China's Inflation Shocker

Disruptions caused by January's harsh weather helped drive up inflation by 8.7% in February, making a mockery of official government targets

By Frederik Balfour

Shoppers rush to buy discounted items during a promotion at a store in Beijing. Getty Images

One week ago when Chinese Premier Wen Jiabao unveiled an official inflation target for this year of 4.6% at the National People's Congress in Beijing, analysts expressed strong doubts (BusinessWeek, 3/5/08) that it was realistic. Inflation had been gathering momentum for months and in January the consumer price index rose to 7.1%. Pessimism has grown even stronger with the release on Mar. 11 of February inflation figures clocking in at a stunning 8.7%, the highest since 1996.

The jump in prices was led by rocketing food prices, especially staples like pork and vegetables, after supplies were ravaged by January's severe winter storms (BusinessWeek, 1/29/08). Pork prices rose 63% and vegetables 46%. Transportation snafus and power outages also caused temporary disruption to other supply chains, pushing up prices. Housing costs jumped 6.6%.

That's bad news, especially for Chinese families at the bottom of the income scale. It could lead to upward pressure on wages too, putting the squeeze on labor-intensive manufacturers that have been faced with annual labor cost increases for the past several years, averaging about 8% to 10% in the heavily industrialized coastal areas. "China's inflationary 'scare' will likely be with us for a while longer," UBS (UBS) economist Jonathan Anderson wrote in a note to clients after the release of the inflation figures today. Deutsche Bank revised upward its 2008 inflation forecast from 6.4% to 7.2%.

Shelving Plans for an IPO

Tackling inflation isn't the government's only worry. Shanghai stocks are 30% off their October highs, and investor pessimism is palpable. On Mar. 10 when China Railway Construction began trading on the Shanghai stock exchange, the company's shares closed up 26% from its initial public offering price. While that might sound like an impressive first-day performance, it's actually the worst debut for a stock in Shanghai since 2006. Negative sentiment has also prompted Beijing-based property developer Soho China, whose Hong Kong-listed shares are down 38% this year, to announce Mar. 11 it was shelving plans to sell shares in the Shanghai bourse.

So what options does Beijing have for taming the inflationary beast? A tighter monetary policy through interest rate hikes certainly carries some risks. With the Federal Reserve looking likely to cut rates further in the U.S., a move by the People's Bank of China to hike rates in China would only attract more capital. That would put even greater pressure on yuan, China's currency, to strengthen. The return on deposits in China is already 2% higher than the U.S., making the yuan attractive to the "carry trade" where investors take advantage of interest-rate differentials in different currencies. "When you factor in that the yuan has appreciated at an annualized rate of 15% during the first two months of 2008, that could yield a "risk-free [yuan that] can give a 15%-17% return against the U.S. dollar," says Frank Gong, China economist at JPMorgan (JPM).

Higher interest rates could also eat into corporate profits, potentially pushing manufacturers and small property developers over the brink. Added currency appreciation will only compound the woes of low-end export manufacturers with limited ability to pass on higher prices to their customers.

Pain for Low-End Producers

Indeed, export growth in February declined sharply according to figures released on Mar. 10, registering a year-over-year increase of just 6.5%, compared with 26.7% in January. Even taking into account the recent storms and the difficult comparison with February, 2007, when exports were unusually high as firms accelerated shipments before export subsidies were removed, the slowdown is still bound to cause further pain for low-end manufacturers.

Business Exchange related topics:
China Business
China Labor
Inflation

Balfour is Asia Correspondent for BusinessWeek based in Hong Kong.