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China Is Nowhere Close to Victory on Inflation: Andy Mukherjee
Commentary by Andy Mukherjee

June 12 (Bloomberg) -- The 8.1 percent, one-day slump in China's key
stock index this week shows investors are shifting their gaze away
from food prices -- which are stabilizing -- to other sources of
inflation simmering below the surface.
The biggest drop in the equity market in 16 months came just as
information leaked that a government report to be released today will
show a bigger slowdown in the pace of consumer-price gains than
expected by all but three of the 19 economists surveyed by Bloomberg
News.
An annual inflation rate of 7.7 percent in May, 100 basis points lower
than the 12-year high recorded in February, is ``certainly good
news,'' says Michael Pettis, a Peking University finance professor.
Yet, ``it shouldn't give too much comfort to the pro-growth camp in
China,'' Pettis says.
The good news on the inflation front was drowned by the hawkish
monetary tightening that was announced over the weekend when the
People's Bank of China ordered banks to set aside a further 1 percent
of their deposits as reserves, seeking to limit a liquidity buildup,
one of the biggest sources of future inflation in the world's fourth-
largest economy.
``The liquidity threat remains copious,'' says Dwyfor Evans, a macro
strategist at State Street Global Markets in Hong Kong.
According to media reports, the People's Bank of China added $75
billion to its foreign-exchange reserves in April, creating local
money in the process. Some of those funds may get exported out of the
economy by China Investment Corp., the sovereign wealth fund.
Bank Credit
The money that remains in the local banking system and is not mopped
up by the sale of government bonds ``will make its way to domestic
credit, which has risen consistently over recent years,'' Evans says.
``This opens up a potential monetary source of inflation.''
The biggest weapon that Chinese policy makers have against runaway
bank credit is what they call ``window guidance.'' The monetary
authority describes the process as one in which it tells banks to
``encourage growth in some sectors while discouraging growth in
others.''
This kind of moral suasion does produce immediate results, and it may
already be under way. However, past experience suggests the credit
rationing is usually not carried on for too long because it tends to
slow the economy sharply, something that doesn't go down well in
China.
Money supply in China, growing at an annual pace of about 17 percent,
remains a key concern.
It isn't, however, the only one.
PPI and Energy
China's producer-price index rose 8.2 percent from a year earlier in
May, the quickest pace in more than three years. That announcement
caused China's benchmark stock index to fall 2 percent yesterday,
taking the total decline so far in 2008 to almost 38 percent, making
China the third-worst-performing market in the world this year after
Vietnam and Iceland.
Rising costs of coal, steel and labor are crimping corporate
profitability. Pretax-profit growth for publicly traded companies
slowed to 17 percent in the first quarter from 49 percent in 2007,
says Jing Ulrich, chairwoman of China equities at JPMorgan Chase & Co.
in Hong Kong.
The future may hold even more pain because at present Chinese
companies don't have to bear the true cost of energy.
``Price controls on refined oil have kept a lid on the impact of
higher global oil prices on producer prices,'' Ulrich says. ``The
relaxation of price controls would open the door to further increases
in the producer price index and the consumer price index.''
Demand Pull
The price controls and subsidies ``can't be open-ended commitments,''
according to a May 23 research report by Peter Redward, head of
emerging Asia research at Barclays Capital Inc., and two of his
colleagues. ``The government budget is, ultimately, constrained while
price controls create hoarding/shortages and general resource
misallocation.''
The economy, which expanded 10.6 percent from a year earlier in the
first quarter, is overheating. ``Demand-pull pressures exist but are
largely masked by price controls and subsidies,'' say Redward and his
colleagues. That's also the impression one gets when looking at the
number of consumption items in China whose prices are either falling
or not rising as fast as they are elsewhere in the world -- such as
urban transportation.
The prospects for equity investors aren't very encouraging. ``Higher
structural core inflation may be an ongoing concern for policy makers,
and investors in the Chinese economy,'' says JPMorgan's Ulrich.
Three-Stage Proposal
The Chinese currency will need to strengthen markedly to lower the
cost of imported goods: Barclays analysts estimate that for every 1
percent strengthening of the yuan, consumer-price inflation in China
is reduced by 0.1 percent to 0.15 percent.
So what could China do to walk out of its money glut and the attendant
inflationary spiral?
Morris Goldstein and Nicholas Lardy, senior fellows at the Peterson
Institute for International Economics in Washington, have a
suggestion.
They say China should immediately revalue the yuan by 15 percent and
then allow it to appreciate by 6 percent to 8 percent annually for the
next several years. In the third stage, which will be reached in four
to six years, China can allow its currency to float almost freely.
It may be the right strategy to adopt, especially with Chinese exports
growing strongly in May. Yuan revaluation is the bullet that China
must bite; and soon.
(Andy Mukherjee is a Bloomberg News columnist. The opinions expressed
are his own.)
To contact the writer of this column: Andy Mukherjee in Singapore at
amukherjee@bloomberg.net
Last Updated: June 11, 2008 14:01 EDT