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Friday, February 29, 2008

Chinese Inflation: A Mounting Problem

I was asked my views on the Chinese inflation situation today and came up with this short piece:

The Chinese growth story is now sharing the spotlight with the country’s mounting inflation concerns. In January consumer prices rose 7.1%y/y; to a level not seen since 1996, a point when China was in the midst of recovering from levels around 20%y/y. Moreover, based on the current outlook February’s reading is not expected to show any signs of improvement. Starting late January and ending in February China faced a barrage of disastrous winter weather, affecting nearly every aspect of the economy, including crops. This is particularly relevant given that food prices have been the main cause of Chinese inflation, increasing an astonishing 18.2%y/y in January. Important to keep in mind is that January’s reading includes only a small portion of the storm’s total effect, which will be fully reflected in February’s release.

Drilling a bit deeper into China’s inflation problem we look at some of the reasons for the increase in food prices. In part this trend can be attributed to China’s economic success; Chinese economic growth has led to an increase in wealth among its population. With more money to spend Chinese citizens tastes began to shift, in the food sector this meant instead of having vegetables for dinner they preferred meat, especially pork. Since demand for these ‘new’ products are rising faster than they can be supplied, prices are going up. Despite the simplicity of this explanation it could have a significant effect on the Chinese economy. Take this scenario into account; if you expect dinner is going to cost more next month than it did today you are going to ask for better wages to make up the difference. With this in mind inflation expectations have a direct correlation with future inflation based on this principle. Currently, we believe this scenario may already be occurring. Price increases are now showing up in sectors other than food, including services, producer prices, and other non-food products. The increase in service prices could very well imply we are already seeing an increase in the cost of labor due to rising inflation expectations. This scenario will have to be watched closely by Chinese policy makers.

Curtailing the inflation problem will be a tough challenge for Chinese leaders, especially given an increase to inflation expectations. In a more traditional scenario, the solution would simply be a combination of tight monetary policy and conservative fiscal policies. However, a number of problems including reconstruction plans from the winter storms, ‘quasi’ pegged exchange rate, and liquidity factors add up to a unique challenge. Reducing government spending at a time when a large portion of the country’s infrastructure needs to be repaired is not feasible. Additionally, further appreciation of the RMB could reduce exporters’ price advantages to overseas competitors and may reduce Chinese market share lowering economic growth. Finally, increasing rates could make it harder for businesses to borrow within China during a time of industry consolidation; potentially adversely affecting growth. A likely outcome will come by finding a balance between tighter monetary policy and further appreciation in the RMB.

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