Bill Emmott - International Author & Adviser


China turns inflationary
Exame - August 2007

For the past five years, companies around the world have talked of “the China price”, by which they mean the lowest price in their industry. China has come to be synonymous with low, or even falling prices as Chinese manufacturing has grown bigger and been fuelled by hundreds of millions of cheap workers from the countryside. But this is now changing. China is turning from being a country of deflation to a country of inflation.

          This trend is only just beginning. But if it gets stronger, it will be important both for China’s competitors—which will breathe a sigh of relief—and for the world economy as a whole. For, thanks to China’s unusually open economy and vast reliance on trade, falling Chinese prices have been one major factor that has helped prevent inflation from rising all around the globe, under pressure from costly oil and other commodity prices.

          In June, the consumer price index in China rose by 4.4%, which is the highest for three years. It will take only a small further acceleration to make the inflation rate the highest for the past decade. The most important development, however, is that China’s consumer price index is now rising faster than its producer price index, which means that it is outpacing the rise in the input prices paid in industry.

          For the past five years, consumer prices have risen more slowly than producer prices, because productivity growth has outpaced wage rises. Increases in efficiency, as Chinese factories have improved their management skills and installed better machinery, are the main reason why the prices of Chinese exports kept on falling. Now, it looks as if wages are rising faster than productivity, and are forcing consumer prices upwards too.

          Some economists argue that consumer prices are rising simply for temporary reasons, chiefly related to food. Poor harvests and a rising demand for meat among increasingly affluent urban Chinese have forced food prices to rise rapidly. Supply may well eventually increase in response. But so, in the short term, will wages. And the pressure on food prices, especially grains, is an international phenomenon, driven in part by growing demand for biofuels. It is unlikely to go away quickly.

          You might also quite reasonably point out that a consumer price inflation rate of 4.4% does not sound terribly high, by international standards, even in today’s low-inflation world. You would be right. But Chinese statistics are not to be taken entirely at face value. Most economists in China think that the true inflation rate is one or two percentage points higher than the official rate: perhaps 5.4-6.4%. The consensus is that the level of Chinese official statistics is not usually accurately, but figures do fairly represent the direction of change.

          There are also some other statistics that provide a way to cross-check these trends. The best guide, especially if you are interested in the impact of Chinese inflation abroad, may be found in Chinese export prices. Export prices for Chinese textiles, recorded on arrival in the United States and Europe, have been rising for the past 12 months. Export prices for Chinese electronics have continued to fall, but the rate of decline has slowed quite dramatically.


Next: costly Chinese labour

China still has a big capacity to surprise the outside world, partly because its population is so big and so all statistics about the country are bigger than for anyone else. But another reason why China is always surprising is because it is changing so rapidly. That in itself should not be surprising, since if your GDP is growing each year by 10-12%, then a lot of change must be taking place. Even so, it seems that as soon as foreigners have got a clear idea in their mind about how China works, it changes again.

          The idea that is now becoming out of date is the idea that China has an unlimited supply of workers in the countryside, available to come to work in factories for low wages. It was true that China had a large supply of such workers, which mainly meant that it had a large supply of young people, which are the sort of people willing to migrate hundreds or even thousands of miles to find work. Now, however, the number of Chinese aged between 15 and 30 years old has begun to decline.

          Furthermore, the Chinese government found itself caught in a policy dilemma. Rural migration was a good way to keep costs down and restrain inflation. But the very thing that gave young people an incentive to migrate was also becoming a problem in its own right: rural poverty, and the gap in wealth between cities and the countryside. Fear of rural unrest led the government to take action in 2004: it cut taxes for farmers and increased farm subsidies. Thus, it raised incomes in the countryside and reduced the incentive to migrate, just as the number of young people available to move is diminishing. So wages are rising, rapidly.

          For the Chinese Communist Party, the sign of inflation returning will be worrying: it was rapid inflation that formed the backdrop to the pro-democracy protests in 1989 that ended in bloodshed in and around Tiananmen Square in Beijing. But as long as the trend can be prevented from getting out of hand as it did in the 1980s, it is not necessarily bad news. For the Chinese economy to modernise and raise living standards further it needs the industrial structure to shift away from low-tech sectors like textiles and towards higher-value industries and services.

Inflation will force the pace of that change. It is high time that low-tech manufacturing moves to cheaper, poor countries such as Bangladesh, Vietnam and above all India. It will also strengthen the case for a revaluation of the Chinese currency, the renminbi, as a counter-inflationary tool, which will help restore the authorities’ control over the money supply and start to reduce the country’s vast trade surplus.

China’s inflationary trend will not be so good for the rest of the world, for the rich countries already have their own inflationary pressures to deal with. The re-rating of risk in credit markets during June and July, led by America’s mortgage loan market, has been widely attributed to falling home prices in the United States, plus worries that private equity deals had taken on too much cheap debt. That is no doubt true. But another reason could well be the revival of inflation and the loss of “the China price”. This will make it harder for the Federal Reserve to ease the damage by cutting interest rates. After all, it needs to worry about inflation.


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