China: Inflation and Monetary Policy

Background:

The global economic crisis pushed China into deflation in early 2009, despite the loose monetary policy adopted by the People's Bank of China (PBoC). China's central bank cut the policy lending rate and reserve requirements for banks, but the primary tool of monetary policy in China remains the credit channel. New lending surged in H1 2009, expanding the monetary base (M2) more than 25% y/y, but the velocity of money remained limited. As the slack in the economy narrowed, deflation first eased and then prices began accelerating. Inflationary pressures should continue to prompt monetary tightening from Chinese authorities, particularly because core inflation is also rising.

Inflation Trends

Rising commodity and food prices drove inflation to a peak of 8.7% y/y in February 2008, according to the CPI. The basket of goods in China's CPI is heavily tilted toward food (about one-third), which suffered massive price increases. Energy accounts for about 10% of the basket and provided further upward pressure, despite fixed retail prices. Inflation began easing in the summer of 2008, and the global financial crisis helped tip China into deflation in early 2009. Overcapacities in manufacturing and exports and the base effects from easing food prices helped keep China in deflation through October but prices re-entered positive territory at the end of 2009. Despite weak wage growth and industrial overcapacities, strong money supply growth, agriculture supply shocks and deteriorating base effects suggest inflation could peak above 4% y/y in mid-2010, sparking more monetary tightening.

People's Bank of China

The PBoC was the only bank in the China until 1978, when its commercial operations were split off to form the four policy banks. In 1983, the State Council formally designated the PBoC as the central bank of China, but it took until 1995 for the reforms to become law. The reformed PBoC was modeled off of the Federal Reserve system in the U.S., with nine regional branches whose boundaries do not correspond to the local political boundaries. This gives the bank independence from political influence at the local level, but the bank nonetheless operates under the State Council, which must approve its monetary policy decisions. The PBoC's policy objectives are maintaining the stability of the renminbi and promoting economic growth. Its monetary policy tools include reserve requirement ratios, base interest rates, rediscounting, lending and open market operations, but its tool of choice has historically been credit controls. As China's state-owned banks become more independent, credit controls may lose their power however, and the PBoC may turn to more traditional tools. Its monetary policy committee serves in an advisory role, and it meets quarterly. The current PBoC governor is Zhou Xiaochuan, who has served in this position since 2002. The PBoC's management also includes five deputy governors, a disciplinary, and three assistant governors.

Critical Issues

Will Rising Inflation Spark Monetary Tightening in China?

Overview: China's consumer price growth shifted to positive territory on a y/y basis in November 2009, after rising on a m/m basis since July, when the CPI bottomed out at -1.8% y/y. Food and housing prices led the return to inflation, and the sharp growth in money supply has increased inflationary risks for 2010. However, industrial overcapacities and weaker wage growth will be constraints on future inflation. Producer prices also began growing in December in y/y terms, after increasing on a m/m basis since April. With CPI inflation approaching 3% y/y, policy makers are likely to shift toward tightening policies in the coming months.

• RGE View (June 11, 2010): We expect consumer price inflation to average 3.2% for the year. RGE has long worried that China’s political cycle and concerns about over-tightening would encourage policy makers to fall behind the curve when withdrawing the accommodative measures put in place in late 2008. We stick with this view that monetary conditions remain too loose. However, lower-than-expected consumer inflation so far this year—largely due to collapsing pork prices and problems with the data in the housing component of the CPI—and some capital outflows in the past month have pushed the curve further back. A softening of global commodity prices should provide further restraint, and the base effects have now worn off. We expect the central bank to hike interest rates only once in 2010, by 27 basis points, in July or August.Analysis RGE Adam Wolfe and Rachel Ziemba Jun 03, 2010China Focus: Moderating Inflation to Defer TighteningAnalysis Roubini Global Economics Adam Wolfe and Rachel Ziemba Apr 16, 2010China: Q2 2010 Outlook

• China's CPI increased by 3.1% y/y in May 2010, slightly above expectations, after a 2.8% y/y increase in April. On a m/m basis, consumer prices declined 0.1% in May on lower food and commodity prices, after increasing 0.2% in April. Food prices, which contribute about one-third of the CPI, increased by 6.1% y/y April, but continued to contract slightly on a m/m basis, falling by 0.5% on lower pork prices. Non-food prices increased by 1.6% y/y in May, accelerating from the 1.3% pace in April. Rising property prices and shifting base effects for fuel costs and mortgage rates pulled housing prices up by 5% y/y in April. Producer prices increased by 7.1% y/y in May, also slightly above expectations, up from 6.8% y/y in April. Given that 3% y/y inflation is the government's target for the year, an interest rate hike may be in the offing. However, the uncertain external environment and falling commodity prices may help to delay the move until Q3.Analysis National Bureau of Statistics Jun 11, 2010China's Major Economic Indicators in May

