Yet observers of the Chinese economy, both at home and abroad, now worry that what looms ever closer is instability in its most dangerous guise – that of inflation. Are they right to do so? Probably not, is the answer.
Consumer price inflation did hit 6.5 per cent year-on-year in August, the highest rate in 11 years, largely because of a 49 per cent surge in meat and poultry prices. One much-respected Chinese economist remarked last month that “we have entered a very delicate stage of our development”. He is convinced, moreover, that true inflation is far higher than what he regards as the government’s over-optimistic figures.
Albert Keidel of the Carnegie Endowment for International Peace takes a similarly alarmist view.* He writes that “China’s economy today looks much as it did before the inflationary catastrophes of 1988-1989 and 1993-96”. The first of these episodes contributed hugely to the protests that culminated in Tiananmen Square in Beijing in 1989. The second ended up with inflation at more than 20 per cent, the sacking of the governor of the central bank and a big jump in interest rates.
Mr Keidel makes three points: first, while the price increases have indeed been limited to food, these remain of large importance to Chinese consumers, particularly to the urban Chinese; second, inflation is already visible in the data on nominal gross domestic product, which is growing at between 6 and 7 per cent a year faster than the government’s estimates of real GDP; and, finally, real interest rates on deposits are negative, which is likely to encourage the Chinese to spend at least a part of their huge holdings.
For Mr Keidel, inflation has overwhelmingly domestic origins. Surprisingly, he denies that either the growth of net exports or the current account surplus plays a significant role in generating inflationary pressure.
Mr Keidel’s chief policy recommendations are two: higher domestic interest rates and liberalisation of imports of wheat and rice. The former would persuade people to hold on to their money, rather than spend it. The latter would generate the additional advantage of enabling lucrative diversification towards higher-value farm products.
How far, then, is either the analysis or the recommendations shared by other competent observers? The answer is that it is not. Jonathan Anderson of UBS argues, for example, that a general inflationary process would show up across the board and not just in prices of food and, most particularly, of pork and eggs (“16 Questions on Chinese Inflation”, August 6 2007).
Moreover, while Mr Anderson accepts that the level of inflation is significantly underestimated in the Chinese data, he denies that it is increasingly underestimated, which must be the case if there were an unrecorded surge in inflation. The evidence from a range of data – the GDP deflator, prices of “corporate goods” and raw materials, import prices and producer prices – shows no such surge.
True, wages are rising rapidly, particularly of rural migrants: since 1995 these have doubled in remninbi terms, notes Mr Anderson (“The End of Cheap Labour (Period)”, August 9 2007). But this is precisely what one would expect in a rapidly growing economy with fast growth of productivity (to the extent that the latter can be measured) and a falling supply of young rural adults (the overwhelming majority of the migrants), as a result of the one-child policy.
Chinese growth is at last spilling on to real wages. No doubt this is making the prices of many services higher in real terms. Yet that is exactly what one would hope (and indeed wish) would happen as development proceeds.
Thus the argument that China is confronting a dangerous upsurge in inflation looks unconvincing. This does not mean that higher inflation than in recent years is unlikely. In the longer term, a fast-growing economy with a tightening labour market and a currency that is appreciating very slowly should show higher inflation than the majority of its trading partners. Such an appreciation of the real exchange rate – a rise in the domestic price level relative to the rest of the world – is a normal part of rapid development.
What is surprising, in China’s case, is how long it was before this process began to take hold: after the mid-1990s, inflation remained consistently low and the real exchange rate flat. A part of the explanation has been the ability of the People’s Bank of China to sterilise the impact of the country’s enormous accumulation of foreign currency reserves upon the monetary base or “reserve money” – holdings of commercial banks at the central bank.
Moreover, while deposits in the banking system have grown far faster than nominal GDP – to reach 160 per cent of GDP last year, up from just 100 per cent a decade earlier – the public appears to have held these deposits willingly, as the best liquid store of value available. Recently, this stock of deposits appears to have spilled over into asset markets, including the stock market. But it has not affected consumption: as a share of disposable income, household savings have been rising since 2001, not falling.**
Overall, then, the growth of domestic demand remains subdued, rather than overheated, relative to the rapid growth of potential and actual output. Indeed, the rise in the current account surplus, in relation to GDP, has to mean, by definition, that the economy’s actual (and potential) output is growing faster than domestic demand.
What then are the policy implications? First, the best way to prevent higher inflation would be faster appreciation of the renminbi: the latter has so far gone up by 10 per cent since the move to a more flexible rate was announced in July 2005. Combined with liberalisation of food imports, a faster appreciation would also be a good way to deal with the jump in food prices.
Second, the big macroeconomic issue of today is not inflation. It is the rapid growth in net exports, soaring current account surpluses and persistent weakness of domestic consumption. China suffers not from excess domestic demand, but a lack of it. Rebalancing the structure of the economy – from exports and investment towards public and private consumption and from massive current account surpluses and huge reserve accumulations towards a more balanced external position – remains the true priority.
From this perspective, worries about inflation are largely a diversion. If they led to emergency cuts in domestic spending, they would prove a damaging diversion, since that would merely exacerbate the persistent structural imbalances in the economy. But these worries might lead to a more rapid appreciation of the currency, faster liberalisation of imports, and policies aimed at stimulating domestic spending, particularly consumption. That would be the productive outcome.