Slippery slope

Headlines about inflation threatening China’s future economic stability are getting tiresome, and yet Beijing seems incapable of changing the channel. In March, news outlets broadcast the same familiar story – the consumer and producer price indexes (CPI and PPI, respectively) surged compared with one year ago, and both beat market expectations.

March CPI was up 5.4% (its sharpest increase in nearly three years), while PPI grew by 7.3% after increasing 7.2% in February. In addition, purchasers’ prices for industrial products rose 10.2% annually in the first quarter. Increased concern about inflation’s effect on profitability led Fitch Ratings to downgrade renminbi debt in April.

Rising consumer prices in China are a recognized political risk, and therefore CPI announcements tend to hog the analytical limelight. But while PPI growth doesn’t always trickle into consumer price inflation, the continued rise of producer prices – which are now at their highest level since 2008 – is nevertheless causing concern.

Divergent growth
“Since March 2010, we have clearly seen the gap between PPI and CPI growing larger and larger,” said Wei Yao, China economist at Société Générale. “Large international companies such as Procter & Gamble and Unilever, as well as [domestic competitor] Liby have all had to increase their sales prices. This is a signal: Those companies can’t absorb the increase in costs anymore. Although the government is using administrative methods to suppress the pressure, the increase is starting to spread into CPI.”

Huang Lin, vice director of research at Soochow Securities, concurred. “PPI’s unstopping increase could be risky, putting increased pressure on CPI, corroding company profitability and causing an accelerating economic slide,” he said.

Where companies cannot vent higher PPI into the market by raising prices – either because of government policy or highly elastic demand – producer price inflation runs its course on companies’ balance sheets. Unfortunately, in many industries overcapacity has led to this precise situation. Rising costs are squeezing profit margins and increasing the risk of loan defaults for leveraged firms making textiles, fast-moving consumer goods, steel and aluminum products, and
chemicals.

Quantity and quality
It’s not just that PPI is rising, but the way in which it is rising that has people worried. In addition to being exposed to higher prices for raw materials – recently aggravated by acts of god, war, and the US Treasury (a weaker dollar means more expensive commodities) – PPI is also being pushed up by domestic structural factors. 

First, Beijing’s drive to increase the minimum wage and otherwise improve labor’s share of growth is in turn inflating the price of intermediate and finished goods, both of which include more captured labor value. In comparison, raw materials’ prices have grown more slowly in the last three months.

Ideally, shifting income toward labor also shifts demand out of investment and into consumption, and higher wages then offset the effects of factor price growth by making consumers willing to pay more. This has in fact happened to an extent: Inflation-adjusted urban income rose 7.1% in the first quarter and rural incomes rose a whopping 14.3%. These rising wages help explain the lack of riots in the streets over 11% increases in food prices in the first quarter.

Second, the numbers also show that old-school infrastructure investment continues to play an outsized role in creating demand. Fixed-asset investment increased 25% in the first quarter of 2011, and new loans hit US$106.7 billion, surpassing market expectations of US$91.8 billion.

The central bank says it will make two more interest rate hikes in the second quarter to get inflation under control, but Wei of Société Générale is skeptical: “There’s little hope that the rise in PPI can be mitigated in the second quarter.” Labor costs, she pointed out, are increasing by 20-30% in company reports, and not all companies can endure mandates to hold prices down indefinitely.

“These administrative strategies [like price controls] cannot last,” she said, but noted that structural approaches like increasing interest rates require time to take effect. 

In fact, higher interest rates and tighter money supply have done more to aggravate PPI inflation than alleviate it in the short term. “Tight monetary policy increases the cost and difficulty of corporate financing,” said Liu Xiahui, a researcher in the Institute of Economics at the Chinese Academy of Social Sciences, the leading public government think-tank. “But companies need money to expand.”

The desire to expand is understandable, but the desire of industries like real estate and construction are proving big headaches for China’s economic managers. But the drive to sustain growth comes from a powerful and entrenched constituency that has grown accustomed  –  perhaps even addicted – to policy stimulus, which explains why the central government’s reaction to inflation seems so half-hearted at times.

Liu noted that while the government is not without options, it will have difficulty simultaneously implementing targeted policies to support growth in key sectors, easing consumer inflation, and all the while avoiding the doomsday scenario of widespread manufacturer loan default.

Trade barrier
It’s not just China’s problem. Rising Chinese producer prices are already spilling into the export markets, another risk to global recovery. “The US import price index from China has risen already,” said Wei. “All the international companies are saying that import costs from China have increased by 20%.”

However, while there is concern, there is not yet cause for panic. Interest rate hikes will filter down into the economy slowly over the course of the year and cool growth. And the pain of PPI increases is unevenly distributed. Not all input prices are going up at the same rate, and not all sectors make equal use of different inputs. But businesses on the receiving end of increasing PPI – and trading partners that have grown overly dependent on China keeping costs low – have a rough patch ahead until Beijing gets the policy mixture in better tune.