China Considers Controls to Deal With Rising Prices

Inflation concerns in China and the government’s potential response to these concerns has spooked the equity markets for the past two weeks. Commodity prices have been particularly volatile as investors worry that China’s need for raw materials could wane if recent attempts by the government to slow the pace of growth in the red-hot Chinese economy results in weaker global demand.

Last week, the People’s Bank of China (PBoC) increased for the fifth time this year, the amount of cash financial institutions must hold in their reserves. Depending on its size, lending facilities are now required to maintain reserves of 16 percent of total assets for smaller institutions, to 18.5 percent for the large, state-owned banks. By increasing the amount that must be held in reserve, banks will have less cash available for lending which, it is hoped, will reduce spending and help stabilize the economy.

This half point increase in reserve minimums caused quite a ripple through the markets after last week’s announcement. But it is the prospect of interest rate increases that investors fear could lead to a tidal wave of losses.

By preventing its currency from appreciating against other currencies, goods exported from China maintain a pricing advantage when compared to products manufactured in other countries. China is especially keen to preserve its advantage over the US market which continues to account for nearly 20 percent of China’s total exports. However, as inflation continues to cause hardship for China’s poorer citizens, analysts agree that China will eventually be forced to increase interest rates.

The need for action is reflected in October’s inflation rate which was pegged at 4.4 percent. This is well above the PBoC’s target of 3 percent, and the need to address the rate of growth becomes more obvious each day. Still, raising interest rates falls into the “last ditch” category and the government is offering other possible solutions to deal with the inflation question.

Dramatic Rise in Food Prices Driving Inflation

While a 4.4 percent rate of inflation is bad enough, much of that inflation is being driven by a 10.1 percent year-to-date increase in the price of food. Worried that those least able to afford it are bearing the greatest burden, Premier Wen Jiaboa recently gathered leaders together to craft a response to the rapid climb in food prices.

In a bid to reassure the public, China’s National Development and Reform Commission (NDRC) issued a statement saying that it was “understandable” that people were worried about the rising cost of living. But have no fear, according to the NDRC China still has “the capacity to keep the price level basically stable”.

We did not have to wait long to learn what shape this “capacity” may take. A new drive has been initiated to boost food production and strict controls have been put into place to safe-guard against those engaging in hoarding and other activities that could further drive up food prices.

But it is not only food that is pushing inflation upwards. Other essentials including coal, electricity, and gasoline have also risen sharply. Again, it is the most vulnerable that are most affected by these occurrences and officials are even looking at the potential of offering direct subsidies to help offset the cost of these essentials.

The problem with subsidies of course, is that they do nothing to address the reasons behind the price increases. It is simply not possible to subsidize everything affected by inflation and at some point, the government will be forced to eliminate the subsidies as they become too costly to maintain. This is a task that is easier said than done, and does little more than delay the inevitable.

Given the importance of exports and preserving a positive balance of trade, it is understandable why China resists market-driven interest rates. Ultimately however, there is no other credible option to effectively battle inflation.

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