China Walks Market Tightrope as It Tackles Inflation

Tuesday, 14 Dec 2010 07:37 AM

 

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For global markets that constantly fret whether China's economy is either overheating or heading for the deep freeze, the ruling Communist Party seems to be getting the policy balance just about right for now.

Whether it will get the benefit of the doubt for much longer is a different matter.

Investors reacted enthusiastically to the People's Bank of China's decision late Friday to raise banks' required reserves — viewed as a technical liquidity management tool — rather than to reach for the heavy weaponry of an interest rate increase.

Copper responded on Monday by scaling successive record peaks, while relief that China was not slamming on the monetary brakes also boosted global agricultural commodities.

But to some China-watchers, the markets are ignoring clear warning signs that the central bank is behind the curve.

"The view that inflation is completely under control is complacent," said John Woods, chief investment strategist for Asia at Citi Private Bank in Hong Kong.

Woods cited fast-rising wages, mounting residential costs, a squeeze on arable land and increasing global commodity prices as reasons to be worried.

The global deflationary shock imparted by the collapse of Lehman Brothers in 2008 halted the last bout of Chinese inflation in its tracks. Beijing this time might not be so lucky.

"There's a risk that inflationary pressures start to develop a structural bias," Woods said.

New Paradigm

Jianguang Shen, chief economist at Mizuho Securities in Hong Kong, adds a shrinking output gap as well as rapid money and credit expansion to the list of structural factors that he says count for more than food prices in driving Chinese inflation.

"China's output gap or excess capacity is shrinking due to steadily increasing demand and the phasing out of obsolete capacity," Shen said in a note.

What's more, China is depleting its pool of surplus workers, pointing to a steady climb in wages, while speculative bubbles in property and other assets are adding to price pressures.

"We believe that a new paradigm of higher inflation has begun in China, and inflation will be a fixture in the medium term," Shen and fellow economist Mingming Zhang wrote.

They have penciled in an increase in interest rates of 150-200 basis points next year but still think consumer price inflation, which rose to a 28-month high of 5.1 percent in the year to November, will still average 4-5 percent in 2011.

It's a fair bet that investors will take fright if inflation, which has been driven by higher food costs, does not start coming down in the first quarter.

Ajay Kapur, Deutsche Bank's Asia equity strategist, cites runaway Chinese inflation that would precipitate a severe monetary crackdown as one of the main risks to his bullish forecast for regional markets.

Don't Fear Moderate Inflation

The Communist Party has sound historical grounds for wanting to keep a lid on prices. Discontent over high inflation was an important factor behind the student unrest in 1989 that was put down by the army at the cost of hundreds of lives.

But would it be the end of the world if inflation settled around 4 percent — the rate mentioned frequently by scholars and the official media as the likely target for 2011?

High inflation introduces unhelpful distortions. But in fast-growing countries like China, relative prices need to shift to facilitate structural economic changes, according to Louis Kuijs, an economist at the World Bank in Beijing.

"In most emerging markets moderate inflation — of 4-5 percent — is not seen as a major problem," he said in a posting on the World Bank's East Asia and Pacific on the rise blog.

In the case of China, administered prices for resources and utilities, especially energy and water, need to rise, while higher agricultural prices and rising migrant wages would boost rural incomes and reduce urban-rural inequality.

"It would be really unfortunate if such desirable developments were suppressed because of concerns about moderate inflation," he wrote.

That does not mean policymakers should sit on their hands. The World Bank has consistently advocated unwinding the super-loose policy introduced to counter the global crisis.

"The risks of inflation and the need to manage inflation expectations strengthen the case for normalizing the monetary stance," Kuijs said.

"Indeed, with little spare capacity in China's economy, respectable growth prospects, and concerns about too rapid housing price increases, this normalization will need to be a central objective of macroeconomic policy," he added.

© 2014 Thomson/Reuters. All rights reserved.

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