Chinese Inflation: It’s Money Not Pork

by Michael Pettis

Advance look at the April issue of the FAR EASTERN ECONOMIC REVIEW.

China is suffering from rising inflation. At the beginning of 2007 inflation was, and had been for a long time, well below the 3% upper end of the inflation target set by the People’s Bank of China. But year-on-year consumer-price index inflation has risen inexorably since the summer of 2007 to reach in February 2008 a peak of 8.7%. This inflation hasn’t affected all consumer goods equally. It has shown up largely as a sharp increase in food prices, in a time of food shortages caused partly by bad weather, partly by livestock disease and partly by distribution inefficiencies.

Sharply rising food prices combined with stable prices for other goods have made it seem to many as if Chinese inflation is primarily a problem of food supply constraints, and one that will be resolved by late 2008 as agricultural production returns to normal expected levels. In a Feb. 4 article in the Financial Times, however, Massachusetts Institute of Technology professor Kenneth Rogoff argued that “Those who believe that the cause of China’s inflation is too little pork, rather than too much money, are seriously mistaken.” His formulation—“pork” versus “money”—represents the two competing models that seek to explain Chinese inflation. The pork model claims that inflation in China is a food problem caused by a short-term supply constraint. The money model claims that inflation is the result of several years of furious money expansion set into motion by a currency regime that sharply restricts the ability of the PBOC to conduct domestic monetary policy.

According to proponents of the money model, China has effectively caught itself in a monetary trap. Large net foreign currency inflows into the country from both the current and capital accounts must be purchased by the PBOC if it is to manage the value of the yuan within its prescribed level. These purchases, which add to the country’s foreign currency reserves, are funded by the creation of local currency, which is then channeled through both the formal and informal financial sectors into alarmingly high levels of domestic investment.

As this investment is converted over time into higher levels of industrial production, China is forced to export its growing surplus of production over consumption, which further increases the trade surplus. Because of this self-reinforcing mechanism the country has found itself locked over the past five years into a cycle of rising trade surpluses and sky-rocketing reserves. This cycle of rising trade and capital account surpluses feeding into money growth which feeds into further increases in the trade surplus has caused in China all the conditions typical of an excessively loose monetary policy—low real interest rates, high levels of investment, massive speculative flows into stock, real estate, art and other assets, and, finally, inflation. These imbalances must eventually force an adjustment. There are several ways this can happen, few of them benign, and one of the most obvious ways is for a forced real appreciation of the currency through rising inflation. This is what seems to be happening.

The Rise of Inflation Expectations

Every month China’s National Bureau of Statistics publishes the country’s eagerly anticipated consumer-price index and, as the CPI rose relentlessly since last summer, analysts have pounced on the data to determine the cause of the inflation. From the monthly releases provided by the NBSC, it is clear that almost all of the increase in the value of the CPI can be explained by rising food prices, especially pork and related products, grain and edible oils. The price levels of the non-food component of the CPI have been fairly steady, rising at well under 2% year on year. This seems like prima facie evidence that inflation in China is primarily, if not exclusively, a food problem, caused by food supply constraints that are temporary in nature.

A number of economists and research analysts have made this point forcefully, and it is the official position of the government. According to the pork model of Chinese inflation, China is not suffering from monetary inflation. It is suffering rather from a sharp and unexpected decline in agricultural production relative to the rising food-consumption needs of a large, rapidly growing economy. Once the constraints that caused the reduction in food production are eliminated or wear off, the growth in food production will keep up with Chinese consumption needs and the price of food will return to levels consistent with the PBOC’s inflation target of 3% or lower.

Supporters of the pork model do not think that their claims imply that China has nothing to worry about over the short- and medium-term. For them the danger is that several months of high inflation can cause a generalized change in inflation expectations, which itself will change the behavior of households, consumers and producers such that these changes may lock inflation into place for much longer than it would naturally occur. On Feb. 11 at a press conference at the conclusion of the National People’s Congress after announcing that the country was targeting 4.8% total inflation for 2008 (an announcement few find credible) Premier Wen Jiabao very specifically addressed concerns about inflation expectations when he said: “We are sticking to the 4.8% target because it helps stabilize consumer expectations. When prices soar, expectations can be more horrifying than the increases.”

The concern expressed by Premier Wen and others in his government is that if workers begin demanding higher wages to compensate them for the decline in their purchasing power, if households worried by rising prices accelerate their purchases of consumer goods, and if savers reacting to the negative real rates they receive on their banking deposits withdraw money from the banking system and spend it, their behavior can cause inflation to spread into other sectors of the economy. In this case the main strategy of the government must be to create the necessary incentives to get agricultural production back on track as quickly as possible and to squeeze out inflationary expectations—partly by constraining demand, partly by selling food reserves, partly by freezing prices and partly by simply talking down inflation prospects, as Premier Wen was seen to be doing. (Continued.)

Read the rest of this story in the April issue of the FAR EASTERN ECONOMIC REVIEW.

Mr. Pettis is a director of Galileo Global Horizons, a New York-based fund-managing firm.

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