Thu, Jan 31, 2008 page8

• Inflation makes its way to China

  • By Zhang Jun 張軍
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  MACROECONOMIC CONDITIONS IN any country are like running water. How large and fast is the flow? Where does it originate and where does it go?

  The "main stream" of China's economy is the vast flow of inward investment. China's economy is prone to rapid growth, with buoyant investment demand sustaining powerful short-term inflationary pressures. As a result, credit controls on investment projects and a close watch on the money supply have been used to promote macroeconomic stability since China began its market reforms.

  But in 2003, following five years of deflation, China's economy entered a new phase. Overcapacity vanished, constraints on consumption were lifted, and a dramatic increase in household demand followed.

  Since then, heavy industries -- steel, automobiles, machinery, building materials, energy, and raw materials -- have experienced an unprecedented investment boom, reflecting demand for urban construction, housing, transport, infrastructure, and equipment renewal. Not surprisingly, the economy began to overheat.

  Productivity and profitability in manufacturing and heavy industries picked up, boosting China's national savings dramatically. Indeed, the huge increase in China's trade surplus in recent years is a consequence not of the renminbi's exchange rate, as many believe, but of the domestic savings' increase.

  Yet, from 2005 to early last year, macroeconomic policy was focused on reining in the surplus. Most importantly, the renminbi was allowed to appreciate, and the export tax rebate was virtually eliminated.

  Early last year, because inflation was not really visible, the government did not regard it as a major problem. But when price increases accelerated in the second half of the year, the authorities began to worry.

  The central bank (PBOC) initially attributed it to excess liquidity, and so began to use monetary policy tools, raising interest rates five times since late last year. As a result, the interest rate for 12-month fixed deposits has reached 3.9 percent. Moreover, the PBOC has issued Central Bank Notes six times, reinforcing its anti-inflationary effort.

  Nevertheless, by the end of October, M2 money supply had increased by 18.4 percent -- growing by 1.3 percent faster year on year, and exceeding the 16 percent target. By the start of this year, it was clear that controlling inflation and cooling an overheating economy had become the government's main economic target.

  Indeed, the government's key economic committee, the Central Work Committee, has concluded that after years of "high growth and low inflation," China is on a route to "high growth with high inflation." This invariably means that fiscal and monetary stability will become a priority while controlling the trade surplus has become a lower one.

  The problem is that, until now, the major cause of inflation has been rapidly rising manufacturing costs, and there is no sign of a slowdown in energy and raw material prices. Moreover, a new labor law and income policies will further increase workforce costs. And, due to rising consumer prices, the nominal interest rate will continue to rise. As a result, with investment demand remaining robust, inflation could spread.

  In the face of growing inflation, output is set to suffer. In order to curb investment demand, tighter credit rationing and monetary policy are inevitable this year, while investment projects and land use will be subject to more rigorous control. Likewise, increasing pressure from growing labor costs will force enterprises to lower their profit expectations and cut costs, negatively affecting output growth and employment in the short run.

  It will be difficult to ease these inflationary pressures this year. International commodity prices will continue to rise, increases in domestic labor costs and prices of non-tradable goods cannot easily be stemmed, the international economic situation will encourage further capital inflows, and asset inflation will persist. All these factors will push inflation above the level last year.

  With export performance also set to slow, owing to the economic downturn in the US, employment and growth could be weakened further, which implies mounting pressure on China's government -- and thus on the fiscal deficit, creating another source of inflationary pressure. And, once an inflationary trend emerges and economic growth slows, the steady-as-you-go pattern to China's decade-long boom will be over.

  Zhang Jun is director of the China Center for Economic Studies, Fudan University, Shanghai.

  COPYRIGHT: PROJECT SYNDICATE
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