China’s economic rebalancing entails inflationary dangers

According to an interview with Asian economist Frédéric Neumann from HSBC in Swiss financial paper “Finanz und Wirtschaft” the rebalancing of China’s economy could provoke an inflation danger

The economist underlines that there are signs of recovery in economic growth of China and this is accentuated by the indications of the buyers’ index offering also a more positive picture in March. He is convinced that the cyclical downturn is coming to a halt. Since inflation came down from 6 % to 4 %, he predicts that in the second quarter China’s economic growth will grow closely to nine percent, in the first quarter the growth rate was only 8.1 %. He estimates further an annual growth of 8.6 % for China in 2012. The key however is the fact that China keeps the inflation pressures under control and Neumann expects that the rate of inflation will slow to 3 % by the end of 2012, however with the prospective that it will increase shortly afterwards because of salary increases taking place in the meantime.

The People’s Bank of China has reduced the reserve rates and will continue to do so in further two steps of each 50 base points during 2012. Prices of real estate are expected to remain damped and therefore credits are rather directed to the benefit of companies than to that sector. Authorities are inclined to keep real estate at a lower level (-20 % in city areas) and will not tolerate increases and therefore the buying restrictions will remain in place. It has to be added that consumer behavior is not influenced in the same manner by estate prices as in the Western hemisphere because only 7 % of the Chinese population are making use of mortgages.

The rebalancing is under way and has to be seen in two phases. The first is a reduction of the export dependence and is already in place. The second will be a balancing between investment and private consumption and was not yet crowned by success because Chinese consumption has only a share of 35 % of GDP Gross Domestic Product and should be at a level of 60 % and therefore households will be encouraged to spend more and to save less. Also the expansion of the social sector is enhanced by the government. But to reduce the saving quota it is necessary to increase the average income. Up to now the economy was growing more quickly than salaries and now there is a turning point where salaries are increasing faster than the growth of GDP and exactly this effect could provoke an inflationary effect. And growing salaries above the growth rate of GDP is also true for other Asian countries and therefore the inflationary danger is also given in the entire area due to the lack of workforce, smaller gains of productivity and the demographic development. This means additionally implications for Western countries as Asia has started already to export inflationary tendencies and this at times where salaries in the West are not increasing. It is a common understanding of economists when consumption is increasing then investment has to decrease and thus it will slow economic growth. In China there is a debate whether investment is increasing productivity, if this would be the case then salaries can increase without creating inflation but if this does not become reality such a rebalancing will increase inflation. China under the new leadership seems to be inclined to enhance political reforms according to the last World Bank report, especially concerning the liberalization of the Chinese currency and to test the effect of a partial opening of the capital balance. The question remains if these reforms are sufficient to appropriately increase productivity in such a manner that salaries are increasing without creating an inflationary effect.