China in Transition

Whither Inflation in China?

Chi Hung KWAN
Consulting Fellow, RIETI

(Published in the July 14, 2011 edition of the Allatanys Newspaper Guide)

The inflation rate in China rose to 6.4% year on year in June, its highest level since June 2008, and the possibility of meeting the annual target of 4% or less for 2011 set by the government has become remote. Where inflation is heading will largely determine future monetary policy and, in turn, the course of the economy.

The recent rise in inflation reflects not only the cyclical factor of an overheated economy, but also a structural factor, namely the shift from a labor surplus to a labor shortage.

Economic boom and rising food prices

Although the Chinese economy is slowing, it has yet to eliminate the overheating. The Chinese economy did experience a slowdown, with exports falling sharply, following the collapse of Lehman Brothers in September 2008, but it then recovered rapidly, backed by a stimulus package of four trillion yuan and expansionary fiscal and monetary policies, including significant reductions in interest rates and reserve requirements. With these measures, inflation began rising from its low of -1.8% in July 2009. Although real GDP growth has been declining moderately after reaching 11.9% in the first quarter of 2010, it still remains high at 9.5% in the second quarter of 2011. Generally, as a lagging indicator of economic activity, inflation continues to rise for some time even after growth begins decelerating, and inflation in China is no exception.

The recent rise in inflation is primarily driven by rising food prices (up 14.4% year on year in June). Although it is generally believed that food prices are heavily influenced by weather and overseas market conditions, and have almost nothing to do with the domestic economic trend, this understanding does not necessarily hold true in China's case. Given the huge size of the country, however, only some regions are ever affected by natural disasters such as drought and flood damage, and it is rare that output in China as a whole declines sharply. In addition, as the food self-sufficiency rate in China is extremely high, food prices are not that susceptible to overseas market conditions. Rather, food prices increase faster as economic growth picks up because, with wages accelerating, the demand for food rises on the one hand, and food supply shrinks on the other hand, as more farmers move to work in the cities. In fact, the last bout of inflation in China, from 2007 to early 2008, was also linked to a rise in food prices against the backdrop of a booming economy, as is the recent inflation.

Labor force shifts from surplus to shortage

Changes in the labor market are also driving up inflation. In China, growth in the productive-age population is currently slowing, as the low birthrate persists due to the one-child policy introduced in 1980. In addition, the surplus workforce in rural areas is disappearing as a large number of farmers have moved to the cities to find work. Thus, the labor force is changing rapidly, from surplus to shortage. As a result, the potential growth rate appears to be falling, from around 10% in the past to about 9% now, and increases in wages—and, in turn, prices—are accelerating as the actual growth rate continues to outpace the potential growth rate.

The monetary authorities have been using a tight monetary policy to control inflation. The one-year lending rate has been raised five times, 1.25 percentage points in total, since October 2010, while reserve requirements have been raised 12 times, 6 percentage points in total, since January 2010. Following these steps, growth (year on year) in money supply (M2), an intermediate target of the monetary policy, has slowed from a peak of 29.7% in November 2009 to 15.9% in June 2011.

In addition, the authorities have come to accept the revaluation of the yuan as one of its tools to curb inflation. Since shifting from the dollar peg system to the managed floating rate system in July 2005, the yuan has been strengthening against the dollar, except for approximately two years from around the time of the fall of Lehman Brothers in September 2008 to June 2010. Contrary to conventional economic wisdom, namely that the currency of a country experiencing high inflation will depreciate, in the case of China, the yuan tends to rise more quickly versus the dollar as inflation moves higher. This suggests that the exchange rate of the yuan is not determined by supply and demand in the market, but is controlled by the authorities.

Nevertheless, the effectiveness of Chinese monetary policy has been questioned. In fact, if capital movement were completely free and the exchange rate were fixed, tight monetary policy could increase liquidity, contrary to the original intention of the authorities, as the hike in interest rates associated with the tightening policy causes hot money to flow in from overseas. In contrast, China succeeded in controlling money supply by increasing the flexibility of the exchange rate, while leaving regulations on capital movement in place.

From an overheated economy to stagflation

Growth in China's money supply has already slowed in a manner that suggests the tight monetary policy is working. Inflation is expected to peak over time as the growth rate declines further, but it is likely to remain relatively high for the time being. Speaking from the standpoint of the business cycle, the Chinese economy is entering a phase of stagflation, with low growth and high inflation, as it exits a phase of overheating growth and high inflation. A slowdown in inflation is a precondition for the monetary policy to shift from tightening to easing, and the time for this is likely to be carried over to next year.

The original text in Japanese was posted on July 19, 2011


Among foods, the rate of increase in pork prices, which was 57.1% year on year in June, particularly stands out, and this boosts the inflation rate by 1.4 percentage points. In China, the so-called "pig cycle" is repeated every three years: If pork prices rise, farmers increase the number of piglets they keep, and when these pigs come on the market together, pork prices collapse. If farmers reduce the number of piglets following this, pork prices rise sharply once again. Currently, pork prices appear to be at the peak of this cycle.

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July 19, 2011