Inflating China

By Fan Li, November 19, 2010

Image courtesy Flickr Gareth Harfoot

Image courtesy Flickr Gareth Harfoot

A week is not a long time in Economics. Only a few weeks ago China’s President Hu Jintao was being feted as the most powerful man on the planet, in charge of the most vibrant economy. Here was the man to whom world leaders came to pay homage at the G20 summit. Since then however, China's image has taken something of a beating.

Only a few days after the summit, the Chinese stock market started to slide registering a 10% fall in just one week. Investors were spooked. So what was going on? In a word, inflation.

In October the consumer price index rose to 4.4%, the highest it had been for two years. The September figure was 3.3%. This sent Chinese officials scurrying for a solution and it didn’t take them long. Attentive as they are to avoid any situation that could foment popular dissent, food prices were capped and the food supply chain was guaranteed by providing greater market supervision.

The government announced it would continue to lower utility and transport prices. Coal supplies are also being strengthened to ensure there is no interruption in supply. Prices for essential foods are being capped and welfare payments readjusted to reflect the new price rises. Measures are being taken to fight hoarding and guarantee sugar supplies. This sounds like a prelude to a war. It isn’t but the Chinese are just efficiently using all the levers they have at their disposal.

Prices are on the rise but not everyone agrees on the culprit, although there is a general consensus about the excess of liquidity in the system. The government’s economic stimulation programme, its loose monetary policy, low and negative interest rates over the last few years and easy credit have created too much liquidity. A rise in interest rates now looks inevitable. A reduction in the amount of credit being offered looks set to be capped too.

However, the Chinese authorities are being very precise about what sort of inflation is on the rise. The inflation is just food inflation which is the result of bad weather during the course of this year. They do admit that monetary policy has contributed to the inflation, but claim that it is not the cause. Core inflation is still under control so there is no need for general alarm – just some carefully targeted measures.

Or could it be the creeping rise in Chinese wages which is putting pressure on the food supply? That too is possible but probably only a contributing factor. However, some authorities have taken it a step further and suggested that the inflation is “imported” (a swipe at the devaluing dollar).

Those that object to the fact that the Chinese are artificially keeping their currency low by pegging it to the dollar and printing Yuan like there was no tomorrow see this as the Chinese getting their just desserts for flooding their economy with credit and cash to maintain a devalued and competitive currency for trade. The Chinese insist this inflation is not the result of monetary expansion, just a food capacity problem exacerbated by bad weather.

Only a few months ago the world was watching for a real estate bubble to burst in China, but the focus has moved on to a fear of uncontrollable inflationary pressures. The key now is to see what measures the Chinese government will take to mop up the liquidity and fight inflation and above all if their cure will be worse than the disease. A similar situation took place back in 2008 but this is nothing like as bad, so far. However, the real estate market may get a shock from these inflationary pressures as the government starts to raise interest rates,

The authorities are fighting the inflation with both market forces and top-down regulation. The top-down regulation is to guarantee the food supply, cap prices to avoid social unrest and the market will, in theory, readjust the inflationary pressure once the reduction in money supply takes effect.

The Chinese economists will be the first to tell you that price rises go hand in hand with economic growth. Nevertheless, if you are about to price a billion people out of the food market, suddenly market forces don’t look so effective and reassuring. Hence the decisive action.

The government is already clamping down on speculative foreign direct investment or “hot money” which comes and goes at high speed and as it pleases but it is also reducing the money supply closer to home by ordering Chinese banks to set aside more reserves and basically lend less.

The inflation figure is actually not that terrifying, China has been there before and this is nothing like as serious. It is more the element of surprise: this dramatic rise was not on the agenda, quite the opposite, so it has come as something of a shock.

There is little flexibility in the Chinese food market, supply is always very tight and currently the economy is awash with money so it is putting pressure on the food supply as people are buying more. It does not take much to tighten the supply chain and push prices up. Capacity is limited. This is the nub of the problem.

There are different versions of who is to blame for the excess liquidity in China: some blame the Chinese themselves for their easy credit policies, low interest rates and economic stimulus policies. But the Chinese are looking further afield for the culprit and are blaming Western governments with their loose monetary policies (the Fed’s QE2 policy) which are flooding emerging markets with excess cash that cannot find a worthwhile home elsewhere. But the Chinese are also printing their own currency to match the inflows of FDI coming into the country so as to mop it up and keep the Yuan low.

So the question is, are we witnessing a prelude to a massive hike in inflation and potential social unrest, or is this a mere blip that actually represents a buying opportunity for hot money? Economics is not an exact science and nobody really knows, but this episode of high inflation is a sobering moment particularly for the tens of millions of Chinese living on the poverty line.

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