorities to lean away from their hawkish posture, but also pave the way for Chinese stocks to rally. The decline in share prices has led to a compression in Chinese equity valuations that restored their attractiveness when compared to many other emerging market countries with lower growth profiles. This is a decidedly better framework from which investors can accept risk to participate in the potential for substantial return. The key is allowing the current policy dynamics to play out further and seek a more visible turning point before committing risk capital.

China GDP