A global slowdown and domestic overcapacity could turn China's inflationary pressures into deflationary forces, writes Steven Xu
At this year's National People's Congress, the fight against inflation emerged as the government's top policy priority for this year. In the face of soaring prices, Premier Wen Jiabao said the government would aim to cool gross domestic product growth in 2008 to 8 per cent, from 11.4 per cent last year, and hold the line on the consumer-price index (CPI) at 4.8 per cent. But the mainland's inflation is unlikely to get out of control - even without tighter macroeconomic policies.
Needless to say, the snowstorms that paralysed the country during the Lunar New Year holiday will distort the inflation picture in the first quarter of the year. The CPI for February jumped to 8.7 per cent year on year (in January, it was 7.1 per cent). And almost no one takes seriously Mr Wen's conservative target of 8 per cent GDP growth. The investment component alone has been responsible for 7-9 percentage points of economic growth in recent years, so bringing the overall rate down to 8 per cent will not be easy. Besides, it is important to recognise the usual trade-off between high inflation and low unemployment. Many economists reckon that every percentage point shaved from the mainland's GDP growth means 2-3 million fewer jobs. If the country's export growth also faltered from slowing overseas demand, policy tightening would only exacerbate problems in the job market.
Indeed, the US dollar continues to weaken, making Chinese exports more expensive. To be sure, the country's export machine is still running strong - outbound shipments in January grew about 27 per cent year on year. While exports to the spluttering US rose only 5.4 per cent, they jumped by 34 per cent to Europe. The amazing strength of the euro partly explains the robust European demand for Chinese goods.
But, combined with the prolonged weakness of the US dollar, the shifting destination of Chinese goods has significantly raised the risk of protectionism and a backlash in Europe. All of this is likely to slow China's export sector in the coming months.
What does this changing trade picture have to do with Beijing's ability to bring down inflation? A lot. A significant slowdown of export growth could quickly turn inflationary pressures into deflationary forces.
This is because the Chinese economy suffers from overcapacity in many industries such as steel, cement and cars. If enterprises in these sectors cannot sell their surplus products overseas, they are more likely to slash prices in the domestic market, rather than cut production. Firms with overcapacity often do so because the cost of leaving expensive equipment idle can be greater than revenue losses from lowering the price of their products.
Whether an industry has overcapacity is hard to establish, but it could be inferred in a couple of ways. For example, the National Development and Reform Commission, China's de facto economic planning agency, maintains a list of overinvested sectors based on their weak pricing power in the market. Conversely, if China did not have overcapacity but its export growth remained high, the country would have been a source of inflationary force for the rest of the world.
The empirical evidence of this, however, is very weak. The US import-price index for China showed only a mild rise last year - to the same level it was in 2004. This was the case even though there was a confluence of factors that could have pushed up Chinese export prices in recent years.
For starters, the nominal exchange rate of the yuan has appreciated by almost 15 per cent since July 2005. Global commodity prices, too, have consistently marched upwards, raising Chinese exporters' input costs. Moreover, the Chinese government has deliberately reduced subsidies to exporters while mandating higher labour and environmental standards on businesses.
Meanwhile, bad news keeps roiling global financial markets. As more and more subprime mortgage slime oozes out of western financial institutions, the toxic sentiment is spilling over into China. The country's once buoyant A-share market has seen its trade volume plummet. Global investors' appetite for Chinese initial public offerings is fast disappearing. In the property market, too, sentiment has become noticeably subdued as prices have fallen in several major cities, including Shanghai, Guangzhou and Shenzhen.
As in most countries, the net effect of such asset-price corrections in China will be tightened monetary conditions or even deflationary effects.
Despite such longer-term forces working in its favour, the Chinese government unfortunately has resorted to price controls for electricity, coal and food as a quick-fix defence against the current bout of inflationary attack. But artificially suppressing prices will only make the eventual adjustment more painful.
It is true that inflation hits the poor harder than the rich. But the government is trying too hard to rein in price increases in the name of building a 'harmonious society'. It may be good politics, but it is dubious economics.
Steven Sitao Xu is the Economist Intelligence Unit Corporate Network's director of advisory services in China