As central banks around the world try to contain the subprime crisis by easing money and credit, their response will be stymied by concerns that Chinese inflation might infect other nations.
A price spiral that has its origins in the undervalued yuan and the resultant Chinese trade surplus would weigh in with policymakers—especially the US Federal Reserve—as one of the biggest costs of bailing out the financial system by cutting interest rates.
China’s consumer prices are already galloping at their quickest pace in more than a decade.
Although the 5.6% surge in prices last month from a year earlier was led by pork, of which there is a shortage, expectations of accelerating inflation are becoming entrenched in the broader economy.
And that’s primarily because of the excess money swirling about in the Chinese financial system.
Now, if global monetary conditions were also to turn loose suddenly, the growing Chinese hunger for a protein rich diet could easily spread, leading to a worldwide food price scare.
Already, farmers in China, facing a higher inflation rate than city dwellers, are asking for a better price for selling their wheat to the government procurement agency.
“We believe this reflects farmers’ rising expectations on inflation, which could drive up production costs—fertilizer in particular—and living costs further,” says Credit Suisse Group economist Dong Tao in Hong Kong.
Higher living costs are also causing wages to climb, something that may have already begun to show up in Chinese exports. US labour department figures show three straight months of year-over-year increases in the average price of goods imported from China.
The most recent statistics are for last month, when Chinese export prices rose 0.9% from a year earlier in US dollar terms, their best performance on record.
Rate cut seen
Meanwhile, expectations of a Fed rate cut are quickly gaining ground. Fed funds futures show a 60% chance that policymakers will cut their benchmark rate by 50 basis points to 4.75% at the next meeting on 18 September. A week ago, before the surprise 50 basis point cut in the largely symbolic discount rate, such an outcome had zero probability. A fall in US money market rates may complicate things for China by triggering a new wave of speculative, yield-seeking capital flowing into the Asian nation. The prospect of that happening may make the authorities in Beijing even more reluctant to increase interest rates.
That might worsen China’s inflation challenge at a time when money supply is expanding very rapidly in the world’s fastest growing major economy. M2—cash and bank deposits—grew at an annual 18.5% pace last month, the fastest in more than a year.
China’s liquidity glut presents a stark contrast to the credit crunch that has hit banks across the developed world.
With the exception of the Bank of England, the monetary authorities of the Group of Seven industrialized nations have spent the last few weeks making sure their banks, unable to borrow from one another because of a bout of risk aversion, don’t run out of cash.
The People’s Bank of China, meanwhile, is still grappling with the opposite problem of reining in surplus cash. Just last week it drained a net 290 billion yuan (Rs1.56 trillion) from its banking system by selling bonds and bills, and by making banks set aside more money in reserves.
China is also cautiously loosening controls on capital outflows to let some of the liquidity out of the country. The State Administration of Foreign Exchange, the currency regulator, on Monday announced a pilot programme allowing individuals to buy stocks in Hong Kong.
While that’s good news for the stock market in Hong Kong, it may do little to reduce China’s excess cash.
“China’s liquidity problems stem from its undervalued currency,” Diana Choyleva, an economist at Lombard Street Research in London, wrote in a 13 August research note.
And the inflationary consequences may have already become inevitable, not only for China, but also for the world.
“Whether the yuan appreciates fast, Chinese producers continue to pass on increased input costs to the global consumer or there is a protectionist backlash; China is set to export inflation,” she said.
That might act as a hindrance to Fed’s strategy to deal decisively with the subprime mess.
“In the current global credit crunch, the Fed may be needed to perform its function of a lender of last resort,” Choyleva said. “Uncertainty is making it difficult to assess the need for such action, but persistent inflation worries may slow the Fed’s response,” she added.Much is being made of the risk that Fed might encourage reckless behaviour by shielding the financial system from the full consequences of its own excessive risk taking. Moral hazard, however, may not be the only cost of a bailout. The danger of importing inflation from China is a more immediate threat.
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