"Hot Money" in China: the noose tightens

Today the FT reports on China's continuing problem with "hot money". The flows are perceived to be hampering China's attempt to curtail the ever increasing inflationary pressures.

The policy of requiring exporters to park money is a backward development and is more red tape to trade. This is a dangerous move and could even have inflationary ramifications in the West if cheap Chinese goods prove harder to come by.

China to tighten capital controls in clampdown on 'hot money' [FT]

China announced a major strengthening of capital controls last night in an attempt to limit the amount of speculative "hot money" entering the economy and frustrating its efforts to contain inflationary pressures.

In an announcement on its website, the State Administration of Foreign Exchange, the country's foreign exchange regulator, said exporters would be required to park revenues in special accounts while the authorities verified the funds were the result of genuine trade.

The new system risks becoming a cumbersome burden for exporters such as suppliers of cheap goods to western retailers.

Exporters will now be required to provide documentary evidence that their invoices are based on genuine transactions if they wish to change dollars into renminbi. The regulator said the new computer system for checking invoices would be introduced from August 4. A trial period begins on July 14.

Recent leaked figures showed record inflows of capital entering China over the past two months. Officials believe some money came in illegally after companies exaggerated export revenues.

China has become an attractive country for investors and companies because interest rates are now above US levels and the renminbi is expected to appreciate.

According to Reuters, China's foreign exchange reserves increased by a record $114.8bn (£57.6bn) in April and May to $1,800bn. Although it is impossible to calculate how much of that inflow is short-term, speculative capital, the figures were substantially higher than the combined numbers for the trade surplus and foreign direct investment.

The capital inflows have made economic management more difficult because, even though domestic inflation has been high in recent months, the Chinese central bank has been reluctant to raise interest rates for fear of attracting more hot money.

Authorities have so far prevented the inflows from causing money supply to grow too sharply by issuing bonds and lifting bank reserve requirements.

There has been a growing discussion among private sector economists about whether the authorities should introduce a large, one-off appreciation of the currency in order to limit speculation. However, most economists believe that the government would be very reluctant to take such a step as parts of the export sector are already suffering badly because of higher costs, including the stronger renminbi.

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Forecasting Inflation in China

Inflation in China is something of a hot topic to the extent that the blog and newspaper coverage of this topic is seemingly endless. China Financial Markets for example has long detailed posts on inflation and its cures and consequences daily.

This academic paper from the Bank of Finland is either very timely or completely out of date already. I find it hard to believe the forecasts from a month or two ago can be in any way accurate even a few months later.

The methodology may be of more interest.

Judge for yourself.

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Forecasting Inflation in China

AARON N. MEHROTRA
Bank of Finland - Institute for Economies in Transition (BOFIT); European University Institute - Economics Department (ECO)
JOSÉ R. SÁNCHEZ-FUNG
Kingston University January 27, 2008

BOFIT Discussion Paper No. 2/2008

Abstract:
This paper forecasts inflation in China over a 12-month horizon. The analysis runs 15 alternative models and finds that only those considering many predictors via a principal component display a better relative forecasting performance than the univariate benchmark.


Keywords: inflation forecasting, data-rich environment, principal components, China

JEL Classifications: C53, E31

Tougher stance on inflation

On the back of the steep rise in prices of 8.5% in April China announced further monetary tightening.

What is more worrying is the suspension of the appreciation of the RMB. This may prove to be counter-productive.

The story is covered expertly by the FT (saving me the time).

Beijing takes tougher stance to combat steep rise in prices [FT]

China announced fresh monetary tightening measures yesterday after inflation data showed price rises of 8.5 per cent in April, the second highest monthly figure for 12 years.

The People's Bank of China lifted the share of funds that commercial banks must leave on deposit with the central bank by 50 basis points to 16.5 per cent, the fourth increase this year.

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While Beijing is maintaining an official monetary tightening bias, it appears to have suspended the appreciation of the Chinese currency - regarded by economists as another key instrument for fighting inflation.

The renminbi has stalled in recent weeks against the dollar, after appreciating at an annualised rate of nearly 20 per cent in the first quarter of this year.

Beijing-based economists and government officials, speaking on condition of anonymity, said the PBoC, long known as a supporter of faster currency appreciation, was now being blocked by other ministries.

They said that the slowing rate of the growth of China's exports had prompted some ministries to press for a pause in renminbi appreciation, in order to minimise the impact of the currency on export industries and employment.

China recorded a trade surplus of $16.7bn in Aprilbut the rate of growth of imports outpaced exports.

