The capacity of an economy to absorb rising prices without overheating into an asset-price bubble is a perennial topic of debate among economists worldwide. Policy makers face an evolving puzzle in managing monetary regimes to nurture growth without letting prices get out of hand, and nowhere is the challenge felt more urgently today than in China. Its massive stimulus lending to counter the global financial crisis has flooded the economy with excess cash seeking higher returns than can be earned in bank accounts and lackluster local share markets. Surging international commodity prices, weather-related food price hikes and the spillover effects of controlling the appreciation of China’s renminbi are complicating Beijing’s anti-inflationary struggle, and helping bring to an end anera of low costs.

For the Chinese, each inflationary spike conjures images both of denizens of the early 20th century hauling their near-worthless piles of cash around in wheelbarrows and of the protests that ended in the Tiananmen Square crackdown in 1989, a time of double-digit inflation. This time around, there's been nothing nearly as dramatic: New figures show the consumer price index rising 5.3% in April from a year earlier, edging down from a 5.4% rise in March, which was a 32-month high. Non-food prices rose 2.7% while food prices jumped 11.5%, the sixth consecutive month of increases exceeding 10%.

Among Communist Party leaders, the erosion of purchasing power is a concern for various reasons. For one thing, it's a blow to the material gains that are the party’s main claim to legitimacy. For another, it's a growing source of public dissatisfaction at a time when Beijing is vigilantly guarding against any hint of the types of protests that have toppled regimes in the Middle East. Rapid concessions made by Shanghai authorities following recent protests by truckers angered over fee and fuel price increases highlight the government’s keenness to stave off any trouble. Across the country, wages in both the private and public sectors have been rising.

A Longer Wait

The government wants to lower inflation to a 4% average for the year, but many say the consumer price index (CPI) will remain above 5% for months to come. Just after April's data was announced, Tao Wang, head of China economic research at UBS, forecast the CPI staying above 5.5% in May and June. She expects the central bank to hike interest rates twice before midsummer, following five increases in bank reserve requirements since the beginning of the year, an action aimed at slowing lending and the amount of liquidity sloshing through the economy.

Pieter P. Bottelier, professor of Chinese studies at John Hopkins University, doesn't see a quick fix happening any time soon. “Inflation will moderate somewhat this year, but it will not come down as much as the government would like, partly because of the significant excess liquidity in the economy,” he says. 

Bottelier reckons it could take at least another year to resolve the problem through monetary tightening, particularly given the scale of unofficial, or so-called shadow lending. Fitch Ratings estimates that there was more than RMB 3 trillion (US$461 billion) of such "gray-market" lending in 2010 by the country's lightly regulated non-bank financial institutions and other entities.

“The main factor is that the amount of lending in 2009 and 2010, both official and unofficial, was much higher than the government had originally planned," says Bottelier. "That is the single most important problem underlying inflationary pressures at the present time and it will not just go away.”

China's financial institutions made RMB 7.95 trillion of loans in 2010, overshooting the official target of RMB 7.5 trillion. In 2009, banks lent RMB 9.63 trillion, a record amount encouraged by authorities as part of Beijing's stimulus plan. "If the government were to crack down with very aggressive monetary tightening, it would hurt economic activity too much,” Bottelier says. "They will have to live with higher inflation for some time."

Push and Pull

Beijing’s attempt to prevent a rapid appreciation of the renminbi, also known as the yuan, is helping to push inflation higher. The central bank’s "sterilization" — soaking up U.S. dollars from exporters and foreign investors — is pumping yet more excess cash into the real economy and is fuelling the staggering growth of its foreign exchange reserves, which surged to more than US$3 trillion earlier this year.

There are signs, however, that the official rhetoric on a careful appreciation of the renminbi against the U.S. dollar may be softening. In April, Premier Wen Jiabao, speaking at a meeting of the State Council, China’s cabinet,mentioned increasing the flexibility of the exchange rate as one of several tools the government should use to control prices. “Beijing seems to be close to officially admitting that the yuan’s appreciation has more pros than cons. This contrasts with their previous reluctance to publicly justify any appreciation,” wrote Wei Yao, Hong Kong-based economist at Société Générale, in a recent note.

Most economists agree that allowing the renminbi to appreciate would help. “A stronger exchange rate would help tone down inflation and reduce costs of both imported and non-imported goods because a stronger currency puts downward pressure on all tradable goods that are influenced by world prices,” says Louis Kuijs, senior economist at the World Bank in China.

Allowing a hefty hike of, say, 10% in one fell swoop could backfire, however. “If you let the renminbi appreciate faster or have a one-off, big appreciation, you will kill the economy," says Chen Xingdong, chief China economist of BNP Paribas in Beijing. "It’s like if a doctor wants to cure a patient with a high fever, do you want to just lower his fever or do you want to kill the patient with strong medicine?”

In countries that have floating exchange rate regimes, monetary authorities generally leave fluctuations up to market forces, and sometimes must live with any negative consequences, he says. Beijing shows no signs of abandoning its commitment to only gradual movement toward a market-driven currency system.

