As China increases its required reserve ratio (RR) along with interest rates, questions are being asked whether the country is doing enough to cool its economy.

Inflationary pressures continue to build in China, potentially forcing more substantial monetary tightening than currently signalled by the authorities or the market, according to Brian Coulton, global emerging markets strategist at Legal & General Investment Management.

The situation is increasing the risk of a slowdown in China’s growth, which would have major implications for the global economy. Coulton said the world had become used to China exporting disinflation to the rest of the world. “We think the reverse is going to be true over the next few years – that China’s increasingly going to be exporting inflation to the rest of the world, which is something central banks outside China will have to cope with.”

Coulton also raised concerns about the ability of the government to cope with a changing economic model. “I think they are struggling with that transition [from central planning to a more liberal economy] and still trying to control China’s economy as they did in the '80s and early '90s,” declared Coulton. “You can’t control at a micro level a $5 trillion economy. China’s moved on and the policymakers don’t seem to have made that adjustment.”

Excessive credit expansion is continuing to impact China, said Coulton. “The share of credit to GDP [gross domestic product] on the official figures has increased by a quarter since end of 2008; by 40% if you include what we now know is a lot of off balance sheet lending. That’s been feeding through to very rapid investment growth and that’s been putting pressure on wages and prices more generally and we think the authorities are struggling to slow this down,” said Coulton.

In 2010 the government had the target of slowing new credit but it missed this target by a considerable amount. “We also know lots of ways banks used to get around that [credit] control and extend credit in a way not captured so we think the government is struggling with policy targeting in a way they believed it always worked,” he added.

“Ultimately we think if you leave real interest rates negative, the incentive to lend will be there. There is a lot of tensions between what the central bank and provincial local government leaders would like to happen. There are a lot of vested interests in what happens in funding growth. I think we will see interest rates stay negative for the next three to six months,” he concluded.