The PBoC has generally argued that currency appreciation is essential to stemming the growth of the trade surplus and the unchecked flow of speculative funds into China. Rising food prices continue to be the largest contributor to inflation, with year-on-year price increases in this sector hitting 22.1 per cent in April, compared with 21.4 per cent in March.

But economists say the underlying driver of inflation is the excess demand created by the huge flow of funds into China through the trade surplus and other avenues, as well as the velocity at which money circulates in the economy.

Beijing's efforts to talk down inflation by issuing headline-grabbing edicts that threaten price controls and other administrative measures do not seem to have borne fruit so far.

"As underlying inflationary pressures remain undiminished, it is vital for the government to keep its tightening policy stance to anchor inflationary expectations," Goldman Sachs said.

Inflation picking up speed

From Bloomberg.

This article sums up nicely the inherent dangers when inflation begins to rise at rates like this.

China Inflation Quickens; Close to Fastest Since 1996

May 12 (Bloomberg) -- China's inflation accelerated to close to the fastest pace since 1996 as food prices soared and the government slowed gains by the yuan.

Consumer prices rose 8.5 percent in April from a year earlier, the National Bureau of Statistics said today, after gaining 8.3 percent in March. That topped the 8.2 percent median estimate of 22 economists surveyed by Bloomberg News.

Food prices jumped 22 percent, a threat to social stability as the world's most populous nation prepares to host the Olympic Games this summer. Faster currency appreciation, while reducing import costs, also risks attracting more speculative funds into an economy flooded with cash.

On China's Monetary Trap and Inflation

A link to the always excellent "China Financial Markets" posts on China's Monetary Trap and the increasing problem of inflation.

The first article summarises Pettis' arguments as to why he believed China's monetary policy is out of control. He lists eight main arguments which are well made. The only issue is whether his envisaged "revaluation" will ever take place due to the political implications.

China's monetary trap [China Financial Markets]

This whole argument in favor of a maxi-revaluation depends crucially on the assumption that foreign exchange inflows will continue to accumulate at extraordinary levels until the adjustment is made. This is the bet I made four years ago – I argued that reserves would surge. Of course like everyone else I seriously underestimated just how much it would surge. The key argument against continued rapid appreciation is of course the incentive this creates for speculative inflows.

In a second post Pettis deconstructs Chinese inflation to reveal in simple terms just how bad things have got and how quickly.

Deconstructing Chinese inflation [China Financial Markets]

This gives a better idea than do the headline annual figures of how variable inflation has been and how it has accelerated. The first thing to note is that inflation really began to pick up at the end of 2006, but only began showing up in the annual numbers in the summer of 2007. A quick calculation (which is not included in the graph) indicates that from May 2007 to now China has suffered from double-digit inflation (11.1% annualized). The same calculation also suggests that if the next three months show price increases that on average equal the price increases of the past eight months (around 1% month-on-month) we will have double digit year-on-year inflation in China by May.

The second thing is that the February rate of increase in the CPI was very high (35% on an annualized basis), more than twice as high as the already-high January rate of increase. Because of the big jump in February prices, the numbers for March are likely to be distorted. In fact prices could decline significantly in March (by 1.8% on average) while still maintaining a continuation of January’s 7.1% year-on year CPI inflation. If prices do not decline this month, March 2007 year-on-year CPI inflation will reach 9.1% or more.

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Students in China to get food subsidies

Whenever possible we like to cover the state of education in China and more specifically provide advice to students wanting to study abroad (UK in particular).

It is therefore a sign of the different worlds inhabited by those Chinese students in the UK and the average student in China.

China earmarks more food subsidies to college students [English.esatday.com]

China yesterday allocated more funds to college students as a temporary food subsidy to offset the burden of rising inflation.

According to the ministries of education and finance, the money will be given out "as soon as possible" to students from financially vulnerable homes.

Several days earlier, the two ministries had channeled a subsidy of 189.28 million yuan to students of universities managed by the central government. The size was calculated by 20 yuan per person during each of the four months from March to June.

Local governments had also been directed to allocate subsidies to colleges they manage in accordance with the same criteria.

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Inflation Storm Ahead

The severe storms in China will have serious consequences for firms that reply on brisk holiday trading. However, the more worrying issue is the effect the storm damage will have on food prices.

Jan. 30 (Bloomberg) -- Rain and snowstorms in China have ``severely'' damaged rapeseed, vegetables, wheat and other crops in 16 provinces, hampering the government's measures to increase agricultural production and curb inflation.

