Talking Point

Cloud with a silver lining

Will overcapacity help ward off the spectre of inflation?

Keep an eye on the stuff: it could be a leading indicator on where inflation is headed

It is not how many of us would choose to spend a weekend shortly before Christmas: closeted in a conference room full of planners, technocrats and party leaders debating the direction of the Chinese economy.

But for those looking for signs on what to expect in the next 12 months, last weekend’s Central Economic Work Conference was an important event. The annual session (closed-door) is convened to hammer out the economic policies for the forthcoming year, which are then passed on for rubber-stamping at the National People’s Congress in March.

This year the discussion will have focused on whether Beijing should take its foot off the gas on two of its defining policies for 2009 (the massive fiscal stimulus, and the accompanying surge in bank lending). Delegates will also have had an eye on the horizon, looking for signs of potential inflation in 2010.

Any signs of a rethink?

Most of the recent policy pronouncements have been bland in the extreme. For the Financial Times, that is revealing: the emptier the official rhetoric, the trickier the policy outlook must be.

But at least one statement – from the State Council in November – was more specific on the need to manage inflationary expectations. Asian stock markets shuddered as a result, taking it as a sign of imminent policy tightening.

Since then, a more bullish consensus seems to have emerged, and it expects the stimulus to be maintained at least into the first half of 2010, albeit with more of a focus on improving the “quality” of government spending.

Media coverage of the conference discussions last weekend seems to confirm this; the official line is there will be policy continuity for the foreseeable future.

This is, after all, a policy framework that has helped China to surpass 8% GDP growth for 2009. And HSBC is expecting a stronger performance next year – as much as 9.5%, with the potential to surprise on the upside, according to China economist, Qu Hongbin.

That’s a view supported by the recent monthly data, which points to an economy in expansionary mode. Industrial production in November was up 19.2% in year-on-year terms and retail sales were up 15.8%.

True, export performance is still down on last year. But the shortfall has been narrowing and HSBC’s China Purchasing Managers’ Index (a proxy for factory production) hit a record high of 55.7 for October (ratings over 50 suggest an expansion in output). The PMI has now reported above 50 for eight months in a row, after ratings below the same threshold (indicating contraction) for the eight months previous to that.

So time to start talking about inflation again?

China’s banks lent a record Rmb8.92 trillion ($1.31 trillion) in the first 10 months of this year. That contributed to monetary growth that is close to twice the annual average for the past five years. The risk in flushing so much cash through the economy is that it will stoke up prices and encourage asset bubbles.

It is a sensitive issue for policymakers, who have often been better at stimulating growth than at containing its inflationary backdraft. Last year’s economic slowdown has generally been blamed on the collapse in demand for Chinese goods from overseas. But there is also an argument that the domestic economy was on the skids well before exports dried up, following a bungled response to booms in the property and construction sectors. The resulting correction led to the loss of millions of jobs.

That may give the planners more to think about at the moment. Property is surging again, especially in the leading cities, where real estate prices are back above their 2008 peak. Commentators point to bubbles elsewhere too – from local stock markets (up more than 80% on the start of the year) to the price of garlic (selling at 40 or 50 times the long-term rate). Even the nation’s most prestigious liquor, Moutai is planning a 13% price hike.

Yet, despite the frothiness in specific asset classes, there is less evidence that top line inflation is getting too far out of sync. In fact, the consumer price index had been showing a deflationary trend since January, and only crossed into positive territory (0.6%) in the November data, which was released this week.

This is a trend that is expected to continue. State broadcaster CCTV has polled 120 economists and industry leaders, and more than half expect inflation in the near future (the rest thought it would come by the second half of 2010).

Still, most seem to agree with the think-tank Chinese Academy of Social Sciences (CASS), that consumer price increases will be moderate at about 2% next year.

Food prices are always a factor…

Food is important as it makes up about a third of expenditure for the average urban household (and is weighted accordingly in the consumer price index). So when food prices begin to jump, headline inflation jumps too. In 2007 and 2008, run-ups in the prices of basic foodstuffs like vegetable oil and pork (by as much as 25% at their peak) became a major issue.

This year, food prices are on the up again (rising 1.6% in October) with the rate of monthly growth also increasing. Further, the Economic Observer thinks it has detected circumstances similar to those pre-dating the run-up in prices two years ago. In particular, it says a steady increase in grain, soybean and other feedstock prices will have a knock-on effect on prices for meat, eggs and milk.

So keep an eye on commodity prices in general?

Local brokerage CIC Securities says that the government has stockpiled 60% of annual grain consumption (at least twice its holdings at the onset of the most recent food price scare), so fears on grain prices could be overblown.

But the Economic Observer’s warnings still strike a chord with the People’s Daily, which is worried about “imported inflation”. It fears that a run-up in the costs of imports (especially commodities) will eventually feed through to the prices paid by China’s shoppers. The situation isn’t helped by a weak US dollar (commodities are priced in dollars so, if the dollar is soft, commodity prices rise), or low interest rates internationally (which allow for commodity ‘carry trade’ plays).

But there’s a plan…

Of course, allowing the yuan to appreciate further against the dollar would take some of the edge off import prices. But Beijing worries that this will make Chinese goods more expensive overseas, and throttle the fledgling recovery in exports.

Instead it seems to be ready to sit it out and wait for the US to raise interest rates, hoping that this will take some of the steam out of commodity price rises. In the meantime it is counting on existing industrial and manufacturing overcapacity at home to keep prices down for consumers. The argument is that, with too many factories making too many products, many businesses won’t be able to pass on the increases in their input costs to their customers.

Not an ideal solution, perhaps: although it may protect consumers from the worst of any price increases, it won’t be much comfort to the manufacturers themselves, or their profit margins.

Paradoxically, the government has also made clear its determination to force consolidation upon various industries. If that succeeds, one upshot could be that a reduced number of manufacturers regains some measure of pricing power – and that could well stoke up inflation again.

Still, that’s a problem to worry about in future: perhaps it could be a topic on the conference agenda next year.


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