Can China keep a lid on inflation as the world struggles to stem price rises?

  • As China’s 5.5 per cent annual growth target drifts out of reach, the government is turning to investment to boost the economy
  • But with imported inflation already threatening to drive up consumer prices, Beijing is wise to avoid making matters worse with excessive stimulus spending

When high levels of investment spending fuelled a sustained increase in Chinese inflation from 1991 to 2011, the authorities quickly brought the situation under control and, over the past decade, the consumer price index (CPI) has rarely exceeded 2 per cent, compared to 5.4 per cent in 2011.

But with policymakers in most major economies now losing their grip on price stability, can China continue to keep a lid on inflation this year and next?

To answer this question, we must first look at how China has succeeded in curbing inflation over the past decade. Notably, the government refrained from new rounds of large fiscal and monetary stimulus after 2011, and thanks to the central bank’s increased autonomy, money creation and credit growth stopped passively catering to investment projects from below.

After 2015, China’s central bank adopted a prudent tone and adjusted credit allocation to support sectors with excessive debt ratios. Highly polluting industries and the real estate sector – both of which had driven rapid GDP growth in the past – faced financial repression. At the same time, the central government tolerated minimum growth rates that could accommodate steady employment growth.

Today, that tolerance is being tested. Pandemic lockdowns, especially in Shenzhen and Shanghai, have taken a heavy toll on China’s economy. In the second quarter of 2022, Shanghai’s GDP fell by almost 14 per cent.

Meanwhile, the real estate sector is becoming a drag on the economy. In 2020, China’s government introduced “three red lines” to constrain the sector’s access to credit: developers’ liabilities should not exceed 70 per cent of assets, their net debt should not exceed equity, and their cash holdings must be equal to short-term borrowing.

The new debt metrics, together with the Covid-19 pandemic, have put intense pressure on the sector. Once-thriving developers are now facing serious debt crises. With some residential projects having been delayed or halted, homebuyers in several cities have stopped making their monthly mortgage payments.

The good news is that China has indeed kept inflation under control. In the first half of the year, the CPI rose by just 1.7 per cent, and the government’s inflation forecast for 2022 is about 3 per cent. The bad news is that, while China’s economy has been spared from overheating, this has come at the cost of slower GDP growth, and even a recession in some areas.

Clearly, official targets of 5.5 per cent growth cannot be achieved. Though GDP still grew by 2.5 per cent year on year in the first half of 2022 thanks to relatively strong exports, growth would have to reach at least 8 per cent in the second half to reach 5.5 per cent overall, which is of course unlikely.

Given this, Beijing is planning to launch a new round of stimulus. With unemployment rising – the rate for 16-24-year-olds reached 19.3 per cent in June, up four percentage points year on year – stimulus is urgently needed. But Premier Li Keqiang has been wise to highlight the importance of not overdoing it.

In the past, stimulus has taken the form of excessive infrastructure investment. But China now has limited room for manoeuvre. One key constraint is the huge debt overhang from the massive round of stimulus in 2009-11, which poses a serious risk to the financial system. It means that investment in additional infrastructure projects will largely need to be financed through local government bonds.

Another constraint on stimulus is the threat of imported inflation. Most Western countries are already experiencing rapid increases in consumer prices: the CPI in both the United States and Britain exceeded 9 per cent in June, while the euro zone CPI exceeded 8 per cent.

Likewise, in Asia, South Korea’s CPI rose 6 per cent year on year in June, the largest such increase since November 1998. The increase in Japan’s CPI – 2.4 per cent – exceeded the central bank’s target for a third consecutive month.

As a major energy and food importer, China will find it difficult to insulate itself from this global trend. Two factors explain why the CPI in China has not already surged.
First, China’s importers are all giant, state-owned, state-controlled enterprises whose pricing decisions are tightly regulated. Until inflation expectations are formed, the increase in import costs is not passed on to consumers. This is reflected in China’s producer price index, which has been less stable than the CPI over the years.

Second, the goods included in China’s CPI are those which are largely supplied domestically. And, as with importers, the prices charged by state-owned producers do not fully reflect changes in their costs, owing to government controls.

Consider pork – the single most important item affecting the CPI in China, accounting for 2.5 per cent of the index. The countercyclical regulation of hog rearing and state subsidies to pork producers have gone a long way towards keeping pork prices – and, thus, the CPI – relatively stable.

But, while such regulation can help to cushion external supply shocks, increasing subsidies will add to the government’s fiscal burden, especially amid global inflation. Add to that already-strained local-government finances and the huge costs of maintaining a zero-Covid policy, and the government’s ability to expand and finance public capital spending will be severely limited.

In this context, it is understandable that Beijing has chosen to adopt a modest stimulus package. An overly strong stimulus, experience has made clear, would almost inevitably entail excessive monetary expansion, leading to a surge in inflation that would create further challenges for China’s economy in the coming years.

Author: Prof Zhang Jun, SCMP

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