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2 China's inflation carries long-term
risks By Pieter Bottelier
China's tolerance of inflation has a low
threshold because of the risks it poses to social
and political stability. That is why the
government and the people have been worried about
a steep rise in the consumer price index (CPI)
since the first half of 2007. Is this the
beginning of a new and potentially dangerous
inflation cycle?
Earlier cycles were often
associated with severe social hardship and
political turmoil. The Tiananmen Square disaster
on June 4, 1989, might have been prevented if the
high inflation of those days had not brought so
many additional demonstrators to the square
frightening the leadership. Older political
leaders remember that the communists' defeat of
the nationalists in the Chinese civil war
of 1945-1949 was greatly
assisted by the runaway inflation of those years,
which sharply reduced the popularity of Chiang
Kai-shek's Republic of China government.
In the economic arena, the greatest
challenge facing China's leadership at the present
time is a new round of consumer price inflation.
It started in the first half of 2007. The CPI rose
by 8.7% year-over-year (yoy) in February 2008, the
steepest increase in over a decade. The index
ebbed to 8.3% in March. For the first quarter of
2008 as a whole the index was 8%. [1]
The
current inflationary cycle is different in origin
from the previous one of 1992-1995, which was
triggered by endogenous excessive credit expansion
and economic "overheating". [2] The present cycle
was ignited by domestic supply disruptions in the
food sector - mainly pigs and poultry - and
reinforced by sharp international price increases
for oil, coal, soy beans, grains and metals. The
combined effect was to drive up the price of many
food items, especially pork, poultry, eggs,
vegetable oil and dairy products.
CPI
inflation received an extra jolt in the early
months of 2008 from the worst-ever transportation
and power supply disruptions caused by severe
snowstorms. The non-food CPI has remained
surprisingly modest so far (at least through
March), but there are some troubling signs that
inflation may become more pervasive - for example,
in March the producer price index (PPI) for
industrial goods rose to 8%.
China's
economic growth rate accelerated from 10.1% in
2004 to 11.9% in 2007 [3], but this was mainly due
to an increase in net external demand (trade
surplus), not domestic demand, as was the case in
the earlier inflation cycle. Although growth was
extremely high, domestic monetary expansion in
2007 was relatively moderate and the margin of
loanable funds in the banking system [4] actually
contracted due to the aggressive sterilization of
excess bank liquidity by China's central bank.
Tight liquidity in the banking system drove up
short-term inter-bank rates and increased their
volatility in 2007. It is therefore hard to argue
that the recent CPI increases are due to an
"overheated" economy, as was the case in 1992-3.
China's rising import demand for soy
beans, oil, coal, metals and other commodities has
undoubtedly contributed to the global commodity
price increases of recent years, yet for economic
planners in Beijing such price increases have to
be seen as exogenous [5].
In principle,
China should not aim to reduce global commodity
prices by deliberately slowing down domestic
demand, unless a slow down is necessitated by
domestic policy requirements. When inflation is
driven by exogenous factors beyond the
government’s control, as has essentially been the
case since early 2007, a further tightening of
monetary policy may have perverse effects: it
could reduce employment and slow growth without
necessarily reducing inflation. Yet, the
government is understandably concerned that a
prolonged period of relatively high CPI inflation
may generate inflation expectations, which could
trigger new inflation dynamics that are even
harder to control.
In this context it is
important to draw attention to the fact that
China's broad money supply (M2) as a percentage of
GDP - around 160% since 2004 - is exceptionally
high by international standards. Moreover, China’s
M2 (cash + time deposits + demand deposits) is
becoming increasingly liquid [6] as a result of a
gradual shift of household deposits from savings
accounts to checking accounts or demand deposits.
This shift has been going on for some
years, reflecting a growing need for larger cash
balances to pay for consumer durables and down
payments for mortgage loans. In recent years, the
shift accelerated, presumably because deposit
rates were lower than inflation for most of the
period since the middle of 2004. Negative real
deposit rates made it unattractive to keep money
in savings accounts.
China's high M2/GDP
ratio combined with the increasing liquidity of
household deposits, points to the existence of
serious excess liquidity in the economy. Until now
this excess liquidity has mainly expressed itself
in asset price inflation, not in CPI inflation,
but that may change. Excess liquidity does not
necessarily trigger CPI inflation, but it
facilitates it when expectations take over as the
driving factor, which is precisely what the
Chinese government is worried about.
The
government faces serious dilemmas in how to deal
with the current CPI inflation, and thus far
Beijing seems to be pursuing a set of right
measures: a relatively tight monetary policy while
refraining from additional tightening; an
increased supply of basic food items from
government stocks and imports; and a freeze on
some basic food prices in the expectation that the
supply disruptions that sparked CPI inflation are
temporary. Maintaining price controls and delaying
upward price adjustments for energy, however, are
a double-edged sword. Faster appreciation of the
yuan, as implemented since December 2007, will
help on the margin to counter domestic inflation,
but it will force accelerated adjustment in
low-margin export industries.
A new
situation would arise if and when inflation
becomes more widespread and extends beyond food
into producer goods, general consumer goods and
wages. There are some early indications that that
may happen [7]. Should those indications persist,
China will have to tighten monetary policy. That
said, there is still reason to expect that
domestic food prices will stabilize later this
year of their own accord. The situation is complex
and hard to read, and the room for policy mistakes
through over-reaction or under-reaction is ample.
During the past 15 years, China's economy
has become closely integrated into the global
economy. The country cannot avoid the consequences
as inflation also reappears on the global scene.
The golden age of low inflation, which was
associated with intensive globalization during the
past 15 years, seems to have come to an end. The
next 15 years may well see higher global inflation
because of rapidly rising demand in the developing
world and supply constraints in minerals (oil,
gas, metals) and grains.
Potential role
in Doha talks There is also a serious risk
of rising protectionism, which would contribute to
global inflation. This can be prevented if nations
stick to both the letter and the spirit of the
World Trade Organization charter. Given its
sharply increased weight in international trade
and strong domestic economy, China is now in a
position to play a pro-active role in promoting
multilateral trade liberalization through the Doha
Round. Unfortunately, it has shied away from
playing such a role until now.
In the
current inflationary cycle, China has been
reluctant to increase domestic deposit rates
sufficiently to make them positive in real terms,
which would encourage long-term savings deposits
and thus reduce the liquidity of M2. This may
reflect the government's belief that current CPI
inflation is driven by temporary domestic
supply-side factors and temporary international
price hikes beyond its control.
It may
also reflect a concern that higher domestic
interest rates would: (1) adversely affect the
profitability of state enterprises and (2) attract
additional hot money inflows, which would require
even more sterilization of excess liquidity in the
banking system.
The first concern should
be resisted on the ground that capital is so cheap
in China that it has contributed to overinvestment
in manufacturing and other economic imbalances.
The second concern does not seem to be
well-founded; because China's capital account
remains largely closed, the transaction costs of
bringing large amounts of speculative capital into
the country tend to be high. In light of this, it
seems unlikely that hot money inflows are strongly
influenced by relatively modest adjustments in
domestic interest rates or, for that matter, the
nominal exchange rate.
In China's case, it
seems more likely that hot money inflows are
primarily driven by large anticipated asset price
increases - real
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