China's government, stuck in a policy bind of its own making, is facing a growing risk of stumbling in its battle against a global wave of inflation. The government's control of its currency and a political commitment to fast economic growth are sapping its ability and desire to tackle inflation this year. A weak response to rising prices risks encouraging the kind of inflationary spiral that has led to political turmoil in the past. And if China's economy doesn't cool down, its demand for raw materials could lead to inflation staying higher around the world.
Caught between a rock and a hard place: can't slow the economy too much, for that will cause pain and dislocation that might lead to grumbling or unrest; tap the brakes too easy, and lose credibility.
China's predicament is perhaps the biggest and most dramatic example of the conundrum facing many emerging economies. Having years ago decided to purchase financial stability and investor confidence by fixing their currencies more or less firmly to the U.S. dollar, they are now finding that the choice has limited their room for maneuver. As the U.S. has cut interest rates, that link has made it harder for these countries to raise them.
Raise rates, and the currency appreciates by attracting more hot money.
Consumer-price inflation has come down from its 12-year high of 8.7% in February to 7.7% in May, and it is expected to ease further. But a government target to keep inflation at an average of 4.8% or less for 2008 has been quietly dropped, as achieving it has become almost impossible. Analysts think 7% is a more likely result, which would be the fastest rate since 1996.
Inflation of 7% in the US would cause a panic.
“The government has lost its credibility in fighting inflation. They are just sitting there and wishing that the oil price comes down so it will be business as usual,” says Xu Xiaonian, a professor of economics at the China Europe International Business School in Shanghai. The government's desire to avoid harsh measures that could hurt growth is understandable but misplaced, he argues. “Inflation could pose an even greater threat to the economic and social stability of China than a drop of a couple of percentage points in economic growth,” he says.
Ironic: do nothing, and it might be worse. Yet it can be claimed that the government is not at fault; outside forces, or forces beyond our control can be assigned responsibility, or blame.
How China handles inflation will have consequences beyond its borders. A boost in the value of its currency would further push up the price of goods it ships to rich countries like the U.S. On the other hand, cooling its consumption of food and fuels might remove some support from record commodity prices. Without naming names, Donald Kohn, vice chairman of the U.S. Federal Reserve, said last month that in fast-growing economies that consume a lot of resources, “actions to contain inflation by restraining aggregate demand would contribute to global price stability.”
See? Unnamed economies put pressure on prices; never mind that the weak dollar puts pressure on price stability by raising the price of petroleum.
The choice isn't easy. China's exporters are now being squeezed by higher costs and the stronger currency. Real-estate developers are feeling the crunch from the lending quotas, and property-price gains have leveled off. Yet overall economic growth is still more than 10%, strong by any standard. Headline inflation rates are higher than the interest rates charged on a one-year loan, or paid on a one-year deposit. And with price pressures spreading beyond foods like pork, many economists make the same prescription.
“I think that monetary restraint has not worked, inflation remains too high, and the central bank needs to take more serious action in the form of raising interest rates,” Stephen Roach, Morgan Stanley's Asia chairman and former chief economist, said recently in Beijing. The World Bank and the International Monetary Fund have both urged China to tighten monetary policy.