With inflation rearing its ugly head, China has a lot to worry about because of the terrific, and sometimes terrifying, growth figures its economy generates
Entering the new year, Beijing has been increasingly worried about inflation, even going so far as to release regulations early last month which attempt to introduce government controls on retailers increasing prices.
Back in the summer of 2007, things were finely poised. On meat prices, the big mover, we took the view this was a disease-driven pig event, combined with a cyclical and not-that-worrying upturn in grain prices, which was a global trend anyway.
Super-low real interest rates were a worry, asset prices were heading higher, global oil was heading higher, and the quality of the data was so terrible in many sectors that we would not be able to spot an inflation break-out before it was too late. Tighter policy would be the safest approach.
We got tighter monetary policy, well a bit anyway, as nominal interest rates crept up, but since the summer more people have grown more concerned about a generalised inflation breakout.
Other food prices have pushed upwards. Grain prices are also still grinding up and have accelerated in recent weeks globally. At the same time, non-food prices seem to be on the rise too.
The higher global oil price has forced China's authorities to hike several key oil products including diesel (farmers and trucks) and petrol (cars, buses) prices, which is now filtering down the supply chain.
Low-income groups are feeling the pinch. Public expectations about future prices are changing too. The concern among senior leaders on this topic is now palpable.
Inflation is a sustained increase in overall prices. However, food or oil prices may infect other prices.
Moreover, if households in your economy spend a large chunk of their incomes on food and/or a large chunk of corporates are dependent upon oil (or coal in China's case, which is also rising in price), their effects will be much more widespread and could affect overall expectations.
In China's official CPI basket there is a 30 per cent+ allocation to food. The other problem is political; food price rises make low-income urban groups edgy.
Looking ahead, we are not confident that things are going to get better on the food front. A deadly pig disease - Porcine Reproductive and Respiratory Syndrome (PRRS), better known as Blue Ear Disease - is going to be a problem. Subsidies are being rolled out for farmers. Could imports help? Probably not, even with yuan appreciation.
What about grains? Again, the news is not good. China's grain inflation is not caused by higher import prices; China hardly trades grain at all, the only exception being soybeans.
But shipping costs have recently soared, forcing the domestic soybean price up. Currency appreciation will give China more buying power, but freight rates and Brazilian/US production are more important factors.
On oil and raw materials inflation, producer prices are heading up again. We now expect 2008 CPI to be 5 per cent, and 3 per cent in 2009, primarily driven by food prices, but with higher energy prices underpinning the 2008 number.
Slowdown
The second challenge facing policymakers in the next two years is that the US slowdown will not only undermine exports to the US but also impact upon China's newer export customers: Europe, Asia and the rest of the developing world. As the world slows, China will too. We think the US economy will only grow by 0.5 per cent in 2008.
This slowdown will not be as sharp as the one in 2001, but - although we do not forecast the slowdown to be long, predicting 2.8 per cent growth in 2009 - it clearly could be worse if house prices continue to fall and households need more time to rebuild their balance sheets.
The American consumer is clearly in trouble, with house prices falling, consumer credit drying up, and overall job growth weak.
But the US slowdown is not just about consumers. The credit markets are still tight, despite central bank efforts to pump liquidity into the system.
Corporates are finding banks drawing back on their credit lines as they hoard liquidity and attempt to reduce risk. At the same time, the corporate bond market has dried up, both in the US and in much of the rest of the world.
The only bright spot for the US economy is that exports are growing and the current account deficit is improving. But that will be of little comfort for China's (or Asia's) exporters when US consumption and corporate investment are failing.
Until now, we have taken a pretty sanguine view of China's vulnerability to the US, and this seems to be the view too on China's main street.
The United States accounts for just 22 per cent of all China's exports, while Europe (defined to include Russia and the former Soviet republics) buys 27 per cent.
Asia (ex-Hong Kong) and Japan account for 14 per cent and 9 per cent, while the grouping of South Asia, Middle East, Sub-Saharan Africa and Latin America take up 15 per cent.
Over time, the relative decline of the US and Japan has been offset by the growth of emerging markets as significant buyers. As these areas boom, they not only buy China's clothes, toys and cheap electronics (consumables), but also its steel, cars and, most of all, its machinery.
And yes, you did read that right - China accounts for 9 per cent of China's exports, since there is a large amount of re-exporting of China's exports back into China via Hong Kong for tax reasons.
We might say therefore that China is pretty well-diversified across geography, especially compared to 2001, when the US accounted for around 30 per cent of exports. Which might suggest that we should not be too worried about a US slowdown. If only the global economy were that simple.
The problem with this scenario is that a US slowdown will affect a whole lot more than the US. As the US has slowed, the 'decoupling' hypothesis - the idea that the rest of the world economy runs independently of the US business cycle - looks ever weaker.
To some extent, China is already acting as a growth engine itself. But in much of Asia, where China's exports are huge, many economies which grew up on the back of exports are still reliant upon the US and EU for a chunk of their final demand. And Asian export growth to the US was already falling.
China's overall exports look just as vulnerable to a global investment slowdown as a consumer slowdown. Base metal exports - mostly aluminium sheet, copper tubes, low-grade steel etc., mostly sold into nearby markets - now make up a growing chunk of exports, as do chemicals. This means that compared with ten, or even five, years ago China is much more vulnerable.
How will this impact upon domestic investment? That is much-debated. A large part of China's investment is in infrastructure, which has long-term benefits and is not directly linked to short-term demand.
But a chunk of recent fixed asset investment has gone into productive manufacturing and infrastructure (ports, railways, roads) - capacity which has been built with global demand in mind. We see investment growth slowing mildly in 2008, with the trend becoming more obvious in 2009. Facing such trends, what does the government do?
Policy
First, the Chinese yuan. We are now looking for a 9 per cent move in the US dollar/yuan rate in 2008, 7 per cent in 2009, with more volatility too. Beijing seems to have decided to take the exchange rate tool out of the box as a result of its heightened inflation concerns.
Second, interest rates. We expect four more hikes in 2008, each of 27 basis points (bps) for deposit rates, but two 27bps hikes and two 18bps hikes for one-year loan rates. We are also looking for eight 50bps reserve requirement hikes in 2008, to cope with the additional liquidity generated by the trade surplus.
Third, other interventions, namely credit controls, administrative controls, price subsidies, price controls, and food tariffs and non-tariff barriers. Will the moves on inflation be effective?
On food, it is difficult to imagine so. The exchange rate will not encourage more food imports, while interest rate increases will only have a very marginal impact on household demand. Higher food price inflation will have to be coped with for a while - and will continue to support overall CPI.
On the oil and raw materials side, rate hikes will curb industrial demand somewhat, as will credit controls if they are enforced.
Cooling down the industrial economy is key to getting the systemic inflationary pressures out of the system. If these measures do not have a perceivable effect around the time of the March parliament meetings, more wide-ranging administrative controls might be brought out.
The second half of 2008, and 2009, present a different challenge. Slower US and global growth, alongside yuan appreciation, will take some of the steam out of China's export demand. In 2009 this will feed into slower investment as margins get hit.
At the same time, the global downturn will mean weaker commodity prices, but these trends will take time to feed through into the mainland economy.
For now it means a story of slower growth and still high levels of inflation. Expect to add a new word to your
Chinese vocabulary: zhizhang. It means 'stagflation'. With growth likely to be above 8 per cent for the next two years, China won't be in it - but that won't stop people worrying about it.
The writer is Head of Research-China, Standard Chartered Bank.
