Volume 3 Issue 34: Two-Cent Economics

China's Inflation Muddle

After the most recent inflation data from China which saw the year-on-year CPI growth accelerate to 6.5% is it time to start worrying about inflation? The worry has been there for a long long time and the China bears claim that China is going to hit a hard-landing while the China-bulls have been harping that inflation has peaked time and again after each acceleration in the CPI growth. 

The fact of the matter is, this is a delicate issue. This article pretty much sums it up pretty nicely:

While China’s inflation problem should not be exaggerated, complacency would be dangerous. Current inflation is more broad-based than it appears, regardless of the controversy surrounding the adequacy of China’s CPI basket in reflecting the reality of underlying price movements. In fact, annual increases in non-food prices accelerated to 3% in June, up from 2.9% in May. According to China’s National Bureau of Statistics (NBS), living expenses increased by 6.1% year on year in May. Many worry that non-food prices may rise higher.

Barring unexpected shocks, I believe that China’s inflation may peak soon. From a macroeconomic perspective, China’s current inflation is attributable both to demand-pull and cost-push factors.

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To tighten or not to tighten: that was the question. The PBC continued to tighten. But the collapse of Lehman Brothers in September 2008 brought global economic growth to a screeching halt. China’s GDP growth fell dramatically, owing to the collapse of external demand. To offset the negative shock, the Chinese government enacted a four-trillion-renminbi stimulus package, and the PBC shifted its policy stance abruptly. There is no question about the necessity for the turnaround. However, with hindsight, one might ask whether an earlier loosening by the PBC would have been wiser.

With taming inflation its top priority, the PBC has raised banks’ mandatory reserve ratio six times this year. Commercial banks must deposit with the central bank 21.5% of deposits as reserves. Recently, the PBC raised the one-year lending rate and the one-year deposit to 6.56% and 3.5%, respectively.

Currently, China’s inflation is not as bad as it was in 2007-2008. The rise in house prices has begun to stabilize, and the impact of the rise in commodity prices is tapering off.

External demand in the second half of 2011 is unlikely to be strong, owing to the shaky global recovery. The steady increase in production costs, partly attributable to high borrowing costs, is squeezing enterprises’ profit margins of – small and medium-sized enterprises in particular. Declining profits and rising enterprise bankruptcies are posing challenges to China’s monetary authority.

The fact of the matter is, China will have to tighten. With the Western economies running around like a headless chicken with no solutions to their problems in sight, the global economy is headed into another recession. It's time to be prepared. One of a million things can go wrong, and we don't want to be caught in that kind of tsunami.