Source: Financial Times

Inflation Scare Will Hurt China's Economy The unexpected rise of inflation in October in China – 4.4 per cent on a year-on-year basis – spooked global equity and commodities markets. As soon as Chinese authorities announced the unpleasant news and declared measures to contain further acceleration of price rises (a 50 basis points increase in bank reserves and possible price controls), investors around the world sold off equities and commodities in anticipation of a significant slow down of growth in China.

Official Chinese data show that rising prices of food, commodities, and housing fuelled the inflation spiral. Some Chinese analysts even blamed recent natural disasters for reducing harvests and adding to price increases. But China’s inflation scare is being driven by more fundamental and powerful forces than unco-operative weather.

First and foremost is the loose monetary policy the Chinese government has been pursuing for the last seven years. M2, a measure of the money supply, has risen more than three times in this period. This combination of negative interest rates and massive credit increase is the most direct contributor to China’s frothy property sector and broad inflationary pressures. Excess liquidity aside, rising labour costs (driven largely by demographics) and commodities prices are the other powerful long-term variables driving China’s higher inflation equation.

On the surface investors seem to have overreacted. The October inflation data were bad, but China is a long way from runaway price rises. But what investors rightly fear most is the fallout of the policy measures now being taken by Beijing to combat inflation.

Obviously, Chinese growth will fall as rising interest rates and administrative tightening of credit emissions cool down the economy. But most analysts already expect Chinese growth to decelerate. Even the most bullish China boosters project an annual growth rate that will fall from 10 per cent now to 7-8 per cent in the coming decade.

More worrying are policies designed to prick the real estate bubble. The credit boom in China in the last few years has led to an unsustainable increase in property prices, rapid expansion of industrial capacity, and excess leverage taken on by local governments. If Beijing is serious about fighting inflation, it will need to go far beyond imposing a few price controls.

This, in turn, will mean China raising interest rates further, and cutting down bank lending. And one can only imagine what such measures will do to an inflated property sector and over-extended state-owned enterprises and local governments.

That said, this may not even be the worst of what is to come. Even if policy is changed to damp down price rises, the persistence of the real estate bubble flows from much deeper structural imbalances in China’s economy. Even as Chinese leaders prevaricate and take half-measures to address the underlying causes of inflation, these problems are not being dealt with.

In all this politics will definitely get in the way. As the Communist party prepares to select a new generation of leaders in the next two years, Beijing is likely to become extremely risk-averse, and keen to postpone painful but necessary reforms to rebalance the economy. In the end, of course, they will have to clean up the mess. But delay means the price will then be much higher.