China is set to use medicine strong enough to cool down its investment fever, but not so potent as to bring the economy to a standstill. Banks are at the forefront of this austerity campaign, acting on the orders of the central government to choke off credit supply to overheated sectors.

China’s fixed asset investment, the leading indicator of industrial activity, showed amazing first-quarter growth of 43% year-on-year. Last year, investment growth reached 27%, contributing much to the country’s 9.1% growth in GDP. Years of fiscal spending to stimulate growth and pent-up demand finally paid off, but inflation also made a comeback: in March, the consumer price index rose 3%, the highest for China in seven years.

Banks were a major culprit behind the credit-fuelled growth, lending loosely to fast-growing sectors such as property, steel, cement and aluminum.The government is concerned that the high double-digit growth in capital expenditure spending would lead eventually to oversupply, failed businesses and bad bank loans.

Since last August, it has tried to put on a brake on the runaway growth, using monetary and political measures.

The People’s Bank of China, the central bank, has introduced so-called “window guidance” (direct administrative levers) to restrict credit supply to overheated sectors. It has raised the reserve ratio of banks, increased the rediscount and refinance rates of loans to them, and allowed these banks to set higher rates in high-risk sectors. It also withdrew billions of dollars of foreign exchange inflows from the financial system, by various open market operations.

The State Council (cabinet) has also weighed in with a series of strongly worded directives, threatening to punish bank officials who defy the state’s orders to restrict lending to sectors classified as overheated.

These measures have had limited results so far. In the first quarter of this year, investment in steel, cement and aluminum achieved year-on-year rises of 107%, 101% and 40% respectively.

The next logical step is to raise interest rates, an option the central bank has resisted so far for fear of a hard landing. Analysts expect any rate hike will be gradual and moderate, as the government does not want to stifle growth, as it did in the late 1990s when it also tried to bring the investment heat down.

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