As much as 103 million mu (17 million acres) of crops were damaged, including 1.8 million acres that were completely destroyed, and the damage may spread as more storms are expected, the ministry of agriculture said in a statement on its Web site.

China boosted farming subsidies last year to increase food production as meat and oilseed shortages stoked inflation and threatened social stability.

US rate cuts puts the PBC under increasing pressure

China's slapdash approach to economic management that has so far appeared to work in spite of the PBC often not seeming to know what it is doing will come under increasing pressure as recession in the US and perhaps the EU gets closer.

The dramatic rate cut of 0.75 points in the US also brings with it problems. Massive Chinese trading losses on exchange rage movements will also anger the Chinese people.

The loss the Chinese will realise on US paper has been inevitable for years. This policy of buying US paper to keep exchange rates low to boost exports was never sustainable. These losses are in many respect a travesty.

This excellent article outlines the technicalities. It also illustrates very clearly that macroeconomics can get complicated very quickly.

US action adds to pressure on China [FT]

The sharp cut in US interest rates has increased the conflicting pressures on Beijing's management of its economy and its simult-aneous efforts to stem potential losses of billions of dollarsin its foreign exchange holdings.

To keep the currency stable, the People's Bank of China buys almost all incoming foreign currency, and then attempts to "sterilise" the monetary impact by issuing renminbi bills to take the funds out of circulation.

The US cut means China's central bank will pay almost 200 basis points more on the bills it issues at home to manage its currency than it will get on purchases of US Treasuries.

The PBoC pays about 4 per cent on its so-called "sterilisation" bills, while one-year US Treasuries now carry an interest rate of 2.07 per cent.

Both countries are likely to maintain their policy biases in coming months, the US cutting rates, and China lifting them, a trend that will intensify the pressure on Beijing's currency policies.

"Things just got a lot more complicated for the managers of China's economy," said Stephen Green, of Standard Chartered bank, in Shanghai, yesterday.

China does not release the exact makeup of its foreign exchange holdings, nor how they are invested, making it difficult to get a precise reading on their profitability.

But Hong Liang, Goldman Sachs China economist, calculates the PBoC is losing about $4bn a month on its bills because of the turnround in the interest rate differential over the past 18 months.

"The trend is clearly accelerating as the reserves continue to grow faster than GDP," she said.

China has lifted rates eight times since early 2006, to cool an economy that grew by more than 11 per cent last year and, more recently, to combat inflation, which hit an 11-year high in November.

But further use of interest rates is constrained by Beijing's tight management of the renminbi, a policy aimed at preventing it appreciating too rapidly.

The government fears more rate rises could attract speculative capital inflows, adding to already swollen foreign reserves, which stood at $1,530bn at the end of 2007.

Despite this objection, the government's commitment to fighting inflation means further rate rises are inevitable, China economists say.

The PBoC, in expectation of losses on its sterilisation bills, has used other tools in the past year to drain the funds, mainly by requiring commercial banks to leave more money with it on deposit. Chinese banks are required to place 15 per cent of their deposits with the PBoC, at a much lower interest rate than the 4 per cent offered by the sterilisation bills.

The heavy use of this measure has allowed the PBoC to limit losses on its foreign exchange holdings.

Some economists argue the reserve losses are only on paper, but "at some point, that paper loss may result in a fiscal loss", said Brad Setser, of the Council on Foreign Relations. "It certainly represents a fall in domestic purchasing power of China's external foreign assets. Money held in dollars will end up buying fewer Chinese goods in five years than it does now," he said.

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More on China's trade surplus

As always, an excellent post by Michael Pettis. His well written posts save me a lot of work as he always identifies the points and accurately describes them in a technical but still accessible manner.

His blog is certainly the best blog that covers China economics.

The cause of China’s trade surplus [China Financial Markets]

Prime Minister Manmohan Singh is currently visiting China and yesterday he too complained about China’s trade surplus. There is still a debate about the structure of China’s balance of trade. There are at least three reasons commonly cited to explain China’s massive trade surplus.

Read the post to get the three reasons. Pettis concludes:

It may already be too late to adjust easily, and even if it isn’t if the authorities are too wedded to the ideology of gradualism to make a rapid adjustment, so in this case I expect that the end game will occur either in the form of runaway inflation, which would eventually cause a sharp contraction in the money base, or in the form of sharply rising inventory leading to equally sharp cuts in production, which is how overinvestment cycles classically ended in the 19th Century.

