• Consumer price inflation should not be a problem in mainland China. Of potentially greater concern is asset price inflation. Rather than chasing consumer goods and services, the excess liquidity resulting from the Mainland's huge balance of payments surplus has found its way into asset markets.

High growth coupled with accelerating inflation is a strong indicator of economic overheating. Mainland China's real GDP growth has been higher than the trend rate for the past four years and the outlook for inflation is now the major focus of Mainland policy makers.

When demand begins to exceed what an economy can produce, inflationary pressures will start to build. In the first three quarters of 2007, the Mainland economy was growing at 11.5% year on year, the highest rate in 13 years. Headline CPI inflation has moved sharply upward since the beginning of the year and surged to an 11-year high of over 6% year on year in August and September. Wages are rising rapidly in many cities with companies reporting double-digit employee turnover rates and difficulties in hiring new staff. Do all these signs mean that the Mainland is entering a stage of runaway growth and price inflation that will require a strong dose of tightening medicine?

Inflation Should Not Be a Problem

If inflation is a result of supply being unable to keep up with demand, the Mainland is unlikely to be facing secular inflation. On the supply side, the Mainland economy is experiencing virtually no resource constraints at this stage and the country has an abundant supply of the two factors of production - labour and capital. If properly deployed, existing resources should create sufficient production capacity to meet the rising demand for goods and services.

On the labour front, productivity gains and millions of rural sector workers play a key role in checking inflation. While it is true that nominal wages have been growing strongly by about 13-16% annually between 2001-2006, rising wages are not necessarily a sign of inflationary pressures. During the same period, labour productivity gains outpaced nominal wage growth significantly and thus enterprises managed to make good profits despite rising rates of pay. Profits of industrial companies have jumped 20-40% per annum in the past few years (Exhibit 1) and gross industrial output has expanded at an average annual rate of 21% in the past decade. Huge investment in manufacturing production capacity has not only helped to increase the amount of capital per worker and raise productivity, but has also intensified competition among industry players, which tends to keep prices - and thus inflation - low.

Labour mobility from rural areas to cities has also played an important part in checking wage inflation. Over the past five years, about 10 million rural workers have taken up employment in urban areas. This trend has been particularly apparent in the past two years due in large part to improvements in the urban-rural transportation network (Exhibit 2). The existing pool of over 480 million rural labourers should help prevent a secular shortage in manufacturing or urban workers and moderate wage rises. This should help ensure the Mainland retains a comparative advantage in labour-intensive production activity for many years to come.

The Mainland also possesses a huge pool of capital from both domestic accumulation and foreign inflows. Domestically, years of strong economic growth have resulted in the fast accumulation of household savings and financial wealth. In the past five years, household savings have doubled to reach RMB17.4 trillion in July 2007. On the external front, the Mainland is Asia's hottest spot for foreign direct investment (FDI), one of the major sources of capital formation. FDI inflows to the Mainland expanded at an average rate of 21% per annum between 1996 and 2006, from USD3.5 billion to USD69.5 billion. During the same period, the Mainland's total fixed asset investment (FAI) expanded at an annual average rate of 30%. While most of the focus has been on how the fast-growing FAI adds pressure on the demand side, capital and infrastructure investment also adds new capacity to the economy and is essential to a nation's long-term economic development and growth.

Indeed, the Mainland has experienced many years of phenomenal growth with only moderate inflation in the past two decades. The only exceptions to this were in 1988-89 when the government lifted price controls in a comprehensive price reform exercise and in 1993-95 when accelerating demand strained the capacity of a pre-enterprise reform system still dominated by state enterprise production, causing widespread production bottlenecks.

Headline CPI inflation has escalated since the beginning of the year, and in August and September reached the highest level since December 1996. If both labour and capital are abundant and market mechanisms are now playing a greater role in directing resources allocation, what are the major reasons for the surge in inflation this year?

Why Has Inflation Surged This Year?

