Wednesday, October 29, 2003

Well, it's been a while since the last posting. A story on inflation finally got my interest. My friend Bill from Berkeley wrote the following speculation, followed by my reply, followed by the article:
Cutting wages in an environment of significant inflation, when income
disparities and poverty rates have already been shooting up, is not a recipe
for political stability.

That said, I wonder how much of these price hikes are really due to increased
demand and robust growth. Might increasing uncertainty, burgeoning corruption
and graft, more and more common distribution and transportation problems, be
behind this? Also, could it just be a flight from government bonds and
inflated A-shares into durable or valuable goods that then is driving other
prices up as a by=product? Overall, it just seems to me that there is a
pessimistic explanation for all of this that looks just as probable as the
WSJ's version of skyrocketing growth and pent-up demand.

I think the raw material price hike and rapid increases in bank loans are the main culprits here. There hasn't been a huge sell-down in A share stocks, and bonds are doing okay. The raw material story is interesting. China now consumes so much raw material, especially in steel, food, and even plastic, that it is affecting world prices. This mean that China is pushing the physical limit of the world. Thus, there will be inflationary pressure even if there is redundant capacity in China to push down prices of manufactured goods. It is interesting to note that Wen and Hu are less inflation averse than Zhu. I strongly suspect that this is Hu's doing, with his "xiaokang shehui" campaign to promote higher growth in the interior regions. I suspect that the PBOC is under some political pressure to continue the current course of loose monetary policies. The PBOC itself has tried to lobby the government to retrench more, but only with limited success. You can see their frustration when they talk about the accumulating risk in the real estate market.

The WSJ Story:

October 29, 2003
Inflation Hits China
Amid Surging Demand


SHANGHAI -- During a trip to his favorite supermarket this month, Yu Maomei was surprised to find the shelves for cooking oil stripped nearly bare. When he returned the next day, the 68-year-old retiree figured out what had happened: The store had raised the price of cooking oil, and some customers had stocked up in advance.

In following days, Mr. Yu found that prices for pork, rice, green vegetables and even some seafood had also jumped. "Many of the goods I need for daily life suddenly became more expensive," says Mr. Yu, in a slightly worried voice.

Long mired in a spiral of ever-lower prices, China's economy is dealing with something else these days: price inflation. In the first nine months of this year, China's benchmark consumer-price index rose 0.7%, and many economists expect it to shoot well past 1% next year. (Producer prices rose a year-on-year 1.4% in September, China reported Tuesday.) The CPI rise is still mild compared with inflation in other countries -- and a far cry from the nearly 25% inflation that spread through China's economy in the early 1990s -- but it marks the first significant inflation China has experienced since 1997, showing how the nation's booming economy is creating demand not seen in nearly a decade.

Several factors are behind the climbing prices. Demand for raw materials such as steel, cement and rubber has soared, the result of economic growth that could reach 9% this year, and surging investment across the economy. Nascent supply bottlenecks in the agricultural industry have also raised prices.

No less important, economists say, is warp-speed growth in the amount of money sloshing through China's economy -- money supply is up more than 20% this year -- a phenomenon that fuels inflation by making more money available to spend. The return of inflation is significant because it spells the end of China's five-year bout with deflation, a fall in the general price level caused in China's case by tight credit, and an oversupply of goods ranging from rice to cellphones.
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The result was a boon to shoppers, Chinese and foreign. Yet alongside the cheaper prices, a new fear emerged: of global price deflation. As China's exports filtered through the world market, so did concern that the country was spreading deflation, aggravating a problem already vexing some other countries.

Now, such fears are moving to the back burner.

Just how far inflation spreads in China has implications for a big question hanging over global financial markets: a potential revaluation of China's currency, the yuan. Washington is pressing Beijing to let the yuan strengthen, a move that would make Chinese exports less competitive. So far, Beijing has resisted.

But if prices in China continue to rise, the issue could become moot. Prolonged inflation would eventually erode the yuan's purchasing power, raising costs for Chinese manufacturers and making their exports less competitive. It would also fuel demand for cheaper raw-material and other imports, narrowing the nation's trade surplus. And as China imports more, it might help dispel its reputation as an unfair trader interested only in flooding the world with cheap exports.

"Inflation," says Yuan Gangming, a senior researcher at the Chinese Academy of Social Sciences, "would be a good way to relieve international pressure for a yuan revaluation."

Even so, economists say greater Chinese demand for foreign goods would provide little relief for foreign manufacturers of finished goods, particularly those competing against China. The reason: Many Chinese companies would likely use the nation's deep pool of low-wage labor as a way to cut prices.

For now, it's unclear to what extent inflation may grip China. Though personal incomes in the biggest cities are rising quickly -- by about 9% this year -- they are rising far more slowly in many other parts of the country, particularly the countryside. Uneven income growth hinders consumption, which has grown at almost the same 8% rate for five years.

Indeed, economists say inflationary pressure thus far is largely the result of demand for raw materials needed to build factories, roads and other infrastructure. Yet the surge in this type of investment, which accounts for 42% of China's economic growth this year, and surging bank lending -- up a year-on-year 23% in September -- is fueling concern that China's economy is becoming stretched. That in turn is prompting a debate within China's central bank over whether to cool things down by raising interest rates.

If rates rise, and demand for raw materials eases next year, China could be stuck with an old problem: vast new manufacturing capacity but fewer places to sell what the new factories make. That means prices could come down nearly as fast as they went up, Merrill Lynch economist Timothy Bond wrote this year.

Even so, most signs suggest that China has entered territory where price pressure is clearly tilted upward, not downward. Reinforcing this change is a different view of inflation among China's new leaders, particularly Premier Wen Jiabao, who appears to have decided, unlike his predecessor Zhu Rongji, that a measure of inflation is good for China. "The government is now willing to see inflation in the range of 2% to 3% a year," says Mr. Yuan, the Chinese economist.

Some foreign companies say they see opportunities to raise prices on their best products. Swiss agrochemical company Syngenta AG, for instance, recently started charging China's export-focused vegetable farmers more for crop-protection chemicals, because "they go straight for quality," says Karl Gutbrod, a Shanghai-based executive. John Mullen, regional chief executive of DHL Worldwide Express Inc., echoes that sentiment: "We're not seeing price declines at the moment," he says.

Because it can take 18 months for price increases to filter through China's relatively primitive economy, today's inflation figures reflect the pressures of early 2002. The upshot: If inflation spurts higher in coming months, Beijing may have no choice but to tighten credit, hindering its efforts to speed job growth, a top priority.

Inflationary pressure may be stronger than Beijing realizes. Though prices for finished goods continue to fall, the price of many services, such as health care and education, are rising fast.

Agriculture is another critical area. In the late 1990s, overproduction put downward pressure on China's most important farm product, grain. That has changed, leaving China on the verge of a grain shortage that is pushing up prices.

People like Mr. Yu, the retired worker in Shanghai, are already feeling the impact. With a monthly pension of just over $100, Mr. Yu says making ends meet wasn't easy when prices were falling. Now, with both food and medical costs rising, he says he is growing anxious. "Daily life is getting more difficult," says Mr. Yu, "It's a huge burden for retired workers."

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