China’s Rumble With Globalization – Part I

BEIJING: Conventional wisdom that a fast growing Chinese economy would be immune from global turmoil has proven to be wrong. Like the rest of the world, China has declared war on inflation which hurts the country’s poor. But by pursuing a populist policy in the name of building a harmonious society, China may waste an opportunity to end distorting policies and put its economic house on a sounder footing.

To be sure, times are hard for some in China. Truck drivers wait in long lines, often more than a kilometer long, hoping to purchase fuel at the state-mandated price. Many stations demand that drivers buy additional goods, at marked-up prices, to receive their diesel fuel. Meanwhile, the urban poor, confronting high food prices, skimp on meat.

The question remains whether China, still growing fast and flush with cash, should follow the West in fighting inflation or take care of the hard-hit poor.

The country’s economy continues to speed ahead – with year-on-year GDP growth of 10.6 percent in the first quarter of 2008 – but recently its central bank has slammed the brakes in the first quarter to slow the pace of inflation lest the country fall victim to an unhappy combination of sustained high inflation and slower growth.

Chinese economic policymakers certainly worry about rising prices even though the problem is partly of the government’s own making. In mid-June the government was forced to raise the state-mandated prices of petrol and electricity – in effect, an admission that China found it impossible to hold down domestic energy prices when it must buy oil on the international markets at US$140 per barrel. The move, long overdue, was not dramatic enough to match the rise of international prices. In hindsight, officials should have raised energy prices before the country’s headline inflation began marching along. China, nonetheless, is better off biting the bullet now, as it is not inconceivable that oil prices could soon reach US$150 to $200 per barrel.

Further price adjustments are unlikely before the politically invested Olympics – Beijing is unwilling to do anything that could dampen the mood. In fact, the Ministry of Commerce has even launched an investigation to determine how to sustain the profitability of small- and medium-sized enterprises most hurt by currency appreciation, a slowing economy and tougher environmental regulations. China’s fear of economic troubles before the Olympics may prompt a slowdown in the pace of RMB appreciation and the reintroductions of the export rebate, which would effectively serve as a real term depreciation of the RMB.

After the Olympics, however, if China continues to distort its markets, the international market could respond by pushing commodity and oil prices even higher. This could reveal how dedicated China is to price controls in the coming months, amidst the current financial challenges.

The policymakers’ chief goal is to engineer a soft landing of the economy. The decision to hike energy prices underscores Beijing’s commitment to move towards a more sustainable growth path by liberalizing politically sensitive but economically inefficient state price controls. China has a long way to go to normalize the prices of fuel and other items. Thanks to its strong fiscal profile – the budget surplus is expected to be 0.5 percent of GDP in 2008, while the government-debt-to-GDP ratio is less than 45 percent – China can easily afford to maintain fuel subsidies via price controls. The costs of such subsidies are mainly borne by state-owned companies in the form of a profit squeeze.

In comparison to many other countries, for example, Vietnam and India, China faces a less serious dilemma in reining in accelerating inflation while avoiding a major slowdown. Unlike Vietnam which struggles with a CPI of almost 27 percent, China has not suffered from runaway inflation since 1994. This can be largely attributed to the extreme price competition, impressive build-up of infrastructure, vast improvement in education and rapid urbanization in China. As a result, supply-side constraints faced by many Asian countries are alleviated. Unlike Vietnam and India, China’s trade balance is also favorable. This has supported continued appreciation of the renminbi against the US dollar, helping to keep import prices down.

Meanwhile, a sharp correction of Chinese share prices – the Shanghai index has lost more than half its value since October 2007 – and less bubbly property markets help drain liquidity from the economy. Regarding inflation expectation, China is fundamentally different from the other countries with rising prices but also with worsening balance of payments and infrastructure bottlenecks. At the same time, foreign observers underestimate China’s tolerance for inflation. For China’s rapidly expanding middle class, the country’s CPI basket – in which food takes up around one-third – hardly reflects everyday spending patterns. In other words, food-price driven inflation only hurts the cities’ poorest, the 20 percent whose incomes rise slower than the CPI.

Bringing down headline inflation rates, at any cost, does not make sense for China. For a large developing economy with a massive labor supply and excessively high savings rates, the key task should be to invest as efficiently as possible to create maximum jobs. Alas, the government has made combating inflation unnecessarily political by announcing an official but unrealistic CPI target of 4.8 percent for this year. Determination to meet this target, Beijing has taken some inefficient, economically unsound measures. For example, on several occasions authorities have sold grains from national reserves to dampen food prices. Rather than dramatic gestures, it would make more economic sense to let farmers charge more for agricultural products and provide more subsidies for food to the urban poor.

At this point, even if policymakers theoretically have the ability to pass more effective methods to control inflation while fostering growth, the political imperative of keeping the population quiet has placed China in a catch-22 situation. The government delicately balances the need to listen to investors and the need to protect the poor. Investors would benefit from looser monetary policy and eased control of prices because many listed companies are hurt by margin squeeze.

But looser money will exacerbate inflation and hurt China’s poorest, who lack bargaining power. Passing an economically feasible plan that would satisfy both parties and create conditions for the stated party goal of a harmonious society is difficult politically. It’s also difficult for the government to start an all-out war with inflation. For example, China could relax capital controls to lower their reserves, an economically sound move that would eventually lower inflation. However, China’s stock market has been performing weakly, and the risk of capital outflows would make the move extremely unpopular.

Also, given the turmoil that developing countries like Vietnam and Indonesia have experienced with capital outflows, China is perhaps too cautious when it comes to liberalizing its capital account. Most likely, the government will continue its strategy of distorting the market to keep inflation low. Any sudden reversal of government sentiment towards inflation, such as relaxing price controls, would send alarming signals to the market. In this case, policymaking is likely to remain indecisive before the Beijing Games.

The bottom line is that China’s unique economic profile allows for remarkable policy leeway to support strong economic growth in the face of the spread of global stagflation. However, Chinese policymakers should realize that an economic model to sustain growth for the longer term can only be achieved by removing severe distortions stemming from artificially low prices of land and pollution, as well as energy. For China’s own good, artificially low inflation must end.