World on red alert over China’s inflation

Article by Johns

China could be hit by inflation of 7pc to 8pc over the next two months, panicking Beijing’s policy-makers into dramatically raising interest rates, economists have warned The prospect of at least four further interest rate rises in the world’s second-largest economy is likely to alarm global markets, which tumbled in shock at China’s decision to raise rates on Christmas Day.

However, inflation has become the central concern for the Communist Party, which is struggling to contain growing outrage in the People’s Republic over rising prices.

“If you look at the sequential growth over the last two months, inflation is rising at double digits. In the very worst-case scenario, if Beijing does not take action, we could see double-digit inflation this year,” said Yu Song, chief China economist at Goldman Sachs.

At stake is the future of the global economy, according to Andy Xie, the former China economist at Morgan Stanley. Writing in Caixin, a Chinese magazine, he said that the two most likely candidates to trigger the next financial crisis are either the US’s sovereign debt or China’s inflation.

“You can describe the global economy as a race between the US and China to see who goes down first,” he wrote. “If China manages its inflation, the US will cause the next crisis. But if China suffers a hard landing, the US trade deficit might even halve because of lower import prices. That would boost the dollar’s value. The US would have lower financing costs for its debt and could enjoy a period of good growth.”

In food markets around Shanghai, the price of meat and vegetables has risen by at least 50pc in the past year, sparking anger among poorer shoppers who spend up to half of their income on food.

In some parts of China, the price of basic foods has doubled and shoppers in the southern city of Shenzhen have even taken to skipping across the border to Hong Kong to buy their daily groceries. On the Chinese internet, the Chinese character “Zhang”, which means “inflate”, has been picked as the word of the year.

Now, a freezing winter is threatening to further push up food prices and global commodities such as copper have already broken through record levels, a combination that spells further inflation.

“If there is a recovery in the West, and global commodity prices continue to rise, that could feed problems in China,” said Li Wei, an economist at Standard Chartered, based in Shanghai. “I would not be surprised to see inflation touching 7pc or 8pc in the first half of the year.”

In response, said Mr Li, the Chinese government would push out all the stops. “The government has been quite cautious so far, but it will have no option but to focus on inflation going forward. At least four more interest rate hikes and significant controls on bank lending, particularly in January, are required,” he said.

Other economists expressed concerns that the authorities may already have left it too late. Diana Choyleva, at Lombard Street Research in Hong Kong, said that China was “behind the curve” in dealing with inflation and now risks “a hard landing in 2011″.

The official Communist party line is that inflation will run at 4pc this year, and that the Chinese government’s “capacity to combat inflation is quite strong”.

Behind the scenes, however, panicky officials have already released large shares of government food reserves in order to calm prices. The ministry of Civil Affairs has also ordered emergency measures to help poor Chinese cope with inflation over the Chinese New Year period, a key national holiday.

Meanwhile, Wen Jiabao, the Chinese prime minister, has taken the rare step of appearing on radio to reassure the public. “I can tell everybody, the government has complete confidence in tiding over this difficult stage together with the masses,” said Mr Wen.

Responding to a caller angry about rising prices, Mr Wen added: “Indeed, in recent times prices have risen across the nation and under these circumstances the lives of low and middle-income earners are evidently more difficult.”

Inflation remains a deeply emotional and political issue in China and the Communist Party is keenly aware that periods of high inflation have caused turmoil in the past. Inflation is widely blamed for having helped fuel the popular unrest that led to the Tiananmen Square protests in 1989.

“Since I was a kid I was told that one of the reasons the Communists came to power was because the previous Nationalist government had caused hyperinflation,” said Goldman Sachs’ Mr Yu. “In the early 1990s we saw inflation hit 24pc or 25pc. If we got that kind of inflation again, I think it is pretty clear that some senior officials would be forced to resign,” he added.

Two recent surveys, one by a government think tank and one by the People’s Bank of China, have revealed that inflation is already causing deep resentment. According to the 2011 Social Blue Paper from the Chinese Academy of Social Sciences, residents in smaller cities and the countryside are especially dissatisfied with their lives, despite their per-capita income rising 9.7pc after inflation.

A questionnaire given to 20,000 banking customers in 50 cities also detected the same trend, with 74pc of respondents saying that prices in China are now “unbearably high”.

During China’s last inflationary cycle, the government tackled the issue extremely aggressively, hiking interest rates eight times by a total of 189 basis points, or 1.89pc points, over a 21-month period from April 2006 to December 2007. Nevertheless, inflation continued to rise, peaking in February 2008 at 8.7pc. “I think we could see a repeat of that,” admitted Mr Yu.

In addition, China is likely to impose higher reserve ratios on its banks and to allow its currency to rise in order to fend off the threat of “hot money” inflows from overseas speculators looking to take advantage of the relative weakness of the yuan and attractive interest rates.

The consensus is that the yuan will be allowed to appreciate by 6pc against the dollar this year, and the currency has already reached its highest level since its landmark revaluation in July 2005.

“The government appears to have given a signal that it will use both interest rates and the exchange rate to fight inflation, including imported inflation,” said a trader at a Chinese commercial bank in Shenzhen.

However, some analysts are fearful that a heavy-handed approach by Beijing to calm inflation and slow the economy could have a knock-on effect for the rest of the world, which is now looking to China as a major pillar of global growth.

Already, Chinese bonds have become the worst performing among Asian markets, returning just 1.7pc in 2010. The Shanghai Stock Exchange, meanwhile, has fallen by 16pc over the year, making it the worst benchmark index among the 21 countries in the MSCI Emerging Markets index.

Michael Pettis, a professor of economics at Peking University, said that inflation would naturally unwind because of China’s “severely repressed financial system”. He explained that the negative real interest rates at Chinese banks would put “significant downward pressure” on household income as a share of China’s GDP. “And as household income declines relative to GDP, so does consumption relative to GDP,” he said.

Meanwhile, as Chinese households buy less, producers would be spurred, again by the low real cost of borrowing, to invest in manufacturing capacity. “When the borrowing cost is negative in real terms, companies tend to borrow and produce more, since even if it is not economically viable it is still profitable,” he said.

“There is an automatic stabilisation so that inflation never turns out as bad as a monetarist might normally expect,” he said.

This is likely to be doubly true in 2011, since bank loan quotas have been maintained at 7.5 trillion yuan (?750bn) for the year and the government will be keen to step up investment ahead of China’s next five-year plan in 2012, when its next generation of leaders take over.

“This isn’t, however, a free lunch” said Mr Pettis. “It tends to be a trade-off of consumer price inflation for excess capacity and asset price inflation. It is pretty clear that this is what we are seeing in China.”

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