China’s tolerance of inflation has a low threshold because of the risks it poses to social and political stability. That is why the government and the people have been worried about a steep rise in the consumer price index (CPI) since the first half of 2007. Is this the beginning of a new and potentially dangerous inflation cycle? Earlier cycles were often associated with severe social hardship and political turmoil. The Tiananmen disaster on June 4, 1989, might have been prevented if the high inflation of those days had not brought so many additional demonstrators to the Square frightening the leadership. Older political leaders remember that the Communists’ defeat of the Nationalists in the Chinese civil war of 1945-1949 was greatly assisted by the run-away inflation of those years, which sharply reduced the popularity of Chiang Kai-shek’s Republic of China (ROC) government.
What is driving current inflation in China and what are the prospects?
In the economic arena, the greatest challenge facing China’s leadership at the present time is a new round of consumer price inflation. It started in the first half of 2007. The consumer price index (CPI) rose by 8.7 percent year over year (yoy) in February 2008, the steepest increase in over a decade. The index ebbed to 8.3 percent (yoy) in March. For the first quarter of 2008 as a whole the index was 8 percent (yoy) . The current inflationary cycle is different in origin from the previous one (1992-1995), which was triggered by endogenous excessive credit expansion and economic “overheating” . The present cycle was ignited by domestic supply disruptions in the food sector—mainly pigs and poultry—and reinforced by sharp international price increases for oil, coal, soy beans, grains and metals. The combined effect was to drive up the price of many food items, especially pork, poultry, eggs, vegetable oil and dairy products. CPI inflation received an extra jolt in the early months of 2008 from the worst-ever transportation and power supply disruptions caused by severe snowstorms. The non-food CPI has remained surprisingly modest so far (at least through March – Chart 1 in PDF), but there are some troubling signs that inflation may become more pervasive—for example, the producer price index (PPI) for industrial goods rose to 8 percent in March.
Although China’s growth rate accelerated from 10.1 percent in 2004 to 11.9 percent in 2007 , this was mainly due to an increase in net external demand (trade surplus), not domestic demand, as was the case in the earlier inflation cycle. Although growth was extremely high, domestic monetary expansion in 2007 was relatively moderate and the margin of loanable funds in the banking system  actually contracted due to the aggressive sterilization of excess bank liquidity by China’s central bank. Tight liquidity in the banking system drove up short-term inter-bank rates and increased their volatility in 2007. It is therefore hard to argue that the recent CPI increases are due to an “overheated” economy, as was the case in 1992-3.
Although China’s rising import demand for soy beans, oil, coal, metals and other commodities has undoubtedly contributed to the global commodity price increases of recent years, for economic planners in Beijing, such price increases have to be seen as exogenous . In principle, China should not aim to reduce global commodity prices by deliberately slowing down domestic demand, unless a slow down is necessitated by domestic policy requirements. When inflation is driven by exogenous factors beyond the government’s control, as has essentially been the case since early 2007, a further tightening of monetary policy may have perverse effects: it could reduce employment and slow growth without necessarily reducing inflation. Yet, the government is understandably concerned that a prolonged period of relatively high CPI inflation may generate inflation expectations, which could trigger new inflation dynamics that are even harder to control.
In this context it is important to draw attention to the fact that China’s broad money supply (M2) as a percentage of GDP—around 160 percent since 2004—is exceptionally high by international standards. Moreover, China’s M2 (cash + time deposits + demand deposits) is becoming increasingly liquid  as a result of a gradual shift of household deposits from savings accounts to checking accounts or demand deposits (Chart 2 in PDF). This shift has been going on for some years, reflecting a growing need for larger cash balances to pay for consumer durables and down payments for mortgage loans. In recent years the shift accelerated, presumably because deposit rates were lower than inflation for most of the period since the middle of 2004 (Chart 3 in PDF). Negative real deposit rates made it unattractive to keep money in savings accounts. China’s high M2/GDP ratio combined with the increasing liquidity of household deposits, points to the existence of serious excess liquidity in the economy. Until now this excess liquidity has mainly expressed itself in asset price inflation, not in CPI inflation, but that may change. Excess liquidity does not necessarily trigger CPI inflation, but it facilitates it when expectations take over as the driving factor, which is precisely what the Chinese government is worried about.
