Growing pains

In Quzhou, a city of 2.5 million in the southwest corner of Zhejiang province, Mr Xu is at the center of a major economic debate. As consumer inflation in China remains high, Xu’s business – pig farming – has attracted the interest of politicians, economists and consumers across the country.

Xu, who raises piglets and sells them while they are still young, was getting about RMB7.5 (US$1.08) per kilogram for each animal in 2006. A combination of fewer farmers raising pigs, disease and higher feed prices led to a sharp rise in those prices starting in 2007. In February of this year, despite government-mandated price controls, prices soared to above RMB35 (US$5.07) per kilogram.

“It felt like the tables finally turned,” said Xu, who had suffered through a pig glut in 2005, when oversupply depressed prices. “But people aren’t making a lot of money [now] like you think.”

Xu’s unenthusiastic assessment of his business comes thanks in part to the recent fall in pig prices. With food making up about a third of China’s consumer price index (CPI) basket – and pork being the country’s staple meat – those decreases helped to push CPI inflation down to 7.7% in May, from 8.5% in April.

However, what might appear to be a positive development masks significant ongoing risks. The reason, quite simply, is that inflation is not just about food.

“China has broad-based inflation,” said Andy Xie, an independent economist in Shanghai. “People who are talking about ‘just food’ – they should ask people on the street.”

Consumer protection
In reality, people on the street have been sheltered from many of the effects of inflation. Government caps on electricity, water, fuel and public transportation have kept prices low. Consumer goods manufacturers, meanwhile, have been reluctant to pass higher prices on to consumers despite rising input costs that drove China’s producer price index to 8.2% in May. A recent report by CLSA noted that the costs of a number of non-food items, such as clothing, have actually fallen.

“Prices of raw materials have been increasing since 2005,” said a manager at home appliance maker Galanz, surnamed You. “[But] competition in the home appliances industry is severe. We can’t cover the costs by raising product prices.”

Fan Xin, a Shanghai-based brand director at electronics and appliances retailer Gome, confirmed You’s statement. “There have only been slight rises,” he said. “We digest increased costs by improving logistics and management, but we don’t transfer them to customers.”

The liquidity problem
An even more potent inflationary force than rising input prices is excess liquidity. Despite ongoing renminbi appreciation, which helps improve the trade balance, China’s foreign exchange reserves are still soaring. Much of it is speculative capital – or “hot money” – looking to profit on the rising renminbi. Beijing has struggled to sterilize the excess cash flowing in.

Wang Tao, chief China economist at investment bank UBS, says that the economic fundamentals behind currency appreciation are sound, but there are problems in the way it has been managed.

“A gradual but steady appreciation does invite very stable expectations of appreciation,” she said.

Those are not the only expectations the government has had to handle. As prices have risen, so has public expectation of prolonged future inflation. According to Logan Wright, an analyst with Stone & McCarthy in Beijing, these expectations are already feeding into the wage-setting process in some cities, creating a potent inflationary force.

“It doesn’t necessarily affect all workers, but it’s a sign that higher prices for everything are leading people to ask for additional wage increases,” Wright said.

Despite anecdotal evidence that wages are beginning to rise, Wang doesn’t think wage increases are yet a major concern. She credits the price controls with helping to rein in expectations of inflation. However, she warns that these controls may create problems in the long term because they distort price signals. Producers need price signals to indicate the need to increase supply, while consumers should face real costs to moderate their demand, Wang explained.

Price controls are not the only way Beijing has tried to fight inflation, nor are they alone in having significant drawbacks. A case in point is raising the reserve requirement ratio, a favored tool of the People’s Bank of China (PBOC) for attacking liquidity. By increasing the proportion of assets banks must hold on deposit, the PBOC can effectively reduce lending. But with banks only getting 1.89% returns on required reserves, high ratios can be a problem for small lenders.

Since January 2007, the PBOC has raised the ratio a cumulative eight percentage points through 15 hikes, with another hike planned for June 25.

The PBOC has also turned to raising interest rates to increase the price of money. However, Wang at UBS notes that interest rates are not a binding constraint, and would therefore be unlikely to have a strong impact on lending. Furthermore, rising interest rates could appeal to foreign speculators and encourage even greater hot money inflows.

Another option is for the government to allow a radical revaluation of the renminbi. In addition to easing pressure on the trade surplus and foreign exchange reserves, it would remove the expectations of a steadily rising currency that are contributing to hot money inflows. A stronger currency would also allow China to buy imports more cheaply, which could reduce energy and commodities prices.

Stone & McCarthy’s Wright describes this as the “least-bad” option but accepts that it is unlikely to happen. As China’s economic growth begins to slow slightly, he believes Beijing will be leery of any plans that would hobble exporters.

Mix and match
Given the difficulties of each solution, the best bet is likely to be a mix of all of them – credit quotas, reserve ratios, interest rates and currency exchange rates. But Xie, the independent economist, is ultimately pessimistic about Beijing’s ability to tackle inflation effectively.

“The government has this tendency to wait until something bad happens,” he said. “It takes a spark. The whole system is very vulnerable. Inflation takes years to build up and years to ease off. So for people to think that somehow inflation is over in a few months, think again.”