Pricing In China’s Inflation Risk
March 2008
by Jonathan Anderson
As long as most of us have been watching the Chinese economy, there’s rarely, if ever, been a dull moment. And the past few years in particular have resembled nothing so much as a roller-coaster ride: from rampant overinvestment to a sharply rising trade surplus; from property bubbles to a stock market bubble and back again, and the list goes on.
What’s the biggest economic topic for 2008? In a word, inflation. From absolute obscurity only a few quarters ago, inflation has come raging forward to command the full attention of domestic policy makers, global investors and even casual observers as “the” issue of the moment.
For seven years following the bursting of the 1990s bubble the Chinese economy was in outright deflation, as the resulting overhang of capacity decimated commercial profits and pricing power and forced final goods and services prices down. As late as January 2004, the official consumer price index was no higher than it had been in July 1997. Prices finally began to rise on average during 2004, increasing at an annual pace slightly above 2% for the next three years, and economists and policy officials generally heralded China’s return to a more normal, “healthy” inflation environment.
Since the spring of 2007, however, the situation has changed radically. The economy, which had already been expanding at a real pace of 9% to 10% finally shot across the 11% growth barrier in the first half of the year. And CPI inflation, ticking over at 2.2% in January, rose to 3.4% by May, then to 6.5% in August, and by January 2008 reached a whopping 7.1%, with no sign of slowing.
These are the highest growth and inflation rates that China has seen in more than a decade. And on the surface, at least, the situation looks very much like a repeat of 1992, when inflation went from 3.4% at the beginning of the year to 11.4% at the end and growth accelerated from 9.5% to a stunning 14.2% over the same period.
By 1993-94 the economy was completely out of control, with runaway inflation of 25% at the peak and hair-raising real growth numbers in the midteens. And we don’t need to explain what happened after that: In 1995 to 96 the authorities were forced to drag the economy to a painful halt, and by 1997 China was shutting down tens of thousands of redundant enterprise and sending tens of millions of state workers home. The economy was banished into a seven-year deflationary exile. So it’s natural for investors and policy makers to worry when it looks as if the whole thing is starting up again.
But should they be worried? In fact, even the most superficial look at the detailed figures leads to a resounding “no.” If China is facing an inflationary threat today, then it is certainly one of the strangest threats we have ever seen. All the evidence suggests that the current spike in prices will prove to be temporary, likely fading away by the second half of 2008, and as it does the prevailing furor over the inflation issue will subside as well.
China’s Food Problem
The first chart nearby shows the breakdown of historical headline CPI inflation into food and all other “core” goods and services categories excluding food. Back in the early 1990s, the situation was very clear; prices for everything were shooting up together, and regardless of where you looked—food, industrial goods, consumer services—you saw inflation rates of 15% to 25% year on year during the peak period. This was the very definition of “broad-based” inflation.
By contrast, this time around all of the action has come from food prices. Inflation momentum in the rest of the economy has been, well, absolutely unchanged over the past twelve months, and at a barely significant pace of 1.5% year on year to boot. Meanwhile, the overall food CPI basket is rising at nearly 20% year on year. In short, China doesn’t have broad-based inflation today. It has a food problem.
And as it turns out, the economy doesn’t even have a food problem so much as a “meat and eggs” problem. The second chart nearby shows the breakdown of CPI food price movements by category, split between meat, dairy and eggs and all other food groups. Once again, in the first half of the 1990s all food subgroups were rising together—but this time virtually the entire increase in overall food inflation is coming from meat, dairy and eggs alone, with extreme price shocks reaching 40% year on year in the second half of 2007 and outright doubling for some individual goods.
Does it matter whether inflation is coming from sharp increases in a few isolated goods or more widespread pressures? In one sense, not in the least. After all, food items make up 27% of the urban household expenditure basket (and closer to 35% when food service and catering are included), with meat, eggs and dairy alone accounting for nearly 10%. So when these prices increase they are keenly felt by consumers, and particularly by lower-income households.