The government faces serious dilemmas in how to deal with the current CPI inflation, and thus far Beijing seems to be pursuing a set of right measures: a relatively tight monetary policy while refraining from additional tightening; an increased supply of basic food items from government stocks and imports; and froze some basic food prices on the expectation that the supply disruptions that sparked CPI inflation are temporary. Maintaining price controls and delaying upward price adjustments for energy, however, is a double-edged sword. Faster appreciation of the RMB, as implemented since December 2007, will help on the margin to counter domestic inflation, but it will force accelerated adjustment in low-margin export industries.
A new situation would arise if and when inflation becomes more widespread and extend beyond food into producer goods, general consumer goods and wages. There are some early indications that that may happen . Should those indications persist, China will have to tighten monetary policy. That said, there is still reason to expect that domestic food prices will stabilize later in 2008 of their own accord. The situation is complex and hard to read, and the room for policy mistakes through over-reaction or under-reaction is ample.
During the past 15 years, China’s economy has become closely integrated into the global economy. China cannot avoid the consequences as inflation also reappeared on the global scene. The golden age of low inflation—which was associated with intensive globalization during the past 15 years—seems to have come to an end. The next 15 years may well see higher global inflation because of rapidly rising demand in the developing world and supply constraints in minerals (oil, gas, metals) and grains. There is also a serious risk of rising protectionism, which would contribute to global inflation. The latter can be prevented if nations stick to both the letter and the spirit of the WTO Charter. Given its sharply increased weight in international trade and strong domestic economy, China is now in a unique position to play a pro-active role in promoting multilateral trade liberalization through the Doha Round. Unfortunately, it has shied away from playing such a role until now.
Negative real deposit rates can have perverse economic effects.
In the current inflationary cycle, China has been reluctant to increase domestic deposit rates sufficiently to make them positive in real terms, which would encourage long-term savings deposits and thus reduce the liquidity of M2. This may reflect the government’s belief that current CPI inflation is driven by temporary domestic supply-side factors and temporary international price hikes beyond its control. It may also reflect a concern that higher domestic interest rates would: (1) adversely affect the profitability of state enterprises and (2) attract additional hot money inflows, which would require even more sterilization of excess liquidity in the banking system. The first concern should be resisted on the ground that capital is so cheap in China that it has contributed to overinvestment in manufacturing and other economic imbalances. The second concern does not seem to be well-founded; because China’s capital account remains largely closed, the transaction costs of bringing large amounts of speculative capital into the country tend to be high. In light of this, it seems unlikely that hot money inflows are strongly influenced by relatively modest adjustments in domestic interest rates or, for that matter, the nominal exchange rate. In China’s case, it seems more likely that hot money inflows are primarily driven by large anticipated asset price increases—real estate or shares. An appreciating exchange rate and higher interest rates add relatively little to the large profits that can be earned in bullish asset markets.
The experience with previous inflationary cycles in China confirms that negative real deposit rates can be harmful to the financial system by driving financial intermediation underground  and by increasing the liquidity of M2, which facilitates inflation. It is in China’s interest to raise deposit rates to make the positive in real terms. Since current CPI inflation in China is primarily driven by exogenous and temporary domestic supply-side factors, an attractive alternative to nominal deposit rate increases would be to index them to current inflation, as was done during the inflation cycles of the late 1980s and early 1990s. Indexation would avoid the need to lower nominal rates when inflation begins to fall.
What is the risk of asset price bubbles in China?
Another potentially dangerous risk to China’s economic stability, the bubble on China’s stock market—fueled by excess liquidity in the hands of the public and enterprises—has subsided, in part because of government intervention. Between October 2007 and the middle of April 2008, the Shanghai Composite Index fell by almost 50 percent. A new bubble may develop, of course, but it is likely that the government will again intervene should that happen. The risk of a national housing price bubble, as developed in the United States from 2002, seems remote in China. There may be local bubbles, but at the national level average urban housing prices have been rising more slowly than personal incomes—making houses on average more affordable. In some large cities, such as Shenzhen in Guangdong, housing prices have actually been falling for some time.
