SPEAKING
FREELY China's inflation policy stirs the
world By Thomas Palley
Speaking Freely is an Asia Times
Online feature that allows guest writers to have
their say. Please click hereif you are interested in
contributing.
China's government
recently announced that inflation hit a 10-year
high of 6.5% in August. This increase in inflation
is directly related to global trade imbalances,
yet China is trying to control inflation
without addressing that
problem.
That carries two consequences.
First, it is doubtful this strategy can work,
which likely signals rising Chinese inflation.
Second, the strategy aims to shift the onus of
global trade adjustment on to the United States,
which may come back to haunt China and the global
economy.
China's current inflation is a
textbook case of prolonged undervaluation of a
fixed exchange rate in tandem with export-led
growth. As such, significant exchange rate
revaluation should be a central element of its
anti-inflation policy.
However, instead of
making such an adjustment, China's authorities are
hoping to control inflation by exclusive reliance
on tighter domestic monetary policy. It is
doubtful this strategy can succeed because it
leaves intact the inflationary impulse from
China's trade surplus and undervalued exchange
rate.
One important contributing factor in
China's inflation is the rise in global commodity
prices, including oil and base metals, which are
now feeding through into prices. Food prices are
also on the rise because of increased global
prices for wheat and corn. Furthermore, China has
been hit by a virulent outbreak of swine flu that
has decimated its hog population, driving up the
price of pork, which is China's favored meat.
In coastal areas, which have been the hub
of China's export-led growth, wages have started
going up in response to rising living costs and to
the gradual elimination of extreme surplus-labor
conditions.
Most important, China is beset
by significant asset-price inflation that borders
on an asset-price bubble. This asset-price
inflation is the product of massive expansion of
the money supply caused by China's trade surplus
and foreign-investment inflows.
Dollars
earned by Chinese exporters have flowed back to
China and been converted into local money by the
central bank, which has bought them at the fixed
exchange rate to prevent appreciation.
Holders of these money balances have then
bought stocks and real estate to gain higher
returns and to protect against potential
inflation. This has driven up real-estate prices,
triggering a massive construction boom that has in
turn caused inflation.
The implication is
clear. China is suffering from imported inflation
caused by higher global commodity prices,
domestic-demand inflation caused by excess demand
in export industries, and asset-price inflation
due to an increased money supply caused by China's
trade surplus.
The undervalued exchange
rate is a key culprit, since it contributes to
excess demand in export sectors, and it also
drives the money-supply increase via the trade
surplus - which has hit record highs in 2007. That
suggests significant exchange-rate revaluation
should be a central component of China's
anti-inflation strategy.
Moreover,
revaluation would also diminish the impact of
global commodity-price inflation because
commodities are priced in US dollars, so that a
revaluation lowers their domestic price in yuan.
Instead, China has chosen to rely
exclusively on monetary tightening, raising
interest rates and reserve requirements on bank
deposits. This strategy is unlikely to work.
First, there is already significant asset
inflation and extensive debt-financed speculative
investment, which means the monetary authorities
are constrained from sufficiently meaningful
tightening for fear of triggering a financial
collapse.
Second, raising reserve
requirements on bank deposits lowers the return on
deposits and makes them less attractive. That
provides an incentive for depositors to spend
their money or invest elsewhere, which spurs more
inflation.
Third, and most important,
continuation of China's undervalued exchange rate
means continuing trade surpluses and large inflows
of foreign direct investment, which means further
monetary expansion in China.
Putting the
pieces together, the picture is one of rising
Chinese inflation, and with that comes the risk of
inflation-triggered social and political problems.
In this regard it is worth recalling that the
Tiananmen Square disturbances of May 1989 were in
part caused by industrial-worker unrest over
erosion of living standards by inflation.
As for the global economy, China's
anti-inflation policy and continued refusal to
adjust its exchange rate place the burden of
trade-imbalance adjustment squarely on the US.
This adjustment will likely happen via recession,
and there are signs that process may already be
under way. This is a sub-optimal approach that
could injure all.
Thomas Palley
is founder of the Economics for Democratic and
Open Societies Project.
(Copyright
2007 Thomas Palley.)
Speaking Freely
is an Asia Times Online feature that allows guest
writers to have their say. Please click hereif you are interested in
contributing.
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