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Remember last week when I told you that China is the world’s third largest economy? Well, scratch that. A report just released today showed that China grew 10.7% during the final quarter of 2009, overtaking Japan as the second largest economy on the planet. On a yearly basis, China was able to expand 8.7%.

Looking beyond the country’s GDP, there is a slew of other economic data that supports this new ranking. While industrial productions in major economies have been dropping, China managed to report an 18.5% year-on-year increase on December. Retail sales have consistently treaded the double-digits, with the most recent one showing a 17.5% climb in sales.

Now, if you think 8.7% annual GDP growth is amazing, here’s a newsflash: China isn’t happy with it. Mama used to say “Too much of a good thing is bad for ya.” The recent developments show that China isn’t excluded from this.

The country now runs the risk of overheating because of growing way too fast. Three quarters of accelerating economic growth increases the risk that inflation could surge out of control which eventually could lead to asset price bubbles. I took a look at consumer prices in December 2009, and what did I find out? Prices have already climbed by an annualized rate of 1.9%!

To keep inflation in check, Chinese policymakers are now scrambling to mop up the excess liquidity in their financial markets. Bank lending, which was more than 95% higher than a year earlier, is pushing asset prices higher, particularly in the housing industry. Since China doesn’t want the housing bubble to burst like it did in the US, policymakers are now focusing on three goals: to manage credit growth, to counter speculations on property prices, and to curb inflation.

Yesterday, the Chinese government announced that they would slow down bank lending. This came on the heels of the People’s Bank of China’s decision to raise reserve requirements as well as hiking the rates of its three-month bills. These moves were all made to help curb growth, in fear that inflation would become a big problem down the line.

One would think that after posting double digit GDP growth, the Chinese would stick to what they’ve been doing. After all, why fix something if it ain’t broken right? Then again, prevention is always better than a cure. If anything, it seems like they have learned from the mistakes of their Western counterparts and want to avoid another financial crisis.

It’s no mystery that traders and investors take cue from any news flash that comes out of the number two economy in the world. For instance, positive growth and upbeat outlook on Chinese economy tend to help the Aussie, as Australia is one of its major trading partners. On the flip side, when Chinese policymakers decided to up the central bank’s 3-month bill interest rates a couple of weeks ago, the Aussie got hit pretty bad. The same thing happened yesterday when China said it would cap lending.

For now, it seems like the relationship between risk appetite and the foreign exchange market is back on track. As the global economy stabilizes, China will more likely continue its growth, pushing the Aussie and other non-dollar currencies higher. But news that China will cool off any excessive economic expansion is keeping a tight lid on risk appetite. The Chinese are now tip toeing on a fine line, as their moves will have a big effect on global economy and the foreign exchange markets.