China’s Long-term Shift In Inflation



By John Richardson

THE odd chemicals trader who has gone long might well seek to talk-up his or her markets by claiming that the slowdown in China’s inflation rate is great news.

But nobody interested in anything beyond the sale of the next cargo should read anything too-positive into the decline in consumer inflation in August to 6.2 per cent from a three-year high in July of 6.5 per cent.

Although the official government data suggests that prices have peaked for the moment, there are some major risks ahead.

China seems to have entered a phase in its development where inflation remains elevated and will not respond in the right direction to government measures, economists are warning.

Ben Simpfendorfer, managing director of economics consultancy Silk Road Associates, told the Wall Street Journal that the latest inflation figures “provide temporary relief, but calls for policy easing are dangerous”.

Rising demand for food and double-digit wage growth suggest the economy is in the midst of a structural inflation shift, he added.

“Inflation continues to bubble away under the surface and would quickly re-emerge, especially given the structural pressures on wages, land, and raw materials,” Simpfendorfer said.

“Inflation remains the most likely trigger of a hard landing in 2012, especially if the People’s Bank of China was to ease policy at this point.”

And the fall in the August inflation rate might, in fact, only represent a statistical anomaly, according to economists at ANZ bank in Australia.

“The moderation in headline inflation is largely due to a high base recorded in the second half of 2010,” they said.

“As sequential growth remains upbeat, it is too early to say that inflationary pressures have eased.

“Food prices, led by pork, are still on the rise, suggesting strong inflation expectations and soaring pesticide costs.”

More important is the structural shift we referred to above as land becomes more expensive and the surplus supply of rural workers is reduced. This is possibly because demographic factors that threaten China’s economy in the long term are already coming into play.

Another factor in the reduced supply of rural workers prepared to move to China’s southern and eastern provinces – its manufacturing heartland – as a result of the success of government efforts in raising rural incomes.

Wages in the manufacturing heartland have also been increased, by as much 30 per cent in some provinces in 2010. This was in response to rising public unrest over lousy pay and terrible working conditions.

The central government is committed to a long-term objective of further raising wages in an effort to stimulate domestic demand – although it could face stiff resistance from the state-owned enterprises worried about eroding margins. The powerful central government body, the National Development and Reform Commission (NDRC) might also fight further wage hikes as long as inflationary pressure remains strong.

Inflation has averaged 2-4 per cent over the last decade, but would range between 4-6 per cent over the next ten years, Bo Zhuang, an economist with Trusted Sources, a consultancy, told the Financial Times.

Because the inflation would now be in this higher band, sudden and unexpected disruptions to the economy, such as a drought, had the potential to result in double digit increases in the cost of living, he warned.

A lot of the talk about China’s inflation problem has centred on the notion that it is mainly due to a temporary rise in food and fuel prices – for example, the surge in pork prices. The cost of pork is expected to moderate as more live hogs (soon to be dead, unfortunately for them) become available.

But Alistair Thornton, a China Analyst at HIS Global Insight told the New York Times that non-food inflation was the highest in over a decade.

Food prices, which account for around one-third of the consumer price index, rose 13.4 per cent in August compared with the previous year, whereas inflation for goods other than food was 3 per cent higher, he added.

This all suggests big structural changes in China as the government attempts to make the poor slightly less poor. ‘Economic rebalancing” is the buzz-phrase as Beijing attempts to most domestic demand and lower the dependence on exports and investment as the main drivers of growth.

Plus the enormous economic stimulus package, which we have written about on many occasions, has created strong inflationary headwinds – particularly, of course, in the real estate sector.

The good news on this score might be that new-home prices dropped or remained steady in August, compared with those in June of this year, in 31 out of 70 major cities, according to official government data. Average residential land prices were 9 per cent lower in August over July 2011.

The government, however, still faces the longer term problem of achieving a gradual cooling-down in the property sector. A collapse in pricing would cause major social unrest as all the citizens who lost money took to the streets. Non-performing loans would also rise to the point where they could even threaten the stability of the financial system.

But let’s take the very short-term perspective of the chemical traders we mentioned at the start of this post to conclude this post with a bit of good news – a rather refreshing change.

Lower inflation in August is likely to mean that Beijing will be in no rush to further raise interest rates or bank-reserve requirements (although last month’s changes in how bank-reserve requirements are calculated was bad news for chemicals trade).

The goal posts have also been moved: Prime Minister Wen Jiabao has adjusted the government’s annual target for inflation upwards from 4 per cent to 5 per cent- meaning, perhaps, even less need for tighter liquidity.

That’s alright then – everything is wonderful.

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