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June 10, 2008 Source: www.AsiaEcon.org The Chinese economy continues to grab headlines. But lately those headlines have been less than optimistic than usual.


10 Jun 2008

Source: www.AsiaEcon.org


The Chinese economy continues to grab headlines. But lately, those headlines have been less optimistic than usual.

For years now, we have read endless feeds about China’s explosive economic growth, which is expected to reach 10 percent this year (compared with nearly 12 percent GDP growth in 2007), while world growth will slow to 3.7 percent. For the past year, and especially over the last few months, however, we have been hearing less about booming growth and more about booming inflation, and the negative consequences it may have for the Chinese economy. The Organisation for Economic Co-operation and Development reported June 4th that consumer price inflation in China is expected to be 6.4 percent for 2008, up from 5 percent in 2007. While this number is encouraging in comparison to the 8.7 percent rate reached in February, a 12-year high, it nonetheless raises a lot of concerns for foreign investors in China.

Many of the factors driving inflation on mainland China are the same as those affecting emerging economies throughout the world. Rapidly rising food prices are a main culprit. Growing middle classes throughout the developing world have increased demand for basic food staples and for meat, whose production requires grain for livestock feed. China in particular suffered from an outbreak of blue ear disease among its hog population in 2007, and low prices in 2006 resulting in lower production, which combined to increase the price of pork by over 50 percent. Overall, food prices in China have risen by 22 percent over the past year, while non-food prices have risen only 1.8 percent. The central government has reduced import taxes on such goods as frozen pork, cod fish and baby food, in an attempt to lower prices.

Increasing energy prices have also contributed heavily to consumer inflation. Surging oil prices are largely to blame. Although the price of gasoline is subsidized in China, such subsidies there and in other emerging economies have pushed up oil prices everywhere. In addition, the winter storms in January resulted in severe coal shortages that hurt the Chinese steel industry, which relies heavily on thermal coal production. While China’s steel consumption will increase by 11 percent in 2008, output of crude steel will grow by only 6 to 10 percent, compared with nearly 16 percent growth last year.

Last month’s earthquake in Sichuan, although it will most certainly not have any long-term economic effects, will nevertheless add to short-term inflationary pressures.  At the same time Beijing is trying to cool the construction industry, rebuilding in this southwestern province is expected to cost CNY 1 trillion (USD 144 billion).

Beyond these supply shocks, however, many analysts also believe that loose and otherwise ineffective monetary policy is largely to blame for sustaining the effects of inflation. The People’s Bank of China has steadily bumped up the interest rate over the past year, but this has been ineffective, as the rate inflation is still higher than the interest rate, thus keeping the real interest rate below zero. The People’s Bank, like many other central banks throughout the developing world, are reluctant to raise rates much higher, due to political pressure to keep growth and job creation at high levels.

The State Council has been trying to restrict bank lending in an efforts to lower the velocity of the currency, but as a recent article in the Asian WSJ pointed out, bankers are ignoring this credit ceiling. This is because many of the companies benefiting from bank lending have close financial and political ties with local party elites, who put pressure on local bankers to lend beyond their quota. Beijing bureaucrats, many of whom have posts that are up for reappointment, are reluctant to enfore the restrictions and thereby anger the party officials upon whose political support they rely.

Additionally, since the beginning of 2007, the central bank has raised the reserve requirement for banks 11 times, to its current level of 16.5 percent, in an effort to decrease the amount of currency in circulation. It remains to be seen how effective this measure will be in reigning in inflation.

Inflation and Beijing’s response to it adds a great deal of uncertainty for investors in China. Most Western analysts agree that the only ways for China to control inflation are to raise the interest rate, which would appreciate the renminbi (RMB), or to revalue the RMB directly. Although China has allowed the RMB to appreciate faster than normal recently (4.5 percent against the dollar during the first five months of 2008), it is reluctant to adopt these measures more vigorously. A stronger RMB would further hurt its export competitiveness, which has already been eroded by the higher costs of wages and input prices. Furthermore, an appreciation would bring even more currency speculators to China, which would add liquidity and exacerbate inflation. More interest rate increases by the central bank would have the same effect.

On the other hand, a tighter monetary policy would hold down commodity prices and limit their effects on the wider economy. Furthermore, China’s high savings rate has contributed to a large pool of money available for investment, so higher interest rates should not lead to much higher levels of unemployment. In spite of the risks, however, it seems inevitable that some difficult short-term adjustments in monetary policy are necessary to prevent sustained inflation from eroding much of the gains enjoyed by China over the past several years.

The effects of inflation on the Chinese stock market are harder to predict. A high inflation rate encourages Chinese to move more of their income from bank deposits to the stock market. On the other hand, higher wages and prices erodes profits, and evidence shows that stock prices tend not to reach their nadirs until inflation peaks. Price controls on steel and coal will also hurt profits. Companies in sectors that are especially susceptible to cost-pressure increases, such as steel, are most vulnerable to inflationary pressures. In times of high inflation, the safest companies are in services and consumer industries.

Finally, the possiblility for widespread social unrest must be considered. Although democracy activists got the lion’s share of the media’s attention during the Tiananmen protests of 1989, the unrest began with large protests by workers and other residents who were upset with the diminished standard of living caused in large part by high inflation. This must certainly be at the front of the minds of Chinese policymakers and investors.

Source: www.AsiaEcon.org


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