On the other hand, as you can clearly see from the charts nearby, agricultural prices are extremely volatile in China, just as they are in every other country, with sharp annual swings depending on weather and other seasonal supply factors. In other words, a sudden, concentrated uptick in food inflation is virtually guaranteed to be temporary—and from a macroeconomic point of view, this makes it very different indeed from the more broad-based inflation.
China is no exception. By all accounts, the recent jump in food prices has nothing to do with macro trends and everything to do with cyclical one-off supply factors. Pig herds have been ravaged by the so-called “blue ear” virus in many parts of China. Beef and milk are recovering from an overproduction cycle that caused prices to fall outright from 2005 to ’06. And the same is true for poultry and eggs; in 2006 farmers were culling flocks because of weak prices and oversupply in the market, which naturally led to rising prices in 2007. All of these spikes should prove extremely transitory as disease passes and farmers readjust output once again to market conditions.
The bottom line is that there’s no need for the macro policy authorities to ring alarm bells and take drastic measures to “squeeze inflation out of the system.” They just need to grit their teeth and wait for meat and eggs prices to subside. This process may take a little longer than expected due to the effect of the severe January and February snowstorms on China’s winter harvest—but it doesn’t change the fundamental finding that the inflation bout is temporary, and that headline CPI growth should be heading back to around 3% by the latter part of 2008.
And All that Jazz
At this point, many readers familiar with the mainland will be erupting into a chorus of protest: What about China’s overheated demand? What about the flood of liquidity rushing into the economy? How about skyrocketing commodity prices and “hidden” energy inflation? Rising labor costs? Structural food price pressures? And what about the role of inflationary expectations?
The short answer to each of these concerns is that China undoubtedly faces rising medium-term inflationary pressures. But the starting point is not today’s headline rate of 7.1%. Rather, it’s the current core inflation rate of 1.5% year on year, and even if underlying structural inflation rises to 4% or 5% over the next few years this is still well below what most economists would see as the “pain threshold” for a rapidly growing low-income country.
Let’s start with overheated growth. At first glance, China’s headline GDP growth rate of more than 11% in 2007 certainly appears excessive, and we agree that it is well above structurally sustainable levels. However, consider where that growth is coming from. The main culprit is not consumption or investment spending at home; domestic expenditure momentum peaked in 2003 and has been slowing steadily ever since. Rather, the real story is the dramatic increase in the trade surplus, as net exports have contributed nearly three percentage points to annual GDP growth over the past few years.
And that rising net export balance has nothing to do with excessive demand. In fact, the main driver of China’s trade surplus is excess supply pressure at home. And this in turn implies that China’s overheated growth is actually deflationary; with heavy industrial capacity and production outstriPPIng demand by a significant margin, profits fell outright from 2004 to ’06 as the trade balance soared upward. Perhaps those sky-high GDP growth rates are a better explanation for why core goods and services prices have remained so low.
Next up is liquidity growth. For many analysts the real cause of the current inflationary pickup is uncontrolled monetary expansion. Macroeconomics teaches us that inflation is always a monetary phenomenon at the end of the day, and with $30 billion to $40 billion dollars showing up in China’s reserve accounts on a monthly basis there’s little doubt that the economy faces very strong liquidity inflows.
We agree that money growth is a fundamental force behind inflation in China, and there is a clear and tight correlation between the two over time. But the salient point is that monetary factors drive underlying inflation, and not every short-term twist and turn in CPI along the way. During the deflationary period 1997-2003, the measure of broad money, M2, grew at an average annual rate of 16.4%. What was the comparable pace for the second half of 2007? Around 17.6% year on year—in other words, only slightly higher.
Base money growth has been much lower still, with sharply falling commercial bank excess liquidity ratios in the process. So while it’s easy to argue that money growth may have been nudging core inflation upward, it certainly can’t explain a seven percentage point rise in the headline rate.
The third point concerns upstream price pressures; it’s all well and good to talk about consumer prices, but shouldn’t we be paying more attention to producer prices instead? If we look at the most common indices such as the raw materials price index, the producer price index or the corporate goods price index, we see an even sharper upturn in recent months, with inflation rates now uniformly in the 8% to 10% range, i.e., higher than the headline CPI rate. Does this mean that stronger final goods and services inflation is soon to follow?
