Inflation in China

In October, China’s inflation rate jumped to 4.4 percent from 3.6 percent the month before, catching many China watchers by surprise. October’s rate was the highest inflation has been in China in two years, and well above the government’s target of 3 percent.

Given China’s impact on the global economy, October’s surge in inflation provoked fears that China’s economy may be overheating as a result of the government’s stimulus measures, and that Beijing will need to further tighten credit in response. China had already begun to implement tightening measures when it raised interest rates and increased reserve requirements last month. October’s rate also renewed pressure on China to accelerate the appreciation of its currency, a move which many believe could dampen inflation in the country.

At least, that’s what many economists are saying.

However, I can always count on my good friend Andy Rothman to have a somewhat different take. Andy is the China Macro Strategist for CLSA Asia-Pacific Markets and always seems to come through with fresh, common sense analyses of events in China that are based on his own extensive experience, combined with a healthy dose of empirical data. Therefore, I was not surprised to learn when his latest edition of “Sinology” came across my screen that Andy has come to somewhat different conclusions. Because his reports are only available to clients, I cannot provide a link and will have to be content to paraphrase here what he has to say about October’s inflation numbers.

First of all, Andy believes that inflation in China this time around is primarily a weather phenomenon, with monetary policy playing a supporting role. According to Andy, 75 percent of CPI inflation in China this year has come from food, primarily fresh fruit and vegetables. In fact, 40 percent of the CPI/food increase was driven by these two categories, according to Andy. The fresh vegetable price index rose from 17.1 percent in January to 31 percent in October, while the fresh fruit price index rose from 9.8 percent to 17.7 percent. In October, increased prices for fresh fruit and vegetables accounted for about 27 percent of the headline CPI increase.

Because of the perishable nature of fresh fruit and vegetables, speculation has played only a limited role in this year’s price inflation. Rather, the primary reason for the higher prices has been bad weather, which has caused a temporary fall in supply. Moreover, there have been no spikes in demand that might suggest that China’s economy is overheating. As conditions normalize, Andy believes that CPI inflation next year will not be dramatically higher than the 3.6 percent average annual rate of the five pre-stimulus years. Apart from credit tightening, Andy believes that steady gains in productivity and overcapacity in most manufacturing sectors are keeping non-food prices low in China.

To combat inflation, Andy believes that Beijing will keep raising interest rates until food prices cool off, and believes that three more 25 basis-point hikes are likely, including one this year.

However, Andy does not believe that higher real interest rates and bank reserve requirements “foreshadow significantly tighter monetary policy next year.” Instead, Andy expects Beijing to continue its ongoing efforts to normalize credit and liquidity levels to pre-stimulus levels. Moreover, the government is intent on bringing China’s growth rates below double digit levels, which is why Andy expects GDP growth to be in the range of 8 to 9 percent in 2011, compared to an overall 10 percent this year.

Finally, Andy’s view is that Beijing does not consider the exchange rate to be a tactical tool for managing short-term problems such as high food prices. Rather, he believes that the government authorities see the appreciation of the Chinese currency as a long-term, structural adjustment. As a result, he believes that the renminbi will continue to appreciate at its current annualized rate of roughly 7 percent annualized against the dollar over the next couple of years.

Makes sense to me. Andy’s 14-page, November 30 edition of “Sinology” is filled with supporting data that is difficult to refute. As always, he has me convinced.

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