• An NBS spokesman said that base effects accounted for 1.8 percentage points of May's 3.1% CPI inflation and that "upwards pressure on prices is actually easing." "Because of the current European debt crisis, international commodities prices have fallen and that's reduced the upwards pressure on (domestic consumer) prices," Sheng Laiyun said.News iMarket News Jun 11, 2010China Plays Down Infl. Threat, Says Europe Helps Ease Prices

• IHS Global Insight suggests that inflation was broad-based in May 2010 and asset price inflation was still serious. "[T]he Chinese economy has hit a reflection point in terms of both growth and inflation, deviating from a most ideal path of low-inflation and high-growth seen in the first quarter," but the chance of a rate hike is diminishing due to the EU crisis." So far the central bank has preferred to use administrative tools to control inflation. "Such a preference over administrative control could be accentuated going forward, as the window of opportunity for rate hikes may close in the next couple of months as the macroeconomic picture becomes even more complicated."Analysis IHS Global Insight Jun 11, 2010China's Growth Pulls Back in May As Inflationary Pressure Builds

• In the People's Bank of China's (PBoC) Q1 2010 monetary policy report, the central bank reiterated that it would maintain "appropriately loose" monetary conditions, although it noted that rising labor and raw materials costs, ample global liquidity and soaring housing prices are fueling inflationary pressures that are not captured in the relatively stable CPI and PPI data. "The potential risks to price stability are on the rise," the report said.News iMarket News May 10, 2010China PBOC Warns On Euro Debt Crisis,Rising Infl Expectations

• Flemming Nielsen, Danske Bank: "In the short term inflation will continue to increase and exceed 3.5% y/y in Q3 10. The People’s Bank of China target for inflation in 2010 is 3%. Today’s data supports our view that China will soon resume appreciation of CNY, although recent volatility on the financial markets has probably postponed it slightly."Analysis Danske Markets Research Flemming J. Nielsen May 11, 2010China: Solid growth and higher inflation clear the way for revaluation

• Morgan Stanley's Qing Wang argues that the recent Greek sovereign debt crisis will delay monetary tightening at the major central banks. Morgan Stanley now expects only one rate hike sometime in H2 2010 in China.Analysis Morgan Stanley Qing Wang May 12, 2010China: Moderation in Activity; Reflation; and Policy Normalization

• EIU: "Although inflation may continue to rise in the months ahead—given the rapid economic recovery and strong growth in bank lending—the Economist Intelligence Unit forecasts that inflation will remain relatively modest this year and next (averaging 3.5% and 3.2% in each of those years respectively). Investment in new capacity is expanding rapidly, and external demand is forecast to remain weak (as goods will be channelled towards the domestic market, price competition among retailers of manufactured goods will remain intense)."News Economist Intelligence Unit May 12, 2010China economy: Quick View - Building price pressures

• Research by Huang Yiping, a Beijing University professor, found "four main factors that determine y/y CPI growth in China: excess liquidity (defined as growth in M2 money supply minus industrial growth); export; real estate prices; and share prices. Stated simply, CPI will increase by 0.36% whenever excess liquidity climbs by one percentage point, 0.13% for every 1% rise in exports, 0.22% when real estate prices jump by 1%, 0.04% when mainland stock market share prices increase by 1%."Analysis Caixin Huang Yiping Feb 23, 2010Policymaking: Market Reform's Next Stop

• BreakingViews' Wei Gu suggests in a February 19 op-ed that China may be on the verge of an inflationary phase of dissaving. The growing gap between the M1 and M2 growth rates suggests that funds are being shifted from time deposits to demand accounts. The shift may be driven by inflation expectations, given that the interest rate on savings accounts is capped at 2.25%, but if the funds are spent, it would exacerbate inflationary pressure.Analysis BreakingViews Wei Gu Feb 19, 2010China's dissaving tiger

• BNP Paribas notes three factors that could drive inflation in 2010: supply shocks to the food supply due to droughts this year, cost-push effects from higher input prices, and higher government-set prices. Given these effects, CPI inflation could reach 5% in Q2 2010.Analysis BNP Paribas Isaac Meng and Chen Xingdong Dec 17, 2009China Perspectives 2010: Growth, inflation and bubble

• Qing Wang and Steven Zhang at Morgan Stanley suggest that worries about the M2 growth rate are overblown. Decades of financial repression in China mean that households' long-term savings show up as deposits in M2, even though they do not represent purchasing power. Movements of these funds between the stock market and deposits can affect M2's growth rate, even though the underlying purchasing power does not change. Because of this they estimate that the "true" M2 growth rate was 20% in Q3, not the headline 29% rate. This leads them to forecast an average inflation rate of 2.5% for 2010.Analysis Morgan Stanley Qing Wang Oct 21, 2009China: Worried About Inflation? Get Money Right First

• Chinese CPI peaked in February 2008 on high commodity prices. CPI growth was negative in m/m terms for the seven months through February 2009, suggesting that China entered deflation before February 2009.

• The disinflation in 2008 was initially driven by the weakness of the real estate market, which has now improved and might become an inflationary pressure. Mortgage rates were cut sharply in October 2008, which will reduce the base effect going foward for housing prices in the CPI.

(from RGE Briefing, June 12, 2010 )