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Soaring Consumer Prices

China's Perilous Inflation Threat


China's Perilous Inflation Threat


China is facing such high inflation that some of its citizens are shopping in Hong Kong for their daily needs. How much of a threat do soaring prices pose to China's economy – and its regime?



China's Perilous Inflation Threat

By Sherry Lee
From CommonWealth Magazine (vol. 461 )

Grain prices have driven Chinese consumers crazy recently, and they are causing the country's leaders huge headaches.

Just how much the issue has taken over discussion at the national level was made evident on Nov. 17 at a meeting of the Standing Committee of China's State Council, led by Premier Wen Jiabao. China's government decided to adjust its financial and currency policies, making fighting inflation the biggest priority on its list of top priorities. This major change in direction will not only affect China, but the whole world.

China's leaders decided at the meeting that the government would intervene in the pricing of agricultural products when necessary. In a declaration of 16 guidelines on fighting inflation issued two days after the gathering, the State Council also said it would crack down on hoarding and punish those found illegally manipulating prices, while putting local government officials in charge of stabilizing the prices of everyday foodstuff, to ensure that the average citizen could have access to affordable staples.

Over the past year, the price level of a basket of 18 vegetables monitored by the government has risen 62.4 percent. The soaring cost of food was finally reflected in the country's inflation rate when it rose above 4 percent in October, going from 3.6 percent a month earlier to 4.4 percent. The figure not only exceeded the government's 3 percent inflation target, it also set a 24-month high. Within the overall index, the food price index rose 10.1 percent compared to the same period a year earlier.

The evidence may only be anecdotal, but rising prices seem to have sparked feelings of insecurity among China's populace. A junior high school student in Guizhou wrecked the school's cafeteria because of dissatisfaction with a 0.5-1.0 renminbi across-the-board hike in meals, groceries and beverages. Senior citizens in many cities have lined up outside discount supermarkets in the middle of the night waiting for the opportunity to grab whatever they can. People in Xi'an are growing vegetables in their homes. And one Beijing taxi driver, fearing that food prices will never return to previous levels, says has reduced his intake of vegetables, limiting himself to a few thin slices of pork per day.

At the root of the problem are dramatic rises in the prices of corn and soybeans.

Sources of Inflation: Grain, Changing Consumer Preferences

In recent years, the Chinese have become avid meat eaters, consuming an estimated 50 million tons of pork per year, an average of more than 40 kilograms per person, more than in any of its neighboring countries. That means demand for feed to raise livestock, which is 80 percent corn and soybeans, has been on the upswing.

The four major multinational agribusinesses that control four-fifths of American grain have been thrilled to see China's demand soar. An executive at one of them observes that China's consumption of protein followed an interesting pattern.

"They really like eating pork, because they feel it is particularly tasty. In areas where there are a lot of laborers, people eat pork to get more energy, while urban residents prefer chicken. Demand will continue to go up," the executive says.

China consumes an estimated 160 million tons of corn per year. In 2000, it was a net exporter of 16 million tons of corn, but this year it will be a net importer of 1.5 million tons. This changing demand has pushed corn prices up from 1,700 renminbi per ton in 2009 to 2,000 renminbi in 2010.

The trade figures for soybeans have also seen a dramatic change.

China entered the 1990s as a soybean exporter, but by the middle of that decade had become a net importer. This year, it will import 51 million tons of soybeans to supply the bulk of its annual consumption of 55 million tons – 27.5 times more than Taiwan consumes.

Changing lifestyles and food preferences, a 20-percent rise in the incomes of China's 6 million farming families, and a 10-percent rise in the incomes of urban salaried workers have all led to strong growth in the consumption of meat, which in turn has caused a spike in the price of upstream grain supplies.

The winds of inflation are being felt everywhere. Not long ago, McDonald's raised prices across the board by 0.5-1 renminbi per item. KFC, which said it would not increase its prices for the moment, already has relatively high set meal prices ranging from 21.50 to 28.50 renminbi, but it is always packed at lunch and dinner hours.

A 19-year-old manicurist who works in the Beijing shopping area of Sanlitun has a daily income of 80 renminbi, but she has to spend 20 renminbi alone to order a takeout lunch. Her food costs per day account for a third of her income.

"Chinese people living in cities spend about 30 percent of their wages on food, and for people living in the countryside, that goes up to 40 percent. We are still in a big meat-eating phase," says Ren Zhiqiang, the president of property company Beijing Hua Yuan Group, explaining why China is more sensitive to food prices than developed countries.

Soaring grain prices may be the immediate source of discontent, but the real factor stoking the inflation fire is the M2 money supply, which has increased three-fold in seven years.

Money in the Bank: A Losing Proposition

Huo Teh-ming, an economics professor in Peking University's National School of Development, says that since 2003, China's money supply has risen dramatically because of the huge amount of foreign currency earned from exports. "In seven years, we've added about US$2.3 trillion, which means China's central bank has printed 17 trillion renminbi to absorb the foreign reserves," Huo says.

He estimates that of the 17 trillion renminbi in new money, at least 5 trillion renminbi is in circulation, and the remaining 12 trillion renminbi returned to the banks as deposits. By using the deposits for loans and other economic activities, financial institutions have effectively leveraged that amount into 70 trillion renminbi in currency through a multiplier effect.

