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China needs to fine-tune policy now

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In Brief

China's consumer and producer price indexes, major gauges of inflation, fell in July, pointing to greater deflationary pressure. Indeed, overcapacity will make price hikes, or inflation, almost impossible in the foreseeable future.

But soaring asset prices fuelled by excess liquidity and infrastructure projects recently launched under the government's economic stimulus package will eventually jeopardize macroeconomic stability – unless policies are adjusted now.

Widespread concerns about inflation have recently been premised on three conditions: a falling CPI, which seemed likely to bottom out by the end of this year; record bank lending in the first half, which pushed up inflationary expectations; and soaring world commodity prices, which may trigger domestic inflation – a scenario that seemed to be supported by recent increases in rice and meat prices.

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But then the CPI in July fell 1.8 per cent year-on-year, following a 1.8 per cent decline in June. At the same time, the nation’s PPI failed to rise in line with international commodity price trends, falling 8.2 per cent year-on-year in July.

Exports, which have contributed about 35 per cent of China’s gross domestic product, have fallen about 20 per cent this year, resulting in massive overcapacity in the export sector of the economy. China’s experience from the past 10 years indicates that deflation always follows a decline in exports.

Until the major developed economies recover, China faces a low probability of inflation. And without recovery in the developed economies, commodity price increases cannot be sustained.

Market watchers tend to see a rise in PPI as a prelude to a CPI increase though there is more to it than that. When the economy is stable, PPI can be expected to rise before the CPI starts climbing. But if domestic demand is weak, a low CPI will drag down the PPI. During 2004 and 2005, when China tightened macroeconomic policies, a falling CPI brought down the PPI.

Although inflationary dangers seem remote in the short term, China’s current loose monetary policy and stimulus programs should not be maintained over the long term. The real economy is rebounding and gaining strong momentum. Although urban fixed-asset investment growth in July slowed from the first-half level, growth during the first seven months of the year still approached 33 per cent. Nationwide GDP growth of 8 per cent, driven by high investment growth, has nearly been secured.

The biggest risks now are linked to dealing with asset price bubbles and the heavy-handed stimulus package. Many experts oppose macroeconomic policy adjustments. But the essence of good macroeconomic policy is to predict and adjust when needed. Anything else could cause disruption in the economy.

The fine-tuning of monetary policy has already started, although the government denied it last weekend. New lending plummeted to 360 billion yuan in July from 1.5 trillion yuan in June, according to the latest central bank data. But any policy changes that affect interest rates or bank deposit reserve ratios may not be put into effect until 2010.

Fiscal policies need to be modified, too. Proactive fiscal policies have led to a quick rebound in the economy. But too much government-backed investment could lead to inefficiency and crowd out private investment, doing harm to sustained economic growth. Many new infrastructure projects involve long-term commitments, making it hard to alter expansionary policies in the short term. And once the global economy recovers, China’s economy could easily overheat.

It may not be time to end the stimulus plan. But it is definitely a time for policy fine-tuning.

This essay appeared in Ciajin, China’s leading business magazine, on 11 August 2009. The full Chinese text is available here.

2 responses to “China needs to fine-tune policy now”

  1. Inflationary concerns in China are more severe in China even than in the US, mainly due to equally loose monetary policies and strong fiscal stimulus, but quite different ways in both monetary and fiscal policy approaches or methods used.
    Many people are concerned that asset bubbles in China are inflating, referring to both a rebounding equity market and a record breaking real property market. It appears that some of the huge increases in credits pumped to stimulate the real economy have gone to the asset markets. While it is not too much a concern at the moment of the stock market, given that is still half of its previous peak level, but the over-heated housing market is a real worry, given that the housing price to income ratio is much higher in China than in most countries and it increasing rapidly again.
    Relatively speaking, China will have much more serious potential inflation pressure than the US, given the former’s focus of its fiscal policy on fixed asset investments and the use of banking credits (by government direct control), both of which would be harder to withdraw.
    Chairman Bernanke has outlined the US Fed’s tool kits available to withdraw from its current loose monetary position, it is unclear yet how China would do a similar job for its different monetary mechanism.
    Yes, China appeared to have reduced the intensity of its loose monetary policy. But the key problem is how the monetary authority to reduce money supply after the huge and almost unprecedented increases in the first half of 2009. Also, as Huang pointed out, if the fiscal stimulus projects are longer term, then when the other parts of the economy picks up steam, how to maintain those projects without too much pressure on inflation.
    I am not quite sure about the likely scenario of world commodity prices. The rebound of commodity prices or “soaring world commodity prices” as Huang put it, was largely not by the expectation of the recovery of the Western major economies – it was largely driven by what was happening in China and other developing economies to a small degree. Of course, the recovery of the major industrialised economies will add further pressure on commodity prices. There is no question about that.
    I personally would not be too concerned with that “Many experts oppose macroeconomic policy adjustments”, whether it is opposing government interventions in the first place, or withdrawing interventions when needed.

  2. A quick note on a conversation i had last week.

    Per the inflation story, an economist I know based in China is following pork pricing as having the potential to spike upward in Sept/ OCt this year as a result of a short supply of adult hogs.

    That due to corn pricing earlier in the summer, many hogs were slaughtered early. which lead to the price drop in June. Which will result in a price hike in Sept/ Oct.

    Any thoughts/ leads on this?

    R

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