China’s Inflation: a shocker or global trend refraction?

Since July 7th, the first time China’s Consumer Price Index rose up to more than 5%, it had kept a upward rising trend and reached a peak at 8.7% in Feb 2008, which was the highest point since 1996. The cost of labor and raw material mounted up during the same period, which arose a concern of the reappearance of the serious inflation between the late 1980s to 1990s of China. With a prospect that the price will keep rising, analysts expressed their strong doubts when Chinese Premier Wen Jiabao unveiled a 2008 official CPI target of 4.8% (Business Week , 3/5/08).

Personally，I agree that the inflation will remain at elevated levels in the near term or even longer. However, I am more optimistic about the realization of the official target, which at least is not as unrealistic as others believed.

What drove the inflation

People hold different ideas about the main drive of the inflation: the most common believe is the rapid money supply and economic fever. While I believe the bubbles in the economy and hot money inflows is quiet responsible for, however, not the main drive of the inflation that emerged quickly in China in the past one year.

It is true that the central bank of China continually enforced eight interest rate adjustments through 1993 to 2002, during which period the one year deposit rate had dropped from 10.89% to 1.98% and had maintained at a historic low level for two years. The FDI inflow kept a steady increase from 1998 to 2007 (see Exhibit 1).

Exhibit 1

However, as we could see from Exhibit 2, CPI and PPI did not show any steady or obvious identical rising trend during these years, but fluctuated between 2-4 and 4-6 respectively. The PPI is generally higher than CPI.

Exhibit 2

It is not until the beginning of 2007, CPI curve began to present a higher tendency than PPI and diverged from it obviously since May, and finally in October, triggered the uprising of PPI. Both indexes reached the peak at Feb, 2008 (See Exhibit 3).

Exhibit 3

What drove the CPI and led to the peak

If we break CPI into food and non-food product component, we could see that it is the food price drove the CPI sharp increase in the third quarter of 2007.

Exhibit 4

As we recognized, pork price increasing is the main support of the food price boom. However it is not a direct result of rapid money supply or fever of economy, but a direct result of summer fever of pig.

Exhibit 5

The pork price had kept a low level since the beginning of 2006 and fell into a trough in May. Although the price recovered the following half year, the breeding cycle and the higher feedstuff price (followed the world trend) sped up the price trend, and finally, a reoccurred pig summer disease in 2007 triggered the large price leap.

Turn to the peak of the price index, it is partly because of the consumption boom of the lunar Chinese New Year, and partly because of the disruption of transportation and power supply caused by the serious winter storm. What is more, the 2-3 season lag between the GDP increase and its reflection in CPI explain the peak to some degree, because there are several bounds of GDP in the first two seasons of 2007, however, a slightly drop in the third season.

PPI and other concerns

Global Trend

I say that the inflation is a direct result of food driven CPI increase, does not necessarily mean there are no concerns of PPI and other factors.

PPI may be not a direct arose the inflation, but is still very responsible for the elevated inflation level and probably a main concern of the 2008.As we may observe from Exhibit 2, there is a huge rise of PPI between 2001 and 2002, when China became a member of WTO and began to peg to products’ international benchmark price.

Throughout 2007, the CBR Future Price Index kept an upward trend and jumped to a historical record; the leap of oil, corn, gold price turned to be a global trend. At the same time, the USD kept its depreciation to RMB and many other currencies, which no doubt raise a “enforced inflation” not only in China, but globally.

PPI & Labor Cost

On one hand, I agree that the new Labor Contract Law’s taking effect at the beginning of 2008 will raise some concern of the pricing pressure faced by manufactures. On the other hand, I don’t agree the points that there is a “diminishing available number of the main labor force” trend as a result of a “demographic distortion caused by the one child policy in the 1970’s” (Harriss, E, 2008). As everybody know, it is the rural migrants who accounted for overwhelming part of the labor force group in China, and it happened that they are not the group that deeply influenced by the policy; what is more, the rural labor migrants is a group that emerged since 1990’s, so deducible, the 1970s’ born is a hard-core of this group all along and thus could not suddenly influenced by the policy and diminished in 2007 and 2008.

Based on the above mentioned reason, my opinion is that the labor force cost will probably raise the PPI but in a more gentle way.

Government’s Reaction

Chinese Government adjusted its original CPI target from 3% to 4.8%, and set a “double avoiding” macro control policy: firstly, avoiding the change from fast-growth economy to fever economy; secondly, avoiding the change from uneven inflation to even overall inflation. I am not sure whether the policy and tight money policy will efficiently avoid the PPI rise, because it is still largely depend on the world market trend. But the recent CPI sharp rise, as just stated, could largely explain by factors with temporary features. In addition, considering the lagged effect of CPI in refection of GDP trend, I believe the realization of the 4.8% CPI prediction at the end of 2008 or in even shorter period is not unreasonable.

Professional Resources
FREE reports posted at chinavestor.com/tour.asp	Professional Stock Research: Advanced Membership
Exclusive China Newsletter w/ stock picks: Basic Membership	Portfolios: Conservative and Growth