Tuesday, June 03, 2008
By STEPHEN GREEN
FROM TODAY'S WALL STREET JOURNAL ASIA
June 3, 2008
Many people in China right now call these the country's Golden Years. But after a fantastic run of double-digit growth, bigger pay packets, low inflation and growing international influence, clouds are now forming over China's economy. Most obviously the dark weather of the snowstorms earlier in the year and the terrible earthquake in Sichuan have rocked the country's confidence. Less tangibly, but more importantly for the economy, stronger inflation is emerging. And there is a danger that the hard decisions needed to break it will not be made while there's still time to do so relatively easily.
In part, this is because policy makers are only gradually grasping the magnitude of the inflation threat. On the surface it looks like inflation as measured by China's official consumer price index has been driven by food, primarily pork and edible oil. CPI has exceeded 8% year-on-year in recent months (but looks set to fall below 8% in May). Exclude food items, and prices overall only rose 1.8% in the year to April.
But few people believe this is an accurate reflection of price trends on the street. Higher service-sector prices in health and education are likely not adequately reflected in the index, while the basket of goods surveyed is updated only once every five years. The GDP deflator – an overall measure of inflation also calculated by the government – was up to over 8% year-on-year in the first three months of this year.
Energy costs are particularly bad. Crude oil is up 35% since November 2007, when government-controlled gasoline and diesel prices were last hiked. Lines are forming again at gasoline and diesel stations as refiners suffer. The still-dominant thinking in Beijing is that all these price hikes reflect a series of supply-side problems. But it is becoming harder to find any falling prices at all – a red flag that this inflation is a monetary phenomenon rather than an unfortunately timed series of supply shocks.
Beijing's bigger problem, however, is that policy makers aren't especially eager to take the hard steps necessary to solve the problem, such as raising interest rates or allowing further appreciation of the yuan. At the best of times, these policies would slow economic growth. And now isn't the best of times, since the economy may be slowing already. While the first quarter still saw export growth of 21% year-on-year, export growth to the United States is down to zero and exports to Europe also look weak. There are reports of export factories closing in Guangdong province on the heels of a slowing global economy and a rising yuan that makes Chinese goods appear more expensive abroad.
Adding to Beijing's reluctance to act on interest rates is its fear that increasing rates would spur more "hot money" flows of speculative cash into China. Beijing is on watch for such short-term flows – worried about the potential destabilizing effects of it all leaving. Indeed, the money is flowing in. Total foreign exchange inflows could have been as large as $200 billion in the first quarter alone, although again the official numbers are not that easy to interpret. At least half of that total might be "hot" money, though.
Beijing is taking some administrative measures to discourage these inflows, such as reportedly stepping up regulatory scrutiny of yuan accounts held by nonresidents in border areas like Shenzhen. Additional controls in other parts of the capital account are likely. Currency policy is also up for debate again. Although the yuan has increased 16% against the dollar since the reform in July 2005, it has lost 6.5% against the euro. Last year the yuan gained only 4% on a real effective basis. Given the concern over exports and hot money, some believe now that Beijing has decided to slow down yuan appreciation. While it moved 4% against the dollar in the first three months of this year, it barely budged in April-mid-May. This pushed the offshore market to move from expecting a 12% appreciation over the next 12 months to just some 3%. That is probably a low estimate – and the effective exchange rate is still appreciating – but it is still a close debate.
If interest-rate increases and currency appreciation are off the table, there are few effective tools left for fighting inflation. For now, Beijing has decided to stop raising rates and to constrain bank loan growth directly. This is certainly causing frustration as companies with big investment plans cannot find financing – and some cash-constrained small- and medium-sized enterprises struggle to survive. But at the same time, loan growth is still running at 14% year-on-year, real loan rates have fallen to zero, and foreign currency loan growth has exploded. It's hard to call this a "tight" monetary policy.
Beijing could, and should, do much more. China is still at the point where strong inflation-fighting would be painful but not catastrophic. With manufacturing wages still rising and many firms moving out of Guangdong province and into other parts of China, it's unclear how serious the job impact of a rising yuan will prove. China is still growing at a double-digit pace and so worries about a crash seem overblown. The key macroeconomic risk for China is not that the government will fight inflation too aggressively, but that it will not do so aggressively enough. Inflation is already in the system and a lack of resolute action now will cause it to become worse. The Golden Years are over, at least for the moment. The time for hard choices is here.
Mr. Green is head of China research at Standard Chartered Bank in Shanghai.