What if inflation in China hits 8%?

Conflicting forces affecting inflation and growth will result in volatility and downside risks for Chinese stocks.
Inflation in China may go above 8% in the coming months before it retreats. Chinese inflation expectations are also rising and corporates are starting to pass on some of the cost increases to consumers. This argues for policy tightening to defend price stability. At the same time the risk to economic growth is rising, due to damages from the recent snow storms and weakening external demand. This calls for policy easing.

These conflicting forces will create growth and policy uncertainties, and lead to confusion, volatility and downside risk for Chinese asset prices in the short-term. Investors should rebalance their portfolios towards sectors that are less vulnerable to the risks of worsening Chinese inflation, BeijingÆs policy interventions and a sharp US economic slowdown.

Near-term inflation risk
The snow storms have aggravated the short-term inflationary pressures by destroying agricultural products and livestock. Food and meat prices will likely rise further in the coming months. While we are forecasting headline CPI to average over 7% year-on-year in 1Q08, recent food price trends (Chart 1) may push the headline CPI to over 8% some time in the first quarter.

Inflation expectations are also rising, as seen in a recent survey by the People's Bank of China (PBoC) in which 65% of the respondents were expecting rising inflation this year. This compares with less than 50% a few months ago. Rising inflation expectations could risk a self-perpetuating process to push up core inflation. International Monetary Fund research shows that in some developing economies, inflation expectations explain 60% of future inflation.

Corporate goods prices have also been rising and producers have been able to pass on some of the rising costs to the consumers, especially on agricultural products (Chart 2). Although pricing power outside the food and energy areas remains constrained, as seen in the subdued core CPI inflation rate, rising inflation expectations are creeping into core CPI, which rose from about 0.5% in 2007 to 1.5% this January. This means an increasing challenge for the authorities to keep inflation from spreading further and, hence, the need for keeping the tight policy bias.

Indeed, the PBoC stressed in a recent (February 22) policy statement that it would keep its tight policy bias for the rest of the year, and would allow more renminbi flexibility to help curb ChinaÆs inflation. This implies it may front-load the renminbi appreciation in the coming months to augment the impact of its macro tightening policy.

The policy risk
On the other hand, the damages to agriculture and infrastructure (including power facilities and communication links) by the snow storms earlier this year argue for policy relaxation to rebuild the economy. Powerful political interests are urging the government to ease credit policy and investment approval procedures, and to increase budgetary spending for reconstruction.

The demand for policy easing to rebuild the economy will clash with the need for keeping the tight policy bias to curb inflation expectations. This will create highly uncertain policy reactions: Upon seeing significantly higher inflation together with strong money and credit growth in the next couple of months, the authorities may tighten up policy further, risking policy overkill in the near-term.

However, if political consideration prompts substantial policy easing around the timing of the National PeopleÆs Congress, a quick policy reversal would be likely because of the temporary nature of the snowstorm damages and rising inflation expectations. All this will aggravate policy volatility and hurt BeijingÆs economic management credibility.

Market implications
There are increasing growth and policy uncertainties stemming from the conflicting forces between worsening domestic inflation and a deteriorating global economic backdrop. With the PBoCÆs higher tolerance for renminbi appreciation, we may see 8%-10% currency appreciation in the short-term before the appreciation pace subsides in the second half when the drag from slowing global demand might prompt a policy shift by the PBoC.

The combination of volatile policy responses and an uncertain growth outlook will haunt Chinese stocks in the next few months, affecting both the A-shares, H-shares and other Hong Kong shares with high volatility and a downward bias.

Under these circumstances, investment strategy should focus on overweighing sectors that are the least vulnerable to risks of worsening inflation and policy interventions, as well as a sharp US economic slowdown. These sectors may include gold, telecom and selected oil and energy stocks. Banks, properties and commodities are more geared towards macro improvement and thus have an unfavourable outlook in the short-term.

Chi Lo is a director of investment research at Ping An of China Asset Management (Hong Kong)
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