Inflation today, risk of deflation tomorrow
Everyone is worried about rising inflation on the mainland. The concern is understandable, but it is just possible that we are afraid of the wrong thing. The real danger may not be rising prices, but a return to deflation.
When the chief number cruncher releases a raft of economic data today, the main focus will not be the country's overall growth rate. Everyone expects a big figure for 2007's gross domestic product growth, close to 11.5 per cent for the year.
Instead, attention will be fixed on the mainland's inflation rate. Judging from recent leaks, Beijing is likely to announce consumer price inflation of 4.8 per cent for 2007, up from 1.5 per cent in 2006.
That seems a steep increase, but in reality the official inflation figure will understate the true extent of price rises last year.
The 4.8 per cent figure the statisticians are likely to announce will be an average of rates for each month of last year compared with the same month the previous year. In other words, it will include a large component of old data from 2006. In fact, mainland consumer prices rose by nearly 7 per cent between the end of 2006 and the end of 2007 (see chart).
The big fear now is that the rate of inflation will accelerate even further this year. Mainland policymakers are certainly scared. In recent weeks they have slapped price controls on a whole range of basic goods including staple foods, fuels and fertiliser in an attempt to prevent new increases by administrative decree.
Analysts are divided over whether this reversion to old-fashioned command economics can succeed. What few are considering is that the real risk may be falling prices.
Admittedly the danger of deflation appears remote at this stage. Nevertheless, some observers are taking the possibility seriously. Qing Wang, chief China economist for Morgan Stanley, points out that when export growth has slowed in the past, so has inflation (see chart).
If the United States now tips into recession, hammering international demand for the mainland's exports, there will be nothing like enough demand at home to absorb the excess output of mainland factories.
In that case, warns Rob Subbaraman, Asia economist at Lehman Brothers, mainland companies could be forced to start cutting prices in an effort to shift rapidly growing inventories.
Add to that the risk that incoming provincial governments could step up investment this year, resulting in yet more excess capacity, together with the likelihood that food price inflation will begin to moderate in response to increased production incentives, and there is a chance prices could begin to fall across the board later this year.
That chance may be remote, but it is worth bearing in mind. Deflation is the kiss of death for companies that have borrowed to invest in new projects. Falling prices mean they have to sell more products to service their debts. But, with deflation, customers have a big incentive to defer purchases, making sales harder to generate. Defaults follow, and bad debts increase.
For the time being, battling inflation will remain the main concern. But if external demand begins to deteriorate more rapidly than expected, Beijing's policymakers may have to switch abruptly to deflation fighting mode. Let's hope they can keep to the virtuous middle path and avoid both dangers.
