Inflation threatens China's stability

Slower growth in China and a boost in domestic consumption will have lasting consequences for food prices, raising the prospect of social unrest, argues Renaissance Capital's Charles Robertson.

This week at the annual meeting of the National People's Congress in Beijing, attention has been focussed on the intention of China’s policymakers to shift the country’s economy from capital investment and exports towards domestic consumption.

If the emphasis were to shift, then the problem of global imbalances might be partly resolved and income disparities in China reduced. The economy might become more balanced, less prone to property bubbles, less vulnerable to wasteful projects, less susceptible to corruption, and less exposed to social tensions.

Unfortunately, that might not be enough. The problem, says Charles Robertson, global chief economist at Renaissance Capital, is the size not the quality of China’s economic growth.

China’s 12th five-year plan (for 2011 to 2015) targets an annual growth rate of 7%, down from 8% in its previous five-year plan. This compares to the 10.3% actual average growth during 2000 to 2010.

“However, even 7% may be more than the world can afford,” said Robertson. The problem is its effect on worldwide commodity prices and its impact on domestic inflation.

And, “in our view, the most likely trigger for social unrest [in China] is inflation”, he added.

Consumer prices reached 4.9% year-on-year in January, above the government's 4% target, and food prices jumped 10.3%. As is well known,China's inflation has been driven by massive bank lending, much of it channelled into the property market, and by a near 50% increase in the money supply during the past two years partly due to fiscal stimulus measures in the wake of the global financial crisis. 

But, even if the government is able to restrict lending and dampen the property market, as long as the country continues to get richer, domestic demand will merely transfer the main source of inflation to commodity prices.

According to Robertson’s figures, when China grew 10% in 2001 it added $126 billion to its GDP, and by 2010, China’s 10% annual growth added $891 billion, more than the 2010 GDP of the Netherlands, the 16th-biggest economy in the world. During the decade, China’s GDP in US dollars increased by $4.7 trillion, equivalent to adding the combined 2010 GDP of both France and the UK to the world economy, with $3.2 trillion of this (equivalent to Germany’s 2010 GDP) added over 2006 to 2010.

“We all saw the impact this had on global commodity demand,” he said.

Yet, now China will add another $3.2 trillion during the next five years, even if it grows at just 3% a year with limited currency appreciation. If it maintains 9% growth and a stable currency, and assuming modest inflation, then by 2015 Chinese GDP will have risen $4.5 trillion to reach $10.4 trillion.

“This expansion would be the same size as seen in 2000-2010, but will happen twice as fast”. And, of course, moderate inflation is far from certain and an appreciating currency much more likely, so in real GDP terms (and its expression in dollars), it is likely to be even higher.

This all implies huge demand for commodities; indeed as much demand in the next five years as during the past 10 years.

Of course, prices have already risen strongly, and analysts have told us that there is a secular move underway.

The United Nation’s Food and Agriculture Organisation’s (FAO) index of global food prices hit a record high in February, the eighth consecutive month it has risen, and 5% above its previous peak in June 2008. The CBOT March corn futures price has risen 95% during the past 12 months and is now close to the all-time high of 2008.

The International Monetary Fund (IMF) argued in a paper last week that the surge in agricultural commodity prices is due to a structural shift in demand, and warned that the world may need to get used to higher high food prices.

It conceded that a big part of the recent rise has been caused by temporary –and mostly weather-related – factors, but said that the increased demand was irreversible as people in emerging countries get richer and switch to high protein diets: feeding a cow requires more grain than feeding a person.

Meanwhile, Brazil, an agricultural superstar, is preparing laws that will prevent foreign governments, state-owned companies and speculators from buying farmland. Last year, it blocked most new overseas purchases, due to fears that foreign countries – especially China – were scouring the globe for land to bolster their food security.

Standard & Poor’s joined the chorus of doomsayers in a report released on Monday about the challenges facing Asia-Pacific countries in 2011. Food and energy price increases are providing a strong inflationary impetus across the region, and present low-income sovereigns in particular with difficult political and fiscal choices.

"In our opinion, inflation has become – or continues to be – an important risk to macroeconomic and social stability in a number of countries in Asia-Pacific, including Vietnam, Sri Lanka, India, Indonesia, Mongolia, Cambodia, Cook Islands, Fiji, Pakistan, and Bangladesh," said S&P credit analyst Elena Okorotchenko.

Popular uprisings like those in several Middle Eastern and North African countries, although “highly unpredictable”, “appear to be more pronounced where high unemployment among the young, inflation, poverty or wide income gaps are combined with growing political disillusionment in an autocratic and often corrupt regime”, she added.

She highlighted the risks to Bangladesh, Pakistan and Thailand, but argued that mitigating factors – notably strong economic growth, low unemployment and “a degree of popular support for the government” -- are strong in China, Malaysia, Sri Lanka and Vietnam.

Food shortages and inflated prices ignited riots throughout the developing world two-and-a-half years ago, including Asia.

As for China, even if GDP increases were to become less driven by resources, demand will be inflationary “and if there is one thing that China fears above all else, it is inflation”, which erodes the value of household savings, said Renaissance Capital’s Robertson, who was ranked the number-one economics and macro analyst for emerging Europe, the Middle East and Africa in four successive Extel surveys up to 2010.

And when per capita GDP rises above $8,000 in PPP terms, “then the risk of a Tunisian-style democratic revolution roughly doubles from today’s levels”, he argued. According to the IMF, it was $7,518 in 2010 – so not far to go.

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