Any major appreciation — either as a one-off or a switch from a crawling peg to a managed float — would hurt the country's many small and mid-sized enterprises (SMEs), which generally operate on thin margins and have less room for financial maneuversthan larger companies. “Different governments make different trade-offs," says Kuijs. "It may make sense from the capital market perspective, if you want to get rid of all those people who think your currency would appreciate and are piling their money into your economy. But the one-off move of your currency will hurt your real economy and exporters. In the case of China, capital market issues, such as hot money inflows, are not the big problem.”

Likewise, Beijing’s reluctance to impose a “hard landing” through harsh tightening, such as bigger or faster interest rate hikes, is also hindering attempts to cool inflation, argues Wang Jianmao, professor at Shanghai’s China Europe International Business School. But, he says, “if the government keeps tightening so slowly, it would take a few years to work out the monetary overhang from the past two years.”

The government has raised interest rates four times since last October, each time by 0.25%. This has taken the interest rate on one-year deposits to 3.25% and the one-year lending rate to 6.31%. Now that banks must hold a record high 21% of reserves following the latest policy change in early May, that strategy may be reaching its limit since such tightening hurts an important growth engine for the country — SMEs and private companies of all sizes, which have struggled to get loans from the state-controlled banks, even under the more lax governance regime of the past, according to Wang.

“The Chinese government should have raised interest rates much higher each time, and faster," he says. Rather than 0.25%, he reckons 1% increases of the benchmark rate would have been more beneficial. The government’s reluctance to move faster reflects concerns that higher interest rates could increase the risk of attracting dangerously high amounts of “hot money” into the economy and increase the number of non-performing loans held by the four major state-owned banks, Wang adds.

Chen of BNP Paribas echoes other economists in arguing that the government’s active role in overall lending policies means that interest rate hikes provide only marginal value in managing inflation. “In Western countries, [policy makers] control money supply by varying interest rates, but China is different," he says. Under so-called administrative guidance, China's central bank is able to pressure commercial banks to control loan growth. As he notes, "China controls the money supply directly — in other words, they control lending.”

The Moral Duty

In parallel with those policies, the National Development and Reform Commission (NRDC), the main economic planning agency, is using “moral persuasion” rather than imposing strict price controls, with a few exceptions. Under pressure from the NDRC, local and domestic food and beverage makers have been postponing price increases. In early May, the NDRC fined Anglo-Dutch multinational Unilever RMB 2 million for merely talking publicly about a planned price hike, which provoked consumers scrambling to buy products like soap and detergent to beat the increases. A few weeks earlier, the non-government All-China Federation of Industry and Commerce urged its members to resist colluding on prices by reducing output.

But such policies go only so far and can have unintended consequences. China is facing its worst energy crisis in years, largely due to controls meant to keep prices from rising. Several provinces have begun ramping up electricity rationing amid concerns that severe shortages this summer could cripple productivity. “Price intervention is causing power shortages because electricity generators cannot pass on higher costs from high coal prices,” notes Chen. Similar problems have arisen in the refining sector at a time when global crude oil prices have surged beyond the domestic controlled prices for fuel products.

The global surge in prices for crucial commodities, such as coal, coincides with escalating wages domestically. The average annual salary for private company employees in China was RMB 20,759 in 2010, up 14.1% from 2009, compared with a 13.5% year-on-year increase to RMB 37,147 for non-private company employees, the National Bureau of Statistics reportedin early May.

Wildcat strikes at Japanese auto factories in China a year ago were just one sign of the rising expectations of China's younger generation of workers, who unlike their parents are pushing for better standards of living, including higher wages. Low-cost manufacturers, such as garment makers, are slowing the upward pressure on wages by moving production to cheaper labor markets locally or in other countries, such as Vietnam, Indonesia and Bangladesh, but the wheels have now been set in motion, say experts.

Even with wage increases, the higher cost of living is hitting Chinese on low or fixed incomes the hardest. And according to a new analysis from London-based Economist Intelligence Unit (EIU), not all parts of the country are feeling the impact of inflation equally. "Contrary to expectations, the highest growth in CPI is not taking place in China's fastest-growing provinces," states the EIU analysis. "Over the past six months, significant acceleration in CPI growth was seen in the Western provinces of Ningxia, Qinghai and Tibet." In some parts of the country, CPI growth has been higher than 6%, while declining year on year in other parts. What's more, says the EIU, more developed provinces, which tend to be on the coast, can adjust more quickly to rises in demand for living expenditure because of their better access to food imports and proximity to food-production centers.

So far, the government has largely succeeded in mollifying public displays of dissatisfaction over rising inflation. But how much longer can their concessions ease tensions? “Given how keen the government is to mitigate those problems, it is surprising that there have not been more people protesting,” says the World Bank's Kuijs. “If strong inflationary pressure continues, I am sure there will be other groups of people … who will want to voice their concerns.”

But Beijing’s addiction to guiding the economy through top-down directives has made their pursuit of sustainable growth difficult. “Price controls had some impact in lowering food prices, but in the long term, it does not work,” asserts David Cohen, an economist at Action Economics, a financial market news provider, in Singapore.

It's widely expected that Beijing will eventually have to loosen its grip and let markets fulfill their role in allocating resources more efficiently. “Most Chinese policy makers are pragmatic and have lived through the central planning years. They know price controls cannot really be the answer.” says Kuijs.