China's Worrisome Inflation Data

The mainland's consumer price index shot up 5.6% in July from the previous year, the fastest rate of increase in a decade

China's high-speed economy has largely been insulated from the credit-squeeze drama that has pummeled global stock markets.

The mainland's $2.8 trillion economy clocked 11.9% growth in the second quarter, the fastest pace in about 12 years. And the closely watched CSI 300 Index that tracks listed A-share stocks on the mainland is up a head-turning 130%-plus in 2007.

Indeed, the biggest challenge confronting China isn't a scarcity of capital, but way too much of it. On top of that, China's inflation rate has moved up sharply this year. It was 3.2% in the first half, above a 3% government target. On Aug. 12, Beijing announced that its consumer price index shot up 5.6% in July year-over-year, the most dramatic rise in 10 years.

Trigger for Social Unrest

Particularly disturbing was the 15.4% year-over-year increase in food prices. The rise in meat prices is mainly driven by an ongoing surge in the cost of pork, China's staple meat. In recent months, there has been hoarding of meat by anxious Chinese citizens, prompting Chinese Premier Wen Jiabao earlier this year to publicly vow to contain further price rises.

A big jump in the inflation rate, which undercuts the purchasing power of ordinary Chinese families, is a worrisome trend in the eyes of Beijing leaders. In the past, most notably in the months leading up to the 1989 Tiananmen Square protests, inflation has been the cause of great social unrest.

A bigger problem at the moment is that the inflation rate is growing faster than the returns on bank deposits (now about 3.3%), providing a big incentive for Chinese families to shift savings into the raging stock markets in Shanghai and Shenzhen. Economists are somewhat split on what the latest reading on consumer prices means for the overall economy and monetary policy.

Central Bank May Move in September

Analysts are quick to point out that if you strip out food, China's inflation rate isn't that big a deal. Core inflation, or nonfood inflation, was stable at 0.9% year-over-year. However, Standard Chartered Bank (SCBFF) Senior Economist Stephen Green thinks the latest inflation number, plus the fact that in July, M2, a broad measure of money supply, grew 18.5% from a year earlier, may prompt the People's Bank of China to raise interest rates twice more this year to prevent the economy from overheating. He expects increases of 27 basis points each that would take China's benchmark one-year loan rate to 7.38%.

The domestic stock markets remain white-hot, and there are signs that housing prices are on the march upward in some big urban markets. "Shanghai house price inflation is accelerating again, and where Shanghai goes, the rest of China is bound to follow," noted Green in a research note on the Aug. 13 inflation data.

Lehman Brothers (LEH) analyst Mingchun Sun in Hong Kong thinks the higher-than-expected inflation number for July means the central bank will only make one more rate move, probably before the end of September.

Alternatively, Jing Ulrich, chairman of China equities at JPMorgan Chase (JPM), isn't forecasting another interest-rate hike. She figures raising interest rates more this year would only invite more speculative inflows of capital in search of higher returns and place upward pressure on the yuan, a scenario Beijing wants to avoid.

She argues the spike in food prices likely will prove transitory, since the government has made moves to increase meat supplies. China has already taken steps to increase food supplies, which should ease supply shocks by the end of the year, she noted in an e-mail message. "These include subsidies for hog farming and restrictions on nonfood crops."

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