China’s announcement that it will control food prices, imposing heavy fines on retailers and producers who increase the price of basic necessities, is not an ideological surprise—the government still calls itself Communist, after all. But it only attacks the symptoms of inflation, not its underlying causes. To do that, China must curb the excessive lending in its banking system, rather than bailing it out through capital infusions.
The Chinese government is making the same mistake the Nixon administration made with its price controls in 1971. Those caused shortages, and after they were lifted, inflation returned in more virulent form. Similarly in China, controls on food prices, in a period of rapid food price inflation, will simply ensure that the controlled items disappear from the stores. When controls are lifted, inflation will return with increased ferocity.
The People’s Bank of China has increased its lending rate five times in the last year, but only to 7.02%, against reported inflation of 6.9%.
In any case, too much of China’s bank lending is independent of interest rates. When a non-market loan is made to a state-owned company, a rise in the interest cost simply leads the company to borrow more next time. The bad debts in China’s banking system were estimated by Ernst and Young at $911 billion (Rs35.8 trillion) in May 2006; they are almost certainly larger now.
However, bankruptcies and liquidation are rare. Instead, further loans are made when more cash is needed, and the loans are recorded as current. China’s infusions of capital into the banks from its $1.4 trillion foreign exchange reserves, via the China Investment Co. and the State Administration of Foreign Exchange, merely make matters worse, as do capital infusions from foreign investors who buy bank shares in initial public offerings. They allow the banks to go on lending, cover up poor asset quality and further inflate the domestic money supply. As long as Chinese banks lend to state-owned and politically connected companies on the basis of need rather than financial prospects, inflation will remain embedded in the economy and will tend to worsen.