The Chinese authorities are playing a dangerous game. There is now clear evidence that their reluctance to tighten monetary policy means that Chinese companies and consumers are changing their behaviour in the expectation of price rises.
This change was clearly evident in the latest HSBC Purchasing Managers’ Index. Chinese companies obviously had a spectacular month in November, reporting strong increases in output and new orders. Interestingly, although Chinese firms experienced strong increases in new export orders, the growth in orders from domestic buyers was even stronger.
But this was clouded by rising cost pressures. Manufacturers reported that their input costs rose at the fastest rate since July 2008, with firms being forced to pay higher prices for cotton, grain, oil and steel.
But Beijing will be worried by signs that Chinese companies now expect these price rises to continue. In response to stronger order books, Chinese companies bought more inputs in November. But in a clear sign that inflationary expectations are building, some Chinese firms reported that they bought more raw materials because they expected future price rises.
The Chinese authorities will also be worried by signs of growing supply chain bottlenecks, with Chinese companies indicating they found it difficult to get raw materials from their suppliers. As a result, Chinese firms were forced to draw down on their existing supplies.
Beijing will also be concerned that these rising cost pressures are spreading through the economy. Chinese firms faced little difficulty in passing their higher input costs onto customers, with the increase in factory gate prices in November reaching a record level for the series. Factory gate prices increased for the fourth consecutive month in November.
Now, the Chinese are fond of blaming US Fed Reserve boss Ben Bernanke and his $US600 billion bond-buying program (known as QE2) for driving up inflationary pressures in Asia. They argue that US monetary policy is creating a flood of “hot money” that is flooding into the region in search of high-yielding assets, and this is driving up property and financial asset prices in Asia, and forcing commodity prices higher.
But it’s clear that China’s own monetary policy is much more of a problem than that of the US when it comes to fuelling inflationary pressures.
At present, Chinese interest rates are negative after taking inflation into account. Even after the Chinese central bank lifted interest rates by a modest 0.25 percentage points in October, the interest rate on one-year deposits is still only 2.5%.
This compares with the country’s inflation rate, which jumped 4.4% in October, largely due to a 10.1% surge in food prices. Most economists expect that November’s inflation figure will be even higher.
Faced with earning a negative real return on their savings, Chinese households are pouring money into physical assets. The rich are snapping up real estate, while less affluent households are hoarding long-lasting food goods, such as baskets of garlic and ginger.
So far, the Chinese authorities have tried to clamp down on inflationary pressures by limiting the supply of credit, through raising the reserve ratio requirement for banks, and instructing banks to ease back on lending. At the same time, they’ve cracked down on illegal market activities such as fraud, collusion and hoarding, that are blamed for driving up the prices of agricultural goods.
And Beijing has tried to ease social tensions caused by rising food prices by handing out one-time subsidies of 100 yuan ($US15) to low income earners.
But it’s clear that the Chinese authorities need to raise interest rates to at least the rate of inflation if they’re going to have any chance of stopping households from hoarding long-lasting food goods, and — as we saw with the latest HSBC China Manufacturing PMI — of stopping businesses from trying to build up their stocks of raw materials because they’re expecting future price rises.
Some argue that the Chinese are reluctant to bite the bullet on interest rates because they are worried that this will increase upward pressure on the Chinese exchange rate, the yuan. And the Chinese are extremely reluctant to let the yuan rise at present, because this would be seen as caving into US demands that China should let its currency rise. The Obama Administration is deeply frustrated by what it considers to be China’s deliberate attempt to keep its currency undervalued, which gives Chinese goods an artificial advantage on world markets.
But this is a hazardous approach. While Beijing delays pushing interest rates substantially higher, and letting its exchange rate appreciate strongly, the inflationary pressures will continue to build, and inflationary pressures will become even more deeply embedded. And despite the booming economy, the Chinese authorities will likely face a growing wave of social unrest.
*This first appeared on Business Spectator.