The new policy challenge

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The growing risk of stagflation has perhaps been one of the most important macroeconomic surprises around the world since the beginning of the year. China is not excluded from the risk. According to the National Bureau of Statistics (NBS), real gross domestic product (GDP) growth moderated from 11.9 per cent in the fourth quarter of 2007 to 10.6 per cent in the first quarter of 2008. Between mid 2006 and late 2007, the growth of export volumes fluctuated largely within the 20-30 per cent range. After that, however, export growth tanked (Figure 2.1). The growth of industrial production showed a similar trend, especially when adjustments were made for changed producer prices.

Meanwhile, inflation rates continued to reach new highs. During much of 2005 and 2006, the headline consumer price index (CPI) stayed well below 2 per cent. From the beginning of 2007, however, it began to rise steadily (Figure 2.2). In February 2008, the CPI reached a new 11-year high of 8.7 per cent. Rising inflation was a result initially of spikes in pork prices, but soon it spread to other food markets, with the overall food CPI exceeding the 20 per cent level in early 2008. The non-food CPI has been largely stable so far; however, nonfood CPI could be underestimated as the government controls domestic fuel prices. Producer prices accelerated to 8.2 per cent in May 2008 from below 3 per cent a year ago.

Figure 2.1 Growth of volumes of Chinese exports and imports, January 2005-May 2008 (per cent per year/year)

Figure 2.1 Growth of volumes of Chinese exports and imports, January 2005-May 2008 (per cent per year/year)

Note: In drawing the chart, I have averaged year-on-year growth rates for January, February and March and smoothed out the effect of the Chinese New Year holiday. Sources: CEIC Data Company and Citi.

Figure 2.2 China's headline CPI, food CPI and non-food CPI, January 1999-May 2008 (per cent per year/year)

Figure 2.2 China's headline CPI, food CPI and non-food CPI, January 1999-May 2008 (per cent per year/year)

Sources: CEIC Data Company and Citi.

The combination of slowing growth and rising inflation poses serious challenges for Chinese macroeconomic policymaking. Deterioration of the US economy, the continuing surge of oil prices, liberalisation of domestic factor markets, the upcoming Olympic Games and unexpected events such as the recent snowstorm and earthquake further complicate policymakers' decisions.

In fact, the Chinese government's macroeconomic policy stance has already swung notably during the past months. At the beginning of December 2007, the Central Economic Work Conference identified two top policy priorities for 2008: fighting overheating and controlling inflation. As the economic conditions in the United States deteriorated sharply in early 2008, however, the State Council added an additional goal for its macroeconomic policies: preventing a slide of the economy. From May 2008, the environment shifted again. The near-term outlook for the United States improved steadily, with many investors believing that the worst might be over. In the meantime, inflation rates continued to ratchet up. The Chinese authorities again toughened their stance for battling inflation problems.

The heated policy debate has not ended. The 'hawks' advocate aggressive policy tightening, including sharp appreciation of the currency. They argue that inflation, regardless of its composition, is a monetary phenomenon; therefore, only aggressive monetary tightening can tame inflation. The 'doves', on the other hand, warn about the downside risks to the economy and call for some tolerance of higher inflation. They point, in particular, to already declining corporate profits and collapsed equity prices. It follows, then, that continuous aggressive tightening will not only kill the growth engine, it could escalate social and financial risks.

In this chapter, I argue that the scenario of stagflation is unlikely to materialise in China any time soon. Development in three areas could, however, reinforce the challenge of slowing growth and rising inflation in the coming year: deceleration of the US economy, elevated international oil prices and gradual cost normalisation in China. We are likely to see growth shifting to a slightly slower gear—about 10 per cent—while inflation will ratchet up to higher levels, of about 5-7 per cent, in the coming year or two.

In this environment, policy decisions will likely continue to be difficult. With elevated inflation pressure, however, the central bank will probably maintain its tightening bias, with a focus on direct liquidity management. Steady appreciation of the renminbi should also continue. In the meantime, fiscal policy could turn more expansionary to support post-disaster reconstruction and to facilitate industrial upgrading. If an expansionary fiscal policy successfully boosts domestic demand and reduces the external surplus, it could in the end help ease pressures on the currency and inflation.

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