Inflation Is Threatening China’s Stability

This article appeared in Investor’s Business Daily on October 10, 2007

When the 17th National Congress of the Communist Party of China convenes Monday, President Hu Jintao will be confronted with some serious challenges. Foremost will be to ensure steady economic growth and price stability.

Inflation is now at a 10-year high, reaching 6.5% (year over year) in August as measured by the consumer price index. Actual inflation is probably much higher given the defects of the CPI, which does not accurately reflect the consumption pattern of the present market-oriented system.

Housing prices and other asset prices are increasing at double-digit rates, but housing is underweighted in constructing the CPI (it only accounts for 13% of the index, compared with more than 40% in the U.S.). Moreover, some consumer goods are still subject to price controls.

Yi Xianrong, an economist with the Institute of Finance and Banking at the Chinese Academy of Social Sciences, is correct to argue that “a CPI that is unable to accurately mirror people’s consumption offers an inaccurate interpretation of the country’s economic life and is also prone to leading the government, enterprises and ordinary households to erroneous decisions.”

Some people blame the current increase in inflation on rising pork and other food prices. But such price increases primarily reflect changes in market demand and supply, and only have a temporary effect on the price level.

The National Development and Reform Commission warned local governments not to interfere with market price determination unless “there is remarkable price growth due to emergencies or natural disasters.” But it is precisely at such times that the free market best performs its role of allocating scarce goods to their highest uses.

Placing caps on prices of food and supplies when they become more limited will simply exacerbate shortages and corrupt markets. The poor will not be helped, but those administering the controls will gain in power. Just look at Zimbabwe.

Real inflation, a sustained rise in the general price level, is due to an excess supply of money — too much money chasing too few goods. Responsibility for inflation, therefore, must rest with the People’s Bank of China, not with the price of pork.

High inflation in the late 1980s led to price controls and shortages. Today, the PBOC is more disciplined and authorities generally recognize the futility of price controls as a means of containing inflation. As the China Daily reported, the recent decision of the NDRC to allow some intervention in the free formation of prices “does not mean the invisible hand of the market should be replaced by the administrative hand.”

Is the current increase in the CPI a monetary phenomenon or simply a short-term increase in the price level due to the food component of the CPI? The answer is that the food component of the CPI is causing an increase in recorded inflation, but the monetary base is currently growing at 15%, and M2 growth of 18% exceeds the PBOC’s target of 16%.

Excess monetary growth is being driven by China’s determination to prevent the renminbi from appreciating against the dollar. When the PBOC acquires foreign exchange, the domestic supply of currency increases unless the newly printed RMB are withdrawn — i.e., “sterilized.”

It is time for the PBOC to stop interfering with the nominal exchange rate and let market forces set that relative price. Capital controls need to be further relaxed, interest rates need to reflect market supply and demand, and the PBOB needs to focus on what central banks do best — control the supply of base money and provide for long-run price stability.

If inflation is tamed and if people are free to choose without price, exchange or capital controls, markets will better be able to create the harmonious society and all-around development that China’s leaders are calling for.
