09 May 2011 00:00 [Source: ICB]
Higher prices for all commodities abound in China
The official explanation of inflation in China is that it is mainly the result of soaring international oil and food prices. But what if the economic stimulus package that came to the rescue of the world economy in late 2008 is the primary cause?
And what if, therefore, inflation is so deep-rooted that it gallops out of control, or the Chinese government is forced into such draconian actions that the economy suffers a sharp slowdown?
Nothing matters more for the global chemical and polymer industries. Despite confident talk of the overall boom in emerging markets, it is the size of China's consumption that matters most of all, along with its rapid rate of growth. The rest of the emerging world pales in significance.
For example, India's chemical and polymers consumption is roughly one-tenth that of China's. India, like so many other developing countries, also faces its own inflation problems.
Patrick Chovanec, a professor at Tsinghua University's School of Economics and Management in Beijing, makes a strong argument that the inflation problems in China are structural, and will not be solved by falling oil and food prices.
"The main driver of inflation in China is monetary expansion, not temporary food shortages due to weather and logistics. The fixation by many analysts on the latter, by focusing on supply shocks and ignoring the bigger monetary story, has led them to consistently underestimate or discount China's inflationary trend," he wrote in a post on his blog on April 15.
"The real story is that, over the past two years, China's money supply has exploded by over 50%, as a way of boosting GDP through a massive lending binge."
The consumer price index (CPI), which was up 5.1% year on year in March - the highest inflation rate in 32 months - told only part of the story, he added.
"Most of the new money that has been created in China went into an investment boom, not a consumption boom," he said. "The result was asset inflation: dramatically rising prices in real estate, commodities, gold, artwork, jade and other tangible forms of savings.
"High GDP growth is not 'good news' that offsets high inflation figures. In fact, China's obsession with high GDP growth is part of the problem. Last year well over half of GDP growth was due to investment in fixed assets, much of it fueled by cheap money and easy credit - the same policies fueling inflation," said Chovanec.
"These turbocharged growth rates only measure the sheer amount of money being invested, not whether those investments are good or bad, or what the return will be," he said. "Stupendous rates of GDP growth due to over-investment or misallocated investment will end up being more of a curse than a blessing."
Chovanec further warned that government price controls will not work until China's high growth in money supply is brought under control.
Netherlands-based consumer products company Unilever, for example, recently agreed to defer price increases after a request from Beijing, and the All China Federation of Industry and Commerce has urged all the industrial groups it represents to heed Beijing's call not to raise prices.
Twenty-four of these groups attended a press conference last month in support of the federation's position, including representatives from the textile, agricultural, fishery, pharmaceutical and bakery industries.
"Food inflation at 11.7% [its rate in March] means the government risks serious social and political unrest if it fails to tighten economic policy and lending," wrote Paul Hodges, chairman of UK-based consultancy International eChem, on his ICIS Chemicals & the Economy blog.
Social unrest in the poorer, rural areas - where food expenditure consumes a bigger percentage of income than in cities and towns - is a major worry.
But if food and overall inflation can be successfully brought under control, the risk is the asset bubbles that Chovanec talks about will burst.
China had 64.5m empty apartments as a result of a credit-fueled building frenzy, according to US investment magazine Barrons in an article published in July 2010. Falling real estate values could also lead to a rise in street protests.
Policy tools to bring inflation under control have so far included higher interest rates and increases in bank reserve requirements. The cost of borrowing has been raised twice so far this year, with economists predicting at least one further rate increase in 2011.
Another means by which inflation could be successfully tackled is through a greater appreciation of the yuan versus the US dollar.
"One of the contributing factors to this [inflation] story is China's maintenance of its exchange rate peg with the dollar, which requires China to continually inject more and more domestic currency into its economy in order to accumulate excess dollars as reserves," said Chovanec.
China might again be caught between a rock and a hard place if it gets its currency policy wrong.
If the value of the yuan is increased this could encourage more money to flow into the economy, as investors gamble on making money out of staged rises in the value of the currency, which would add to inflation.
The alternative of a one-off large rise in the value of the yuan risks a sharp erosion in the competitiveness of low-end manufacturers before the economy has time to adjust, resulting in job losses. Higher unemployment in the export heartlands of southern and eastern China could be yet another cause of social unrest.
Den Xiaoping, China's paramount leader from 1978 to 1992, and the architect of the country's economic liberalization, was quoted as saying that reform was like "crossing the river by groping for stones."
Groping for - and missing - stones is a major risk for the global economy, at a time of uncertain recovery in the West and high commodity prices.
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