Over 90% of the recent increase in the CPI has been caused by rising food prices (Exhibit 3). The non-food component of the CPI has remained stable at around 1%. Why are food prices increasing so drastically? One important contributing factor is the rise in global prices for wheat and corn. Further, meat supply was hit by a virulent flu outbreak that reduced the country's hog population, driving up the price of pork, which makes up about 65% of total meat consumption on the Mainland.

Food prices are unlikely to remain at the current levels as farmers will react to higher prices and increase supply accordingly. Unfortunately, however, such a process takes time. This in large part explains why food prices are volatile in nature: short-term adjustments to the demand and supply imbalance can only be made through prices, rather than through increasing or decreasing supply.

The stable non-food price trend lends support to the argument that, supported by the appropriate policy mix, the ample supply of labour and capital will be able to keep overall price inflation at a reasonable level once sufficient time has passed to allow food prices to sort themselves out. Since food prices have risen by about 10% over the past 12 months, it is expected that supply will gradually increase and prices will stabilise.

As to when the surge in food prices will come to an end, headline CPI inflation will likely peak within the next two months, as the Mainland authorities have offered farmers subsidies to boost hog output and have arranged to import more pork. Prices of pork and a number of other food items seem to have peaked in August. If this proves true, CPI inflation would likely stay at over 6% in the next two months, but drop substantially to about 4% during the first quarter of 2008.

Asset Price Inflation of Great Concern

Since the beginning of 2007, the People's Bank of China (PBOC) has sounded increasingly hawkish on inflation. Interest rates and other monetary tools have been used more often to slow demand and money growth. Why do policy makers still seem worried if inflation is likely to retreat? The Mainland's policy makers are probably addressing other risk factors, including asset price inflation. The real estate boom that began in 2002 has been followed by a rally in stock prices. Residential property investment has surged at an average annual rate of 27% in the past two years. Real estate prices in 70 of China's major cities have accelerated despite various measures implemented by the authorities to cool the property sector. Home prices in Shenzhen, for instance, have been growing at a double-digit level over the past two years.

The Shanghai and Shenzhen stock markets have been on bullish runs since 2006. The Shanghai A-share Index is now close to 6,100 points, a four-fold rise in less than two years. There has also been a sharp increase in price-to-earnings (PE) ratios, one of the most important barometers of the stock market. In September 2007, the average PE ratio of stocks included in the Shanghai A-share Index reached a high of 63.7, compared to 17.6 only 20 months earlier in January 2006, making them the most expensive stocks among the world's major markets. Even former Federal Reserve chairman Alan Greenspan commented that "the Shanghai market has all the characteristics of a bubble."

The biggest factor behind this is the excess liquidity resulting from the Mainland's huge balance of payments surplus. The current administrative procedures require the PBOC to buy foreign currency and sell renminbi in such a situation. During this process, the PBOC has issued papers to absorb part of the increase in reserve assets. Despite this action, however, there continues to be a net injection into the banking system, which has expanded money supply and supported increased lending, helping drive the upward spiral of the stock and property markets.

The fast expanding money supply therefore appears to have had a greater impact on asset price inflation than on consumer price inflation. Rather than chasing after consumer products and services, this money has instead found its way into the asset markets. The resulting rapid rise in asset prices in a relatively short period of time is adding considerable risk to the economy, if experiences in places such as Japan, Hong Kong or, more recently, the United States are instructive. The current round of monetary tightening, which will inevitably have an impact on the real economy, seems also to be aimed at controlling asset price inflation.

Conclusion

The rise in inflation this year - due mainly to food price inflation - will very likely subside in a few months' time. However, the economy is still running at a fast pace, foreign reserves are continuing to accumulate rapidly and, most important of all, asset markets remain red-hot. Given this, there seems little chance that monetary policy measures will be relaxed, and further tightening may even be implemented. To avoid the more negative economic effects of a policy overdose, the measures that are currently in place to encourage an orderly outflow of funds should be strengthened.

MAJOR HONG KONG ECONOMIC INDICATORS