Wednesday, February 20, 2008

China's inflation... good news or bad?

Is inflation procyclical or countercyclical? In China now, the inflation rate is too high so that some people predict it could be a sign of recession. Can you explain? -Amy

At it's base, increasing inflation can be good or bad. Thinking of the standard supply and demand diagram: prices rise when there is either too much demand or too little supply. Too much demand would tend to reflect a rapidly growing economy, which is good; too little supply would reflect a slowly growing (or even shrinking) economy, which is bad.

In the case of China, it's hard to tell. Yes, prices are increasing at the fastest pace for 12 years, and inflation now stands at over 7%. But prices have been pushed up partly by the recent bad weather, which reduced supplies. Now that the bad weather is passing, its effect on inflation should diminish as well.

But there's another sense in which China's inflation is bad. Much of China's recent growth has come from growing net exports. China, the "world's factory," has churned out huge quantities of manufactured goods for world markets, where demand has been growing based primarily on low prices.

But China will not be the lowest cost producer of these goods for much longer. Price inflation directly drives up the price of exports, and the increasing value of the RMB increases the price when converted to other currencies still further. Additionally, the cost of producing goods in China is increasing rapidly, with migrant wages increasing and workers able to be more particular about their working conditions.

But lets not overstate the threat here. The effects I've outlined above are likely to slow that rate of growth of the Mainland economy. In future, more of China's growth will have to come from producing higher valued products, as they will no longer be the world's cheapest source of manufactured goods. But don't expect the economy to completely stagnate anytime soon.

5 comments:

Anonymous said...

Yes, from the demand/supply law, too much demand, too little supply, will lead to price increase. That's simple.

however, inflation is more than just price increase. Will you consider inflation is caused by the increase in money supply? Which is the main reason of inflation?

Like what happened in the last few years?


SAM

James Yetman said...

In my scenario, too much money is a source of too much demand... if you increase the supply of money enough, that'll cause higher inflation.

On average, in the long run, other supply and demand shocks tend to die out. So in the end, inflation is "always and everywhere a monetary phenomenon." (See http://hongkongmacro.blogspot.com/2007/11/price-controls-make-comeback.html)

Anonymous said...

Is the inflation in mainland China a major cause for the inflation in Hong Kong recently? Such as the price increase in pork.

Shannon

James Yetman said...

Yes- given that most of Hong Kong's imports come from mainland China, high inflation in China and an appreciating RMB together combine to increase the inflation rate in Hong Kong.

The third factor is low interest rates in Hong Kong that stimulate demand, increasing inflationary pressure. Our interest rates mirror the low rates in the United States (due to the currency board), and US rates are being slashed by the Federal Reserve Board as they seek to reduce the severity of the (probable) recession that is currently hitting the US economy.

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