China went through a period of relatively high inflation during 2007 and 2008. Back then, food prices – driven by an outbreak of blue ear disease among pigs and high global oil prices – accounted for most of the increase in the consumer price index (CPI). Food price inflation peaked in February 2008 at 23%, while core CPI (excluding food and energy) hovered around 1%.
This is very similar to what is happening now, with recent increases in CPI due almost entirely to food prices. Since February of this year, the CPI food price index has been above 5%, and it has risen steadily since June, from 5.7% to 10.1% in October. Meanwhile, core CPI has been about 1% for the last six months.
Pork prices were the principal driver in 2007, but vegetables, fresh fruit, grain and cooking oil are behind the rapid growth in 2010.
Persistent food inflation
Back in the spring, it was thought that these prices had gone up largely in response to widespread bad weather and the effects would ease off by the autumn. That hasn’t happened. Commodities traders in Shanghai, struggling to explain the continued price rises, offer a combination of factors: bad weather, higher global food prices, a bit of hoarding by consumers, rising labor costs, and speculation.
I’ve seen no evidence of a spike in demand for any types of food that would offer a demand-side explanation for higher prices.
It is difficult to see what factors might break the cycle. One possibility is the early February arrival of the Lunar New Year holiday. Typically, farmers, anticipating higher holiday prices, will want to sell as much as possible. Traders and speculators will want to raise as much cash as possible ahead of the holidays. This rapid rise in supply could prompt a decline in prices – but this might be followed by a post-holiday rebound.
Continued fast income growth means rising food prices are not a significant social or economic problem at this point. Nevertheless, the government is concerned. Since mid-2009, various steps have been taken to rebalance and slow the pace of China’s economic growth: Bank loan quotas and money supply growth have been reined in and infrastructure spending is back at pre-stimulus levels. But interest rates were not raised – until the 25 basis-point hike in October, which coincided with the CPI food index hitting 8%.
As long as food prices continue to climb, the government is likely to continue to raise interest rates. Another hike is therefore almost certain, and two are possible. And yet these actions will have no direct impact on domestic food prices and the indirect impact will be small: If consumers feel the government will succeed in controlling prices, inflationary expectations, as well as hoarding, will be dampened.
The primary reason for the government raising rates is to signal action and empathy to Chinese consumers as they watch food prices increase. A secondary reason is to signal a desire for GDP growth continue to cool. So far, the soft landing from last year’s hyper-stimulated pace has not been much of a landing, with third quarter GDP growth of 9.6%. Beijing has expressed a desire to avoid full-year double-digit expansion.
Cumulative rate increases of 100 basis points or less should have little impact on demand for credit, given that rates are low relative to nominal GDP growth, and because expectations for corporate profit growth remain high. Neither will rate hikes have much impact on the property and equities markets.
Margin squeeze concerns
Despite this, higher interest rates are a positive development. A critical weakness of China’s financial system is that the cost of capital is grossly underpriced, leading to over-investment and mal-investment. Overcapacity in China’s manufacturing sector is probably a bigger cause of the country’s trade imbalances than is an undervalued currency. Raising rates, gradually over an extended period of time, will solve this problem.
This may also help address the issue of persistently low non-food inflation in China. Overcapacity is one of the principal contributing factors to the situation because it severely limits firms’ ability to raise final goods prices. When, for example, the purchasing price index for industrial inputs rose to 15.4% in July 2008 from 3.6% a year earlier, it had almost no impact on core CPI, which rose to 1.1% from 0.8% a year earlier. Industrial profit growth, on the other hand, plummeted.
