Can China Control an Overheating Economy?

China market
China market

What turned out to be a routine mid-recovery slowdown caused plenty of anxiety over the summer, inspiring some bearish analysts to predict a double-dip recession. Now, even as the U.S. economy shows signs of regaining momentum, investors find themselves facing the same macroeconomic worries that helped fuel much of the last major sell-off.

As Ireland negotiates an aid package with European Union and International Monetary Fund representatives, the eurozone debt crisis is weighing on sentiment once again. Perhaps most of all, skittishness about China's rapidly expanding economy is returning to center stage after soaring inflation data raised worries that Beijing would take dramatic steps to cool its economy.

And indeed it did. For the second time in two weeks, China ordered banks to raise reserve requirements in a bid to reduce liquidity and rein in lending. The move follows growing talk of price controls amid rapidly rising food costs. Investors fear that a series of sharp interest rate hikes could be next in the cards Beijing plays.

Similar moves led to a dramatic slowdown in growth during 2008 and would have only a bigger impact on world markets now given China's growing importance on the global stage.

Beijing Has Room to Maneuver

Much like the situation unfolding in the eurozone, though, investors would be wise to take the motivations of the actors involved into consideration and avoid drawing any quick conclusions. Markets may get rattled about a meltdown in China, and high-profile hedge fund managers looking to profit massively from this turbulence could help fan the flames. But Beijing is likely to take a more measured response to fight inflation in a situation that remains manageable, at least for now.

Inflation hit a 25-month high of 4.4% last week, with food prices rocketing up 10.1% at an annualized rate. But inflation still isn't as persistent as it was starting in 2007, when the consumer price index was rising at rate above 5% and eventually peaked at 8.7%, as analysts at political risk consultancy Eurasia Group wrote in a note to clients last week.

"Recent inflation data has not passed a point that China's bureaucracy considers to be unmanageable or that China's leadership consider to be a political vulnerability," the Eurasia Group said.

Chinese leaders have grown more cautious about monetary tightening after throwing in the kitchen sink during 2008. And policymaking has become more complex lately, with a greater divergence of views taken into account, making dramatic hikes less likely, the analysts note.

Increasingly Skilled Technocrats

While many in the markets have worried that Beijing would reach for the chainsaw to fight inflation, it's more likely to go for the scalpel instead. Chinese policymakers need to demonstrate that they're working to rein in surging food costs with a mix of caps and subsidies that will not fundamentally upset the national economy or global markets.

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"China's leaders are most likely to deploy political signals, aimed at persuading segments of the population hit hardest by rising food costs that Beijing is on the case in addressing the needs of China's vulnerable," Eurasia Group analysts wrote.

Given the lack of transparency, thanks to China's autocratic ways, poor visibility helps fuel investor suspicions about the country. Despite those concerns, the Chinese leadership has proven to consist of remarkably competent technocrats.

China has recently demonstrated a flair for calculated diplomacy, and billionaire investor George Soros recently said the country now has a better functioning government than the U.S.

Fears of a Chinese collapse could again rattle markets. But when it comes to managing its affairs, the country should get the benefit of the doubt from shrewd investors.