Consumer Inflation Knocks at China's Door

飞雪寒冰

Inflation fears are spreading in China with expectations for an economic recovery. Sentiments have been on a roller coaster ride since the economy turned sharply from inflationary in the first half of 2008 to deflationary in the first half of this year. And if steep inflation re-emerges in the first half of next year, resource allocations will be distorted and the economy damaged.

The fears may be justified. If the nation's GDP growth rate hits double digits, and the current flood of excess liquidity is not curbed within 12 months, CPI may rise by more than 5 percent per month next year.

China's current liquidity levels are unprecedented, laying a foundation for steep inflation. A lesson from the past is that consumer and asset price inflation always follow increased liquidity levels.

Contributing to the latest liquidity surge are China's commercial banks, which issued 5.8 trillion yuan in new loans between January and May. If banks lend only 500 billion yuan a month through December, this year's total for new loans could reach 9 trillion yuan. And if the lending spree continues through 2010, total outstanding bank loans could push 50 trillion yuan.

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Liquidity in the Chinese economy so far this year has risen to the highest level since the 1997 Asian financial crisis. Two liquidity measures -- M2 growth, and the difference between loan growth and GDP growth -- each surpassed the 20 percentage point benchmark in March. The former climbed 21.9 percentage points while the latter surged 26.2 percentage points. These measures had seldom risen above 10 percentage points over the previous decade.

But such steep loan growth is not sustainable. If lending and government stimulus spending slow next year, inflation pressure will fall. So China's policymakers will have to choose between inflation and GDP growth next year.

Inflation may hit China before it reaches the United States. Liquidity is looser in China than in the United States, although much of it is locked in medium- and long-term infrastructure projects, making it hard for China's monetary policymakers to make adjustments.

Inflation may be triggered by higher costs, stronger demand, structural adjustments, or a combination of these factors. However, insufficient demand and overcapacity will be major problems for all countries worldwide for the foreseeable future. Indeed, the immediate result of the current global recession has been reduced demand

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A recent World Trade Organization report said inflation triggered by excessive demand in the short term is not likely in China. The report also projected a 9 percent fall in 2009 global trade volume compared with 2008. Global trade volume reportedly fell 15 percent year-on-year in the first quarter 2009.

Future inflation may be caused by rapid economic growth that exceeds “potential” GDP growth – that is, sustainable and inflation-free GDP growth – with excessive liquidity as well as soaring commodity and asset prices. Inflation expectations also contribute to real inflation. When the economy expands beyond potential GDP growth, inflation will follow.

There is no consensus on China's potential GDP growth, but most economists put it at between 8 percent, with no increase in export demand, and 10 percent, if external demand rises. Caijing economists have determined that when potential GDP growth is 9 percent, the difference between that rate and the real GDP growth rate will equal to CPI.

If China's GDP growth does not exceed 9 percent in 2009, inflation is unlikely to appear next year. This has been shown historically: GDP growth peaked in the second quarter 2007 while CPI peaked in February 2008, about a half-year later.

Potential GDP growth is falling as overseas demand weakens due to the global recession. And if the current bank lending boom coupled with government stimulus investment -- continues, China's GDP may grow at double-digit rates from late this year into the first half of next.

In the first quarter 2009, GDP growth was 6.1 percent. Investment contributed 6 percentage points to GDP growth, while destocking reduced the rate by 4 percentage points. By the end of this year, though, destocking may no longer be a factor, and fixed asset investment may grow at more than 30 percent. Under such circumstances, real GDP growth would be 11 percent or more, triggering inflation.

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Meanwhile, if consumption growth's contribution to GDP stands at 4 percent, a drop in external demand may reduce GDP growth. According to a Caijing estimate, China's net exports may fall 30 percent this year. If net exports account for 10 percent of GDP, the decline may lower GDP growth by 3 percentage points. Thus, if external demand shrinks dramatically, quarterly GDP growth may slip to 7 percent from the previously projected 10 percent.

Rising commodity prices may push CPI higher as well. Crude oil prices shot up to US$ 70 per barrel from US$ 30 at the end of last year. The Reuters CRB index has risen 60 percent since March. But due to overcapacity, rising commodity prices have had a relatively limited impact on China's CPI.

Lax liquidity not only encourages investment but also pushes up asset prices which, together with real estate development, contribute to higher CPI. Consumer prices climb on the heels of higher housing prices.

Market expectations are also influenced by the central bank's ability to control liquidity. After China's central bank relaxed its monetary policy last year, stock markets rallied and real estate prices rose.

Moreover, inflation expectations are self-fulfilling. If the markets think banking regulators will exit or reverse current monetary policies, inflation will be curbed. But if they see no way out, inflation could spiral out of control.