China’s half-hearted attempts to control inflation are causing a dangerous build-up in inflationary pressures. The worry is that the longer the Chinese government delays raising interest rates, the more aggressive the tightening will eventually become, which could cause a huge slump in commodity prices.

In recent days, the Chinese government has announced fresh measures to stamp out inflationary pressures. The Chinese central bank instructed banks to slow down their lending for the remaining two months of the year. Chinese banks have a target to make 7.5 trillion yuan ($1.1 trillion) in new loans this year. But in the first 10 months of the year, their lending came to 6.9 trillion yuan.

And China’s top economic planning group has announced a crackdown on illegal market activities such as fraud, collusion and hoarding, that are blamed for driving up the prices of agricultural goods. The National Development and Reform Commission threatened severe punishment for agricultural traders and producers found guilty of spreading false price information, hoarding scarce products or manipulating futures markets.

But many economists believe these measures will prove ineffective in fighting rising inflationary pressures. Chinese inflation jumped 4.4% in October, largely reflecting a 10.1% surge in food prices — which make up one-third of the CPI index — and Chinese economists are tipping the inflation rate will move even higher in November.

They argue that China needs to move much more aggressively in lifting interest rates, and allowing its exchange rate to rise more rapidly. So far, the Chinese government has only made small steps in this direction because it is worried that higher interest rates and a stronger currency will hurt Chinese growth.

Chinese companies are able to borrow at low interest rates, and Chinese authorities worry that many companies could collapse if their borrowing costs were to increase sharply. And higher interest rates would also put additional upward pressure on the Chinese currency. China is wary of allowing its exchange rate, the yuan, to rise strongly for fear that it will hit sales of Chinese goods in the United States and Europe, and again cause the widespread collapse of companies producing low-margin consumer goods, such as clothing and shoes, for export markets. The Chinese government is extremely worried that if the economy slows down, unemployment will rise and there will be greater political unrest.

As a result, the Chinese government has only allowed the yuan to appreciate slightly against the US dollar. And, despite rising inflationary pressures, China lifted its interest rate by a modest 0.25 percentage points last month.

This interest rate rise — the first in almost three years, — pushed the one-year deposit rate to 2.5%, which means the country still has negative real interest rates. This leaves Chinese savers in an invidious situation. They know that if they put $100 into a bank account at the beginning of the year, are left with only $98 at the end of the year, after adjusting for inflation.

As a result, Chinese are pouring money into physical assets. The rich are snapping up real estate, while less affluent households are buying up long-lasting food goods, such as baskets of garlic and ginger.

The risk is that inflationary pressures are about to become deep-rooted in the Chinese economy, feeding into higher wage demands and a rising cost of living.

Many economists warn that unless China moves quickly to control inflationary pressures, it will eventually face a situation where inflation becomes much harder to fight. The Chinese government will then have to keep interest rates much higher in order to bring inflation under control.

Such a response would put a sharp brake on Chinese growth, and cause the price of commodities to plummet. And countries such as Australia, Brazil and Russia which have benefited from surging commodity prices would face a steep slump in their export earnings.

*This article originally appeared at Business Spectator

Peter Fray

Save up to 50% on a year of Crikey.

This extraordinary year is almost at an end. But we know that time waits for no one, and we won’t either. This is the time to get on board with Crikey.

For a limited time only, choose what you pay for a year of Crikey.

Save up to 50% or dig deeper so we can dig deeper.

See you in 2021.

Peter Fray
Editor-in-chief of Crikey

SAVE 50%