China's new fight on inflation

Investor’s Corner with Jack Brown

The Setting: China, November 2010. Inflation = 4.4%, Food Inflation = 10.1%

China has just embarked on a mission to nip inflation in the bud - notably through price controls. A stable and growing China is in every one's best interest, but the history of such a strategy is fraught with challenge.

Economists argue that the economic rationale for China to consider letting the Yuan (China's currency) increase in value relates to inflation. The counter, from the Chinese perspective, is an undervalued Yuan benefits China's exports, which have played a large role in their economic growth. The problem is that when the Yuan is undervalued, everything non-Chinese is expensive. Consequently, China's costs of production risks being (or becoming) expensive.

These risks are facilitated by a handful of factors, such as:

- Global agriculture prices are up approximately 32% (Oct 2009-Oct 2010) according to the agriculture component of S&P's GSCI global commodities index. Food makes up about 1/3 of Chinese consumption.

- Input prices, such as energy, have also risen

- The minimum wage in Beijing, and other areas, is up 20%, which is arguably inflationary

- Many economists believe China's rapid urbanization is inflationary

China's Inflation Plan reads right out of a Command Economy Playbook

Here's an excerpt from an article published yesterday by the official press agency of the government of the People's Republic of China.

"Local governments and departments are required to boost agricultural production and stabilize supply of agricultural products and fertilizer while reducing the cost of agricultural products and ensuring coal, power, oil and gas supplies, the State Council said in a seven-page circular.

"The cabinet urged local departments to step up vegetable-planting efforts while stabilizing winter vegetable production and strengthening grain and edible-oil production field management to ward off supply shortages.

"To reduce delivery costs, road tolls for vehicles transporting fresh- and live-farm produce will be forbidden from Dec. 1, the circular said.

"The cabinet also ordered local authorities to continue to reduce the prices of power, gas and rail-transport for chemical-fertilizer producers while ensuring coal supplies for power generation companies and increasing production of oil -- especially diesel -- to guarantee sufficient supply.

"Local governments must temporarily disburse subsidies to needy people and increase allowances for poor students and student canteens, the circular added.

"Local authorities were ordered to establish coordinated social-security mechanisms that promise a gradual rise in basic pensions, unemployment insurance and minimum wages.

"Local departments were also ordered to adjust prices promptly and to impose temporary price controls on important daily necessities and production materials where necessary.

"Market monitoring will be intensified to clamp down on hoarding and speculation in major agricultural products, the circular added.

"Chinese decision makers have made price controls a top priority, as the consumer price index (CPI), the main gauge of inflation, rose to a 25-month high of 4.4 percent in the 12 months to the end of October. The hike was mainly due to a 10.1-percent surge in food prices. Food prices have a one-third weighting in China's CPI calculation.

"China has been moving to mop up excessive liquidity to combat inflation, with the latest move to target over-liquidity in the banking system.

"The People's Bank of China, or the central bank, said Friday it would raise capital reserve requirements by 50 basis points for all the banks of the country for the fifth time this year to control credit and liquidity."

As the release indicates "Chinese decision makers have made price controls a top priority." The challenge for Chinese decision makers remains, however, that price controls are risky. While I don't intend to wade into the economic debate regarding price controls, the main criticism is that by "keeping prices artificially low, demand is increased to the point where supply can not keep up, leading to shortages in the price-controlled product."

Regardless of China's new inflation challenge and an arguably heavy government hand, a stable and growing China is in every one's best interest. Consequently, let's hope that their new plan is both sound and early enough to be effective.

Jack Brown, CFA

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