China Will Have to Sacrifice Growth to Control Inflation

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Well, observers have been predicting the onset of inflation in China for months, and now the first official signs suggest that for some commodities like food, it has been running rampant for the last year. Minxin Pei, writing in the FT, says M2, a broad measure of money supply, has risen by more than three times in the last seven years, reflecting massive excess liquidity in the economy. The combination of negative interest rates (bank rates were almost zero) and massive credit increases injected by state banks, particularly following 2008, are the most direct contributors to China’s frothy property market and the broad inflationary forces at work in the economy.

Food and housing costs are fueling an official rise in inflation to 4.4% from 3.6% before, and significantly above Beijing’s target of 3.0%. A separate FT article quotes Li Wei and Stephen Green at Standard Chartered in Shanghai as saying that on a seasonally adjusted basis, consumer price inflation increased at an annualized rate of 12.1% in October, up from 5.2% the month before. Industrial production increased 13.1% in October compared to the year before, while retail sales expanded by 18.6%, year-on-year.

Despite efforts earlier this year to reign in bank lending, China’s banks are on track to lend RMB 587.7 billion ($88.7 billion) in October, suggesting there will need to be a sharp contraction in new bank lending in the last two months of the year if Beijing is to meet its full-year target of RMB 7.5 trillion.

Food prices appear at the forefront of the inflationary charge. According to an article by Geoff Dyer, the average price of 18 staple vegetables was 62.4% higher in the first 10 days of November than over the same period the year before. Some, like garlic and ginger, two key Chinese ingredients, have risen about 90%. Price controls may well be introduced, but as in the past, may not be strictly applied. The intention is said to be more of a warning to the supply market to control prices voluntarily.

As worrisome as food inflation is to Beijing, it has been the cause of social unrest in the past. Food costs are just a symptom of a deeper underlying cause, according to James Kynge, editor of China Confidential. China has a vast and unregulated underground financial market, according to Mr Kynge’s research. The system includes off-balance-sheet lending by state banks, funds under management by “private funds and the assets of a booming multitude of unregistered banks and loan sharks. Their research suggests that total assets under management by the almost unregulated “private funds industry involved in investing funds for wealthy individuals may total up to RMB 1,000 billion. The off-balance-sheet lending by state banks this year was said to have reached at least an additional RMB 2,000 billion by the time the China Banking Regulatory Commission recently announced a clampdown, which appears now to be slowing lending from this quarter. The total assets contained within China’s twilight economy may well be in excess of RMB 6,000 billion, Mr. Kynge believes. If this number is added to the 2010 official lending target of RMB 7,500 billion, then it becomes clear that China’s record 2009 lending splurge was no “one-off.”

If China fails to control this unregulated source of liquidity, no amount of whining about US QE and capital inflows is going to resolve the inflationary pressures within. Yet imposing control cannot be achieved without sacrificing growth. The combination of actions Beijing may be forced to adopt, including raising bank reserve requirements, interest rates, prices controls, release of key farm and metal commodities from reserve and so on, will increase volatility in China this year and next. But one thing seems clear: to bring down inflation, Beijing will have to sacrifice some degree of growth. The World Bank predicted Wednesday China’s GDP growth in 2011 will slow to 8.7% after more than 10% growth in 2010. Even that could look optimistic a year from now.

–Stuart Burns

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