However, inflation expectations are creeping up, albeit slowly, underscoring the need for China to ônormaliseö its super-stimulative monetary policy. Policy and growth uncertainties will continue to haunt ChinaÆs financial markets and create sharp volatility if the authorities do not act decisively.
Inflation risk still contained
The recent Sichuan earthquake may boost inflation by an estimated 0.3 percentage points in the coming year, mainly due to the increase in reconstruction demand for raw materials, energy and industrial goods. This will boost upstream prices and filter into consumer prices. Nevertheless, the overall inflation dynamics have remained benign. Supply increases are pushing down food and meat prices. And although inflation expectations are creeping up, they have not been entrenched in the economy yet as seen by a recent sharp drop in future price expectations, despite the continued upward push of headline inflation (Chart 2).
To keep inflation expectations from taking root, the People's Bank of China has vowed to continue to keep a tight monetary bias. At the same time, an appreciating renminbi, BeijingÆs self-restraining measures on exports and weakening external demand are eroding Chinese export growth. This export slowdown will have a dragging impact on ChinaÆs economic growth and is thus a restraining force on inflation. Since ChinaÆs economic growth is passing through its peak rate and the authorities have adopted an anti-inflation policy stance, it is unlikely that inflation will get out of hand as many people have feared.
What about wage inflation?
Official data show that average wages jumped 19.2% year-on-year in the first quarter of 2008, triggering fears of a wage inflation spiral. However, the national wage data are misleading because there are sampling problems masking industry, sector and geographical differences.
First, the official wage data are based on surveys of a sample of firms that is dominated by large state-owned enterprises (SOEs). These SOEs have monopoly power in industries that have high entry barriers. Thus, they have stronger pricing power and are able to grant faster wage growth than private firms in more competitive industries. Wage growth in the private sector, which accounts for over two-thirds of national output, has chronically lagged behind that of the SOEs (Chart 3). Finally, the bulk of the wage increases has come from the export-oriented industralised cities on the east coast, while the rest of the country is lagging behind. An impending export slowdown is going to cool the regional labour markets in the east.
In aggregate, ChinaÆs labour market is still a ôbuyersÆ marketö. There are chronic worries among the authorities that the economy might not be able to create enough jobs to absorb the excess labour on the back of accelerating urbanisation. Thus, wage inflation is unlikely to become a structural problem yet. Further, ChinaÆs productivity gains have offset wage growth and helped keep unit labour costs from rising. For example, the share of the total wage bill in ChinaÆs GDP has fallen steadily, and so has the share of administrative expenses in total sales (Chart 4). All this indicates that labour costs have risen slower than output growth, thanks to productivity gains.
The policy challenge
Inflation is rising on a cyclical basis. In the near-term, the massive post-earthquake reconstruction programme will increase demand for capital goods, raw materials and infrastructure machinery. This will boost producer prices and feed into consumer prices. Thus, the CPI inflation rate will remain high and sticky in the coming months.
There are some risk factors that could boost inflation even higher. First is the implementation of the Labour Contract Law, which could result in a sharp rise in labour costs. But the authorities will likely be flexible in implementing the law to minimise its shock on the economy. Second is the risk of surging food and energy prices spreading to core inflation. The government is raising fiscal subsidies to low-income households, pensioners and affected industries to lessen the food/energy cost impact on them. But this could boost aggregate demand and add to price pressures.
Although inflation expectations have not been entrenched in the system yet, the sign that they are creeping up is still worrying. With hikes in the bank reserve requirement ratio (which stands at a record high of 17.5%) and renminbi appreciation ineffective in curbing inflation, the PBoC is left with interest rate hikes (a significant renminbi appreciation to generate a deflationary shock is pretty much out of the political tolerance).
Thus, the central bank will have to keep the tight economic policy bias for a while longer, and it must enforce it seriously. Despite the policy rhetoric, the current true monetary stance is still too stimulative for delivering the PBoCÆs anti-inflation objective since real interest rates are firmly negative. At this stage, interest rate hikes will serve to control inflation expectations from getting out of hand by addressing the negative real interest rate problem. ôNormalisingö monetary policy means nominal interest rate hikes in the coming months - unless inflation comes down sharply or there are significant negative economic shocks.
Structurally, ChinaÆs inflation environment will remain benign because it is still in the early stage of industralisation, with accelerating urbanisation creating productivity gains. Excess labour supply and increasing competition in the economy will keep inflation in check in the medium-term. In the longer-term, as ChinaÆs labour market mature and the impact of an ageing population sets in, inflation will make a structural shift upward.
Chi Lo is a director of investment research at Ping An of China Asset Management (Hong Kong).
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