China's top concern is inflation. But should it be?

2008-04-01 02:52:26 Forbes

After years of high growth and low inflation, China is now worried its economy will slow because of weakening economic activity in the U.S., Europe and elsewhere. Perhaps more troubling, domestic inflation was most recently measured over 8%, the highest annualized rate since 1995. At the recently concluded annual meetings of China's legislative body, the National People's Congress, Prime Minister Hu Jintao singled out inflation as the No. 1 economic problem. But what to do--and how to do it?

Two background points to start with: First, Beijing understands that runaway inflation can be poisonous, especially in economies like China that are not yet mature. Second, Beijing is learning that developments outside of China's control are affecting their domestic economy. Commodity prices, for example, are made in the markets, not by a committee in Beijing.

Welcome, China, to the realities of global competition, and to the big leagues.

China's February consumer price index (CPI) reading was up 8.7%, vs. readings of 2.9% one year ago and just 0.9% two years ago. That's ugly, and it must be stopped. The CPI for all of 2007 was 4.8%, far below the current figures but also far above their advertised annual target of 3%. Recently Premier Wen Jiabao said that the government is confident that they can hold the inflation rate at 4.8% in 2008, but that it will not be easy. I believe inflation around 6%, maybe even higher, is in the cards. China's inflationary forces are stronger than the tools the government has at its disposal.

The 8.7 % inflation figure in February was the highest since 1995, when it hit 17.1%. However, nonfood prices are escalating only modestly, up 1.6% from a year ago, vs. an average of about 1% over the last decade. That means no alarm bells are sounding here, despite spiking commodity prices and $100-a-barrel oil. And, despite some isolated pockets, wage rates in China remain fairly well-contained. That is an important plus for inflation control.

The real culprit in China is the elevated price of food, which is partly the result of one-time supply shortages. The February CPI food component was up a troubling 23.3%. Note that food-related goods make up over one-third of China's CPI, whereas in the U.S. those goods make up about 14% of the CPI. So a price spike in food in China, for whatever reason, has more serious side effects than one would in the U.S., thereby making it a bigger issue for the Chinese citizenry.

But there are two other factors that also lift food prices: First, ever more grain is being used around the world for biofuels, a new and growing industry. Second, as China gets richer, grain usage within the country itself is also growing. Poor countries grow grain and eat the grain. Rich countries grow grain, feed the grain to the animals and eat the animals. The animal is, so to speak, the "middle-man" in this transaction. This is a highly inefficient use of protein as well as an ever-enlarging source of demand. Food inflation should slow later in 2008, but it will take time.

To fight inflation, Beijing has raised interest rates and reserve requirements multiple times over the last year and announced sharp new limits on bank lending. But these tools take time to work in China, just as they do in the United States. We can expect better inflation numbers in the second half of 2008, but a lot of Chinese are feeling a real squeeze right now.

In the biggest difference with the United States, China continues to favor "administrative measures" in its anti-inflation fight. Not as sweeping as the Nixon administration's failed wage and price controls of the 1970s, rather, they are just little interventions--rules and regulations established by the government, which hold down a price that someone has judged too high. Too numerous to catalog, they have included ending subsidies on certain exports, suspending some exports entirely, setting maximum prices on some food and energy products, reducing tariffs on imports and dictating that local governments not increase prices. These steps are scattered and not well-coordinated. Such measures don't do much real good in holding down prices; their real effect is to send a message to the people that the government is on the job.

At the recent meetings of the National People's Congress, Wang Qishan was appointed a new position as vice premier in charge of economic and financial policy. Wang is a respected public official and a person to watch; inflation control is one of his responsibilities. Like the proliferation of administrative measures, what this appointment really means is that the government wants to be seen doing something.

Right now the policy message in China is clear: The economy is too hot and inflation is too high--so tighten some more.

But not so fast. Beijing anticipates that the global slowdown may prove quite damaging. The government has already tightened repeatedly over the last 18 months; it is nervous about the Shanghai Stock Exchange's 38% decline from its peak in October 2007. Moreover, officials are fearful that implementing aggressive tightening to fight inflation now might be the wrong medicine at the wrong time. China's economic policy leaders are in a spot just about as tight as the one cramping our policy leaders in Washington. Before the middle of this year, I think Beijing will abandon its anti-inflation stance, because the risk of economic slow-down is just too high.

(By Donald H. Straszheim)

Donald H. Straszheim is vice chairman of Roth Capital Partners in Los Angeles, former global chief economist at Merill Lynch, a visiting scholar at the University of California-Los Angeles Anderson School of Management and a longtime China specialist. He previously served as president of the Milken Institute and joined Roth in 2006 to spearhead the firm's China initiatives.