Q+A: How aggressively will China move to quell inflation?

By Kevin Yao

BEIJING (BestGrowthStock) – Chinese leaders have pledged to ratchet up efforts to control inflation, paving the way for more policy tightening in coming months, including interest rate rises and lending restrictions.

Here are some questions and answers about inflation in China, which has fueled public anger with the ruling Communist Party in the past.

HOW SERIOUS IS INFLATION?

The jump in consumer inflation to 5.1 percent in the year to November, a 28-month peak, from 4.4 percent in October is worrying for officials who had long expected price pressures to taper off toward the year-end. The government has set a target of 4 percent for inflation next year.

There are tentative signs that price rises are spreading beyond food categories, and they are likely to be entrenched due to rising wages that push up production costs in some sectors.

But inflation is still well below levels in early 2008, when the annual rate hit 8.7 percent. And there is little sign of broader overheating in the economy, which in the past has been linked to inflation.

Moreover, weekly food price data indicate that inflation may be near its peak, at least in the short term. Steps taken in mid-November to crack down on price speculation and increase the supply of commodities have scored some success.

WHAT WILL CHINA DO?

Chinese leaders gave greater prominence to the fight against inflation in their statement on Sunday at the end of the Central Economic Work Conference, an annual meeting at which they chart policy for the coming year.

Another interest rate rise is in the pipeline if inflation continues to surprise to the upside in December. The tightening cycle will continue in 2011, with two rate rises expected, according to a Reuters poll.

But the government’s key focus is on removing excess cash from the economy. Banks’ required reserve ratios, which are already at a record high, could climb further.

The People’s Bank of China has raised interest rates just once this year, while raising banks’ required reserves six times, most recently on Friday.

Part of the reason for this is the nature of Chinese bureaucracy. The central bank, widely regarded as more hawkish than other state agencies, lacks policy independence and needs cabinet approval to raise interest rates, but can decide for itself about required reserves.

This could help swing support in the direction of the central bank’s advocacy of more monetary tightening.

Along with bank lending controls and more rate increases, Beijing could also let the yuan rise about 5 percent against the dollar next year.

WHERE IS CHINA’S INFLATION COMING FROM?

Food prices are leading inflation. Accounting for about a third of the consumer price index, food costs soared 11.7 percent in the year to November, while non-food inflation crept up 1.9 percent.

It is therefore tempting to dismiss concern about inflation by noting that pressure is not broad-based. That would be a mistake. In contrast to 2007, when pork production plummeted because of blue-ear pig disease, there has been no major supply shock this time.

Instead, the main source of upward pressure on food prices is much the same as that in the frothy property market: a big pool of domestic liquidity, fueled by trade inflows and ultra-loose monetary policy during the global financial crisis.

Liquidity has an outsized impact on food prices because agriculture is the one sector of the Chinese economy where supply is tight and there is no over-capacity to ease inflation.

WHAT ABOUT SPECULATIVE INFLOWS AND CAPITAL CONTROLS?

While not the cause of excess liquidity, speculative inflows threaten to add to the problem. Despite China’s tight capital controls, its extensive trade and investment links with the rest of the world leave plenty of loopholes.

A recent rise in foreign exchange reserves not attributable to trade and investment suggests that inflows are indeed climbing. A widening interest rate differential over the United States, yuan appreciation and buoyant property and stock markets give speculators reason to try to pierce China’s controls.

The government has already cracked down on foreign borrowing by domestic banks and will take more steps to curb inflows.

COULD THERE BE SOCIAL AND POLITICAL FALLOUT?

Plenty of consumers grumble about higher food prices, but the strains have not been enough to unleash unrest. Many have made income gains in recent years that offset price rises.

Still, memories of the late 1980s remain fresh. In 1988 annual CPI jumped 18.8 percent, adding to discontent in the build-up to widespread anti-government protests in 1989.

Such concerns may spur the government to take firmer action.

“Throughout the decades of my political career, I have learnt that two issues can undermine social stability, or even the steadfastness of state power. One is corruption, the other is prices,” Premier Wen Jiabao, who was a central government aide in the late 1980s, said in February. (Additional reporting by Simon Rabinovitch, Chris Buckley and Sally Huang; Editing by Ken Wills)

Q+A: How aggressively will China move to quell inflation?