Not necessarily. To start with, commodity and intermediate prices are far more volatile than final prices. In the United States, for example, PPI raw materials inflation has ranged from minus 40% to plus 55% in the past 30 years. The pass-through effect on PPI intermediate industrial prices has been more muted, with swings from minus 5% to plus 10%. And the impact on final goods and services prices? Almost nothing; the U.S. core CPI inflation stayed between 1.5% and 5% during the same period, with very little correlation to upstream trends. Exactly the same is true for Japan, Europe and most major developing countries as well.
And even sustained upstream inflation pressures take many years to show up in downstream indices. Japan’s domestic raw materials price index has been rising at a 13% annual pace since 2003, while CPI inflation has yet to break into positive levels. Upstream indices have been well above CPI inflation in the U.S. and Europe more or less continually for the past five years as well, again with no strong effect to date on consumer prices. All told, we’re certainly not looking at a commodity-led cost “blowout” in China in the next twelve months.
We should also say a few specific words about energy costs. Domestic oil-product prices may have fallen below the level implied by global crude spot prices, but not inordinately below. Adjusting for crude quality, current Chinese refinery prices are roughly consistent with a Brent price of $83 to $85 per barrel, compared to the actual spot price of $93 over the past two months. In other words, if global oil prices stay at recent levels Chinese prices may have to rise by 10% or so—which in turn implies a CPI increase of only a few tenths of a percentage point given the low oil product exposure in the household consumption basket.
Things are a bit more complicated when we turn to coal. Domestic coal prices have historically been close to international levels, but the gap widened considerably over the second half of 2007 as global prices jumped; unlike crude oil, we also expect significant further price increases to come. Assuming domestic prices follow suit and that the government allows power producers to fully pass through input costs to the consumer (both very questionable propositions), final electricity prices would need to rise by at least 30% to offset.
On the other hand, while electricity does have a higher weight than oil products in the CPI basket, a 30% hike over two years would push up overall consumer price inflation by no more than 1% per year. Again, this is hardly comparable to the impact of the recent food supply shock.
So far we have stressed the role of cyclical food price shocks in China’s recent CPI upturn, but isn’t the rest of the world also undergoing a serious bout of food inflation? And couldn’t the problems in the mainland today be merely part of a larger global structural trend?
Again, the short answer would have to be “no.” Global traded agricultural prices have indeed jumped—but mostly in grains; soft commodity and livestock prices have been relatively weak over the past 12 months, with virtually zero inflation today. In China, by contrast, the entire rise in food inflation is coming from livestock, dairy and poultry categories. As it turns out, the farm sector doesn’t have much in common with global market trends, since agricultural goods in China are mostly nontraded, determined by domestic conditions.
The fourth topic is labor costs. Nearly everyone talks about rising wage pressures in China, but this is one of the most misunderstood issues in the economy today. There’s little doubt that wage inflation is picking up, of course—but not from urban workers, who have actually seen stable growth in the past few years; the real story is the acceleration in rural incomes and rising labor costs in the rural migrant sector. This means that the brunt of rising migrant wages falls on export-oriented light manufacturing, and sure enough Chinese dollar export prices have shifted from net deflation to inflation of nearly 4% over the past few years as a result. However, since the trend is relatively concentrated in low-end goods and exports, it has less impact on the core urban CPI at home, which is particularly dependent on urban services and thus urban labor costs.
The final question concerns inflationary expectations. Even if structural factors are more gradual and longer-term in nature and the current temporary inflation spike is set to reverse, in many economies consumer expectations can play a “spoiler” role if expectations of further inflation become entrenched.
Just not in China, however. The normal channels for expectations to pass through to real prices are wages, if unions have sufficient bargaining power, and capital costs, as bond yields and related interest rates rise. China does have one big national union to which most workers theoretically belong, but no history whatsoever of collective bargaining. And the economy has yet to develop a working bond market, or any other mechanism through which investor expectations would affect lending costs.
So China watchers should keep an eye out for a slow, sustained increase in core inflation going forward. But the big story for late 2008 and 2009 will be the coming fall in the headline inflation rate.
Mr. Anderson is global emerging markets economist at UBS.
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