Reek Economics™

China
Why the inflation can benefit the country.
Written by: Martijn Reek

The inflation has risen sharply in China last year, many analysts are concerned this will reduce the
economic growth. In January prices rose by 4,9% compared to the same period last year. This was
slightly lower than the CPI-index change in November. There are different explanations for the rising
inflation. (1) The Quantitative Easing done by the Federal Reserve in the United States. Most of these
dollars are flowing into commodities and emerging markets. 63,9% of all foreign exchanges in the
world is in US Dollars1. This is what makes the currency the reserve currency, but the disadvantage
for the rest of the world is that every law passed by US Congress and every change in policy by the
central bank has its effect on the rest of the world. The US is exporting its domestic monetary policies
to other parts of the world. (2) The relaxed monetary policy in China could be a reason for the rising
inflation in the country. The Chinese government is ‘manipulating’ the Renminbi by keeping it pegged
at a low rate to the US Dollar. Thereby keeping their prices for foreign importers low. If the currency
cannot rise, than assets should rise to reflect the capital flowing into the country. The analysts who
favor reason number two are hammering for a hike in interest rates. But does this really stop the
inflationary spiral?

The reason for this very small decline compared to November is the change in the weighting of food
prices in the CPI figure. The weighting of food prices declined by 2,21%2 and the costs of living were
increased by 4,22%. Food prices still make up one third of the total figure. In one year food prices
went up by 10,3%; in which fruits got the most expensive (+34,8%), grains (+10,3%) and vegetables
(+2%). Housing prices in China rose 6,8%. So the biggest contribution to this inflation figure comes
from food prices. Then why are most analysts / experts demanding a rate hike in China? Does a rate
hike stimulate food production, or does it pushes demand down till it is below production levels? Of
course not! The only way food prices will stabilize or find an equilibrium is the increase in production.
And by increasing the costs of money for farmers you will only make it more difficult for them to
increase their output. 39,5% of the population in China works in the Agricultural sector.3 This counts
for more than 525 million people. All these people benefit somehow from the more expensive food
prices, it is their income. Because of the price rises these people can make a better living, so they are
encouraged to expand their production. By making loans more expensive you curtail them in any
expansion, this will lead to more inflation in the future.

The inflationary spiral in housing prices can probably be broken by increasing interest rates, because
this is pure monetary inflation. People see they can make a profit, so they loan money to speculate in
the housing market. Making these loans more expensive for them will decrease their profit potential,
which results in less willingness to borrow for speculation.

1
IMF – Currency Composition of Official Foreign Exchange Reserves
2
National Bureau of Statistics China
3
CIA World Factbook – China Population

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 Reek Economics™

So there needs to be some middle ground, where both these issues are addressed. This is very hard
for one institution as a central bank. In my opinion that power should be decentralized so the
interest rates can be decided by market forces. The market will balance all information into what the
market thinks is the ‘ideal’ interest rate. This rate will float daily like bonds and mortgage rates are
doing already. One institution should not have the power to influence the economy. Not only in
China, but anywhere in the world.

The inflation in China is a problem for a great part of the population, people who live in the cities
have to spend a bigger percentage of their income on food to consume as they are used to. But the
people in the city are also the ones who benefit the most from the massive economic growth in the
country, and its yearly growth is still twice as high as the inflation rate. While the inflation is caused
mainly by the increase of prices in food and other commodities, parts of the population who live in
rural areas are now starting to profit from this growth as well. As their produce finally earns them a
better income. It will encourage them to stay in these rural areas, and not trek to the cities where
they are bound to live in the slums. The same applies to India, where people moved to the city,
because profits made as a farmer were not enough to take care of their families. This finally starts to
turn. Food prices need to rise to make sure there will be enough in the long run. No one can expect
farmers to work for nothing.

To answer the question in the introduction: Food prices are the main cause of the inflation and
inflation based on shortages cannot be fought by raising interest rates. The production has to
increase to make food prices stabilize. A rate hike will produce higher inflation levels in the coming
years, because farmers are shortened in their lending possibilities. In other words, more expensive
money makes it more difficult for them to increase their productivity. And as the world population
keeps growing rapidly, this could lead to more shortages in food/commodities and to more inflation
in the future.

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