China’s government makes effective use of markets for development, but it is definitely not guilty of “market fundamentalism” . It believes that the state is responsible for controlling potentially dangerous asset price bubbles. Both the national and local governments have intervened with various administrative measures to deflate local real estate price bubbles . The national government intervened in the share price bubble that developed in 2006 and 2007 by: (1) increasing transaction costs though a raise in the stamp duty, (2) increasing the supply of tradable shares in state enterprises, (3) raising the ceiling on amounts that can be invested abroad, and (4) high-level public warnings against price bubbles. It must be expected, however, that controlling asset prices bubbles will become more difficult in China as the economic system liberalizes and the direct influence of the state on economic processes shrinks.
What explains China’s high M2/GDP ratio and what are the prospects for reducing excess liquidity in the economy?
Looking at China’s development since the start of Deng Xiaoping’s reforms in the late 1970s, it is remarkable how modest inflation has actually been on average, especially in light of the super fast growth of money supply relative to GDP for most of that period. The M2/GDP ratio rose from about 0.59 to over 1.6, one of the highest such ratios in the world. This clearly reflects two things: China’s high savings rate and the scarcity of alternative assets available for investment. For most of the reform period Chinese households were essentially limited to domestic bank accounts for the investment of their savings. From around 2004 China’s M2/GDP ratio appears to have leveled off at a little over 1.6. The main explanation for the rapid increase in M2 with surprisingly low inflation on average is the gradual monetization of China’s economy, including the monetization of state subsidies for housing, energy, consumer goods and many services. This monetization process has yielded significant unplanned financial benefits for China’s government in the form of seigniorage —the nearest thing to free money. As most subsidies have now been monetized—while credit cards and electronic payments systems reduce the need for transaction money—China’s exceptionally high M2/GDP ratio may be expected fall in the years ahead. This combined with the development of domestic capital markets and gradual relaxation of restrictions on private capital outflows should reduce excess liquidity in the economy and make it easier to control inflation. Since China’s transition from plan to market is incomplete, effective inflation control in China requires not only appropriate short-term monetary policy, but also long-term institutional development aimed at developing domestic capital markets, freeing interest rates, liberalizing the capital account and flexibilizing the exchange rate regime.
1. China calculates its monthly CPI (and other price indices) as the percentage change over the same period 12 months earlier, not the preceding month as is the practice in most countries. Similarly, China’s quarterly CPI is calculated as the change over the same quarter one year earlier. This often leads to confusion when international comparisons are made. For example, China’s CPI of 8.3 percent for March actually represents a price decline of 2.4 percent relative to February.
2. Economic “overheating” refers to a situation where demand exceeds supply in many sectors of the economy simultaneously.
3. The government’s estimate of GDP growth in 2007 was adjusted from 11.4 to 11.9 percent in April 2008.
4. Defined here as total bank deposits minus loans outstanding, minus minimum reserve requirement at the central bank.
5. The sharp price increases for rice, oil and other internationally traded commodities in recent months may also reflect the effects of speculation related to excess liquidity in pockets of the international financial system.
6. The terms liquid and liquidity refer to the ease with which the market value of an asset can be converted into cash or to the supply of liquid funds in the economy, depending on the context.
7. For example, the producer price index for industrial products jumped 8 percent in March after having been low and stable for many months. In addition, in some parts of the manufacturing sector wages are rising faster than productivity, which increases unit labor costs.
8. For obvious reasons, there are no official statistics on underground financial intermediation in China, but anecdotal evidence suggests that it has become a very important factor in certain parts of the country in recent years.
9. The term is sometimes used to refer to a blind faith or ideological belief in the power of markets to correct their own excesses.
10. For example, when it became concerned that local real estate prices were rising too fast, the Shanghai municipal government intervened by raising the minimum down payment on new mortgages and by requiring that first mortgages were fully paid off before second mortgages could be applied for.
11. Seigniorage is the difference between the nominal value of new money printed (or coined) and the cost of printing (or minting).