Related topics: China, economy, currencies, politics, Jim Jubak
China's leaders have turned an economic problem -- rising inflation that is projected to go from 5.4% in March to 6% in April -- into a political problem. They now face increasing protests over higher prices for everything from cooking oil to diesel fuel.
I think it's still unlikely that China's political problem will turn into a political crisis. China's internal security forces have met even the smallest demonstration with massive force, and Beijing has shown no signs of wavering in its willingness to apply that force.
But I do see an increasing likelihood that China's efforts to defuse its political problems before they flare into violence will push the country into an economic crisis. The political solutions proposed and implemented so far seem certain to make China's inflation worse and to drive the country, finally, to impose drastic measures to get inflation under control.
Here's how I see the interplay between the economic and the political working out.
Economic data released on April 15 showed that China's economy isn't slowing significantly: GDP grew by 9.7% in the first quarter. That was barely below the 9.8% growth in the fourth quarter of 2010. (For all of 2010, China's economy grew at a 10.3% rate.) Underlying trends don't suggest that China's growth rate is about to drop. For example, new bank lending increased by 16.6% in March from the same month in 2010, indicating that the money flows driving China's growth aren't abating.
Jim Jubak
Why does China want to slow its economic growth rate? Because inflation has climbed to levels well over the government's 4% target for 2011 and threatens to roar out of control. Consumer price inflation hit 5.4% in March. That passed the 5.2% rate in November, which had been the fastest rate of inflation in 28 months. March's 5.4% is now the fastest rate in 32 months.
A high rate of inflation -- especially if it threatens to climb even higher in the future -- is a political problem in any country. It cuts most heavily into the buying power of the part of the population with the least money. In the United States, for example, as gasoline approaches $4 a gallon, it takes a bigger and bigger bite out of the income of workers who have no choice but to drive long distances to get to their jobs. Higher food prices -- and food prices are up about 6.5% so far in 2011 -- have the same effect. If you have to buy milk -- and you're already shopping carefully and clipping coupons to find the cheapest milk -- you have to buy milk no matter the price increase.
3 problems for China
Inflation is an especially big political problem in China for three reasons.
First, because China is still a poorer country than, say, the United States, families spend more of their income on basics such as food. Food consumes from 30% to 40% of the median family budget in China, versus about 12% in the United States. Food price inflation of almost 12% in China (the annual rate in March) is about twice the rate of the United States' 6.5% in 2011. But to the average Chinese family, it feels much, much worse than that.
Second, although China is on average much wealthier than it was a decade ago, some Chinese are much, much wealthier -- and that has led to a rise in social tensions, which high inflation exacerbates. According to a recent study by U.S. consulting firm Bain, 585,000 Chinese have more than 10 million yuan, about $1.5 million, in investible assets. That's twice the number it was in 2008. The fastest growth, Bain notes, is among those worth more than $15 million.
The average employment income in China, on the other hand, (even adjusted upward to take into account the higher purchasing power of the yuan in China) is just $4,325. And that average of urban and rural wages hides the huge difference between urban and rural incomes. Urban incomes were about 3.33 times higher than rural incomes in 2010. And that gap grew slightly larger in 2010 than it was in 2008.
I think you can understand why inflation might increase social tensions and resentment on the part of those who don't belong to the lucky upper 585,000. If you're scrambling to find cheaper bok choy as food prices soar, you might find yourself thinking about throwing a rock at the next BMW you see on the streets.
Third, inflation is a big political problem in China because history, as read by the Communist Party, says it is. Unrest caused by higher prices, the official explanation goes, was a key component leading up to the Tiananmen Square protests of 1989. The army eventually put down that demonstration by firing on unarmed protesters. Hundreds, perhaps thousands, were killed.
China's official history also says that the inability of the Nationalist government to control inflation undermined popular support for that government in its war with the Communist Party for control of China after World War II, contributing to the Communist victory.
As you might expect, given that background, China's leaders have been working hard to control inflation. For example, effective April 21, the People's Bank of China raised bank reserve requirements by an additional 0.5 percentage points to 20.5%. That's the fourth increase in reserve requirements this year and the 10th since the end of the global financial crisis. On April 5, China's central bank raised its benchmark interest rate to 6.31% -- its fourth increase in five months.
China's economy hasn't responded by slowing down, though, and consequently neither has inflation.
Why China's inflation-fighting measures aren't working
If you look at what China has done in the context of what it hasn't done, the country's inflation measures have been smaller, far more incremental and much more predictable than the job requires.
Take a look at the increase in reserve requirements, for example. Barclays Capital calculates that the most recent move took $56 billion out of the bank system's lending capacity. That seems like a lot -- until you weigh it against the potentially inflationary $197 billion China added to its foreign exchange reserves in the first quarter of 2011.
Or look at China's interest rate increases -- officials still haven't raised rates to the average 6.49% for the period from 1996 through 2010. The rate top of 10.98% came in June 1996. I'm not saying China has to get back to those kinds of punishing interest rates, but I think you can make the argument that, in historical terms, China's interest rates are still too low and too expansionary.
And look at another thing China's leaders haven't done. They haven't raised deposit interest rates to the point where it pays to keep money in the bank. In the last interest rate increase, the People's Bank raised the deposit rate to 3.25%. With inflation at 5.4%, putting your money in the bank right now guarantees an annual loss of more than 2%. If a government is trying to slow down the economy and the speed of money, this isn't the way to do it.
Finally, of course, there's the exchange rate. Keeping the renminbi limited to 2% or so of annual appreciation versus the U.S. dollar guarantees that the country will remain wedded to its export growth model. Chinese products will remain artificially cheap on world markets, regardless of how many speeches the country's leaders deliver about the need to rebalance the Chinese economy. (The renminbi is up only 4% against the dollar since the beginning of 2010.)
In addition, it makes Chinese consumers less well off than they would be if the renminbi bought more in everything from oil to Coach (COH, news) handbags to U.S. chickens. Since every currency trader in the world is convinced that the renminbi is headed upward against the dollar, the artificially cheap currency guarantees big flows of overseas cash into China. That, of course, makes inflation tougher to tackle.
Why isn't China doing more?
China could really ramp up interest rate increases, increase the rate of appreciation in the renminbi and pay bank depositors a positive rate of interest. But so far it hasn't.
A combination of fear and politics stands in the way. Ramping up interest rate increases, for example, might produce a real slowdown in growth of exactly the sort that's probably needed to stop the growth of inflation. But that kind of real slowdown strikes many of China's leaders as too risky. It could, they worry, endanger the legitimacy of Communist Party rule in China, which rests on the ability of the party to deliver the growth bacon.
