Rising worries

In 2007 and 2008 it was all about the pigs. A combination of a cyclical dip in pig numbers and the highly infectious blue-ear disease wiped out the pork supply; together with severe snowstorms, the pig shortage pushed China’s food-heavy consumer price index to 8.7% in February 2008, an 11-year high.

In 2010, pigs are not the worry. What precisely should be the worry is harder to determine: While most economists agree that dealing with inflation will be a major task for Beijing in 2010, there is less consensus on where it will come from or how severe it will be when it appears.

"At this moment, talking about inflation seems to be quite unclear," said Zhang Jun, director of the China Center for Economic Studies at Fudan University in Shanghai.

Crux of the argument

On one side are economists who argue that China’s inflationary monetary policy has led to a rapid rise in liquidity, which must be kept in check through monetary tightening. On the other, says Zhang, are those who place an emphasis on supply, many of whom expect China’s infamous overcapacity in sectors like steel and cement to balance inflationary pressures.

The truth likely lies somewhere in between, though the balance of the argument tilts in favor of those who support a monetary explanation. "In the past, people have looked at supply factors, but there were also monetary issues underlying those supply factors," said Logan Wright, an analyst with Medley Global Advisors in Beijing.

A rise in food prices in an environment of monetary stability would have led to lower non-food prices, which did not happen. "[That] suggests that food was simply capturing the increase in monetary inflation, rather than being a one-off supply shock driving it," Wright said. The same appears to be true this year amid early signs of rising prices in staples like rice and pork.

The monetary case is bolstered by the sheer amount of liquidity flooding the Chinese economy: Following the US$1.4 trillion in new loans issued by banks in 2009, Premier Wen Jiabao in December capped several months of government caution with a warning to banks about the risks of excessive lending.

Regardless of its cause, the clear trend toward the end of 2009 and into 2010 has been one of gradually rising prices. From a low in of -1.8% June, China’s consumer price index (CPI) rose to 1.7% in December 2009.

"Over the last four to five months we’ve seen consistent increases [in the CPI]," said Qu Hongbin, chief China economist at HSBC. "I think this trend will continue … mainly because the demand recovery has been very strong."

That demand recovery – both domestically and overseas – has helped to raise prices for raw materials. December trade figures showing China’s imports had grown by 56% year-on-year were greeted internationally by sharp increases in commodity prices. In January, copper rose to its highest level in 17 months, while crude oil hit a 15-month high. More expensive materials come on top of more expensive energy: The National Development and Reform Commission raised fuel prices by up to 8% in November.

The full force of rising input prices is not yet reflected in the producer price index (PPI), but it is gradually rising. In December, the PPI rose to 1.7% from ?2.1% the previous month. Even though the PPI has entered positive territory, however, it will not translate directly into more expensive products in stores; severe competition among manufacturers – even in industries not suffering from chronic overcapacity – will keep higher prices from spreading to consumers.

"We will not raise our prices and so will not pass higher material prices on to consumers," said Lu Jilie, a spokesman for Galanz, a manufacturer of microwaves and other home appliances. If the company’s practice of hedging against commodity price increases should prove ineffective, "factories will consume the burden of rising materials," he said.

Whose credit?

Medley Global Advisors’ Wright argues that strong credit expansion has not yet resulted in consumer price inflation mainly because the bulk of new credit has not been focused on consumers. While Liu Mingkang, China’s top banking regulator, in January encouraged lenders to focus on loans to consumers and small firms, analysts say the distribution of credit is unlikely to change significantly.

Neither is the amount of new credit likely to plunge. New loan growth won’t hit the heights of 2009 this year, but it is still expected to reach US$1 trillion. In light of that huge figure, two economists at the Chinese Academy of Social Sciences warned in January that a continuation of current loose policy could lead to crippling inflation, with an overheating economy expanding up to 16% this year.

Their warning was amplified by faster-than-expected export growth in December. "The key thing is that we make sure we don’t have strong demand in China, and at the same time have strong demand outside China," said Qu at HSBC.

Regulators have begun to gently apply the brakes. Following reports of a burst of lending in the first week of the year, the People’s Bank of China (PBoC) took the targeted action of twice raising yields on short-term bills. "It basically reminds the banks: ‘Be careful about your lending. We don’t want to see a repeat of the big jump in lending’," said Qu.

The PBoC sent an even stronger signal when it raised banks’ reserve requirement ratios by 0.5 percentage points to 16%, effectively draining US$36.6 billion from the banking system. But Lu Ting, an economist with Bank of America Merrill Lynch in Hong Kong, said that while the market interpreted the move as a policy turning point, it also indicated the PBoC’s intention to control liquidity – and rein in inflation – without resorting to broader actions like interest rate hikes.

That is a luxury that China has for now. Continued strong bank lending, more of a rebound at home or overseas and a stronger CPI could all force more severe tightening, as could a rise in hot money inflows from overseas. "You’ve created such a large feed-through of initial activity from last year that tightening then becomes inevitable at some point," said Wright at Medley Global Advisors.

More than inflation itself, the key concern for China in 2010 will be finding a way to implement that tightening without throwing off a broader recovery. This won’t be an easy task.

"It’s unclear whether things are really sustainable outside of government stimulus measures," said Wright. "It’s a challenge that governments all over the world are facing."