"The mainland is printing too much money," Huo says with emphasis.

China's inflated money supply and negative real interest rates over the past six months have made people feel that depositing money in a bank is a losing proposition.

They prefer using the money to speculate on the stock market or property or recklessly buy whatever they get their hands on – anything but seeing it sit in a bank and lose value.

In October alone, personal deposits in China's commercial banks fell by 700 billion renminbi.

"You know, the Chinese population only spends about a trillion renminbi a month. Then suddenly 700 billion is injected into the economy, into the property market, into capital markets and some into consumer markets. If everybody were to buy an extra bottle of cooking oil, manufacturers couldn't meet demand. Everything would be sold out," Ren says in describing the influence of a massive injection of funds.

The impact of this spending craze has yet to be fully reflected on China's official inflation barometer. Of the eight commodity indicators that comprise the country's consumer price index, only food and housing prices have seen big jumps. The price levels of tobacco and liquor, health care and personal care items, and entertainment and cultural products have been relatively flat, and those for clothing and household items have dropped compared to last year. Yet the money in people's hands continues to desperately seek new outlets.

"If just 1 percent of 60 or 70 trillion renminbi, about 600 billion, is pumped into the stock and property markets, whatever is bought and sold sees its prices fluctuate wildly," Peking University's Huo says.

Unlike in 1988, when food prices soared and inflation hit 19 percent for the year, China has yet to see signs of hyperinflation this time around. If the problem in the past was akin to that of "a poor person falling ill," the problem now could be described as a "wealthy person getting sick," with many ways available to spend one's way out of the problem.

China's government has already trotted out a number of policy tools to try to keep inflation in check, including price controls, limits on property loans, tight capital controls, the gradual appreciation of the renminbi, and even five increases within one year in banks' reserve ratio requirement, pushing it to an all-time high of 18.5 percent. The most recent move, announced on Nov. 19, increased the reserve ratio by 50 basis points, locking up 350 billion renminbi, or about 5 percent of China's annual loan value. 

Though China's risk management capabilities have improved, they cannot mask the country's ills. As Beijing clamps down on inflation, it will inevitably have major consequences for China and the world.

Consequence No. 1: Growing Social Instability

Inflation reduces the purchasing power of consumers. "The distortion in income distribution and the limited scope of the social security system means that low-income households and migrant workers in urban areas are highly vulnerable to inflation," says Wang Xiaolu, the deputy director of the China Reform Foundation's National Economic Research Institute.

Ten years ago, China's top 10 percent income-earning households had average incomes that were six times higher than those of the lowest-earning 10 percent, but that differential has risen to nine times today, according to official statistics. A study by the executive director of the China Institute for Reform and Development, Chi Fulin, indicates, however, that the income gap is actually much bigger, with the highest-income households now earning 28 times more on average than the lowest-income households.

"There are many destabilizing factors in society, which will eventually erupt in many different forms. Protests and panic buying are the tip of the iceberg," says Peking University's Huo. 

Consequence No. 2: Slower Growth, Weaker Global Economy

In the next two years, China will hand the reins of power to a new generation of leaders. Because Beijing authorities most fear instability during transfers of power, they are likely to do everything they can to keep inflation in check, including substantially reining in credit. Market observers are predicting that China's central bank will raise interest rates one more time before the end of this year and two or three times in 2011.

Rapid growth in domestic demand is unlikely to offset sharp declines in investment and exports, and many economists doubt that China will be able to sustain the 10 percent growth it has experienced in recent years, forecasting growth in the 7-9 percent range instead.

Taiwanese businesses, especially electronics contractors, face a stiff challenge because of China's fight against inflation.

"The price of oil is rising, shipping costs are going up, and the cost of plastics is following their lead. The prices of copper and steel are also going up, so the price of fasteners will probably end up higher as well. We even have to be prepared for the possibility that the minimum wage will be raised again next year," said Sung Chiang, the vice president of Taiwan-based TPV Technology Group, the world's biggest maker of computer monitors.

Sung believes that as Taiwanese contractors race to improve their efficiency, they still face severe cost pressures that they cannot simply ignore.

Predictions of a hard economic landing for China have only helped fuel the fire in unsettled global markets. After Lehman Brothers went bust in September 2008, China contributed substantially to the global economic recovery. But if it now breaks out its full arsenal to fight inflation, it could signify that the world's fastest growing big economy will not have time to bolster the global economy.    

Consequence No. 3: Renminbi, Asian Currencies Push Higher

Even if the appreciation of the renminbi puts pressure on China's exporters, it will lower the cost of imported goods, especially the price of commodities and raw materials, which are mostly denominated in U.S. dollars. To combat imported inflation, China could adopt a policy of allowing its currency to appreciate at an accelerated pace, and if that happens, the currencies of neighboring countries will inevitably be forced to follow.

Rising prices have brought hardship everywhere. At traditional food markets, housewives struggle to buy food, craning their necks, standing on their tiptoes, and forcing themselves to pay prices they can ill afford. As consumers jostle just to satisfy their daily needs, if China fails to deal with its inflationary pressures, the hyperinflation that terrifies it more than anything else could become a reality.

Translated from the Chinese by Luke Sabatier