I tend to agree. The adjustment costs will be severe. China is not sufficiently developed to withstand a deep crisis and the implications may be very serious.

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TheAtlantic.com: The $1.4 Trillion Question

From the inbox:

This is a 5 page US-centric article by James Fallows that asks whether "The Chinese are subsidizing the American way of life. Are we playing them for suckers—or are they playing us?"

The article begins well with a description of the Blackstone saga and the belief among many Chinese that it is them who are subsiding the US with the Chinese government paying $3 billion for a 8% non-voting share of Blackstone. Since it lost $1 billion recently that deal is not looking so clever after all.

Take this quote and think how it sits compared to the usual press stories you ready about the US-China relationship:

Through the quarter-century in which China has been opening to world trade, Chinese leaders have deliberately held down living standards for their own people and propped them up in the United States. This is the real meaning of the vast trade surplus—$1.4 trillion and counting, going up by about $1 billion per day—that the Chinese government has mostly parked in U.S. Treasury notes.

I would strongly advise reading this accessible article very carefully - it covers all the basics in manner that makes some difficult concepts easy to follow.

The $1.4 Trillion Question [The Atlantic.com]

China Slows as Central Bank Policies eventually bite

The Chinese central bank's attempt to slow the economy and put the brakes on inflation appear to be working (finally).

However, China is far from out of the woods yet (and we must also question whether China really wants to get out of the said woods).

China's trade surplus once again hit a new record last week and China's foreign exchange surplus reached another record at $1.53 trillion at the end of 2007.

China Money Supply Growth Slows as Central Bank Measures Bite [Bloomberg]

Jan. 11 (Bloomberg) -- China's money-supply grew at the slowest pace in seven months, evidence that central bank measures to cool inflation and prevent the economy from overheating are beginning to work.

M2, the broadest measure of money supply, rose 16.7 percent to 40.3 trillion yuan ($5.55 trillion) from a year earlier, the central bank said today on its Web site. The pace slowed from November's 18.5 percent and compared with the 18.2 percent median estimate of 20 economists surveyed by Bloomberg News.

The central bank has been trying to stem the flood of money into the economy from a record trade surplus to slow the fastest inflation in 11 years and curb investment. The bank is likely to take more measures to limit credit because money supply growth is still more than the 16 percent target set for last year.

``Money supply and loan growth will continue to slow through the first half of 2008 as the central bank forcefully implements curbing measures,'' said Sun Mingchun, an economist at Lehman Brothers Holdings Inc. in Hong Kong.

China's foreign-exchange reserves, the world's biggest, rose 43 percent to a record $1.53 trillion at the end of 2007 from a year earlier, today's central bank statistics showed.

As well as six interest rate increases last year, the central bank has raised the amount of money banks must set aside as reserves to a 20-year high and directed banks to limit lending.

``The central bank's tightened monetary policies, especially the frequent window-guidance, have started to bite,'' said Sun. ``Banks have got the message that the government will be firm- handed this year from various government meetings over the past two months.''

China's banking regulator last quarter banned seven banks including Agricultural Bank of China from making new loans, according to the official Shanghai Securities News.

Modelling Regional Inflation in China

Apologies for my recent lack of posts - sometimes academic life can result in lumpy work loads and reading 80,000 word PhDs takes considerable time even if they are related to China Economics.

This paper provides a good example of how academics are approaching the Chinese inflation issue. I have my doubts about the validity of this paper than comes out of the Bank of Finland although I am sure it is competently done.

"Modelling Inflation in China - A Regional Perspective"
ECB Working Paper No. 829
BOFIT Discussion Paper No. 19/2007

Contact: AARON N. MEHROTRA
Bank of Finland - Institute for Economies in
Transition (BOFIT), European University Institute -
Economics Department (ECO)
Email: aaron.mehrotra@bof.fi
Auth-Page: http://ssrn.com/author=355749

Co-Author: TUOMAS A. PELTONEN
European Central Bank (ECB)
Email: tuomas.peltonen@eui.eu
Auth-Page: http://ssrn.com/author=355041

Co-Author: ALVARO SANTOS RIVERA
European Central Bank (ECB)
Email: alvaro.santosrivera@ecb.int
Auth-Page: http://ssrn.com/author=508522

Full Text: http://ssrn.com/abstract=1010629

ABSTRACT: We model provincial inflation in China during the reform period. In particular, we are interested in the ability of the hybrid New Keynesian Phillips Curve (NKPC) to capture the inflation process at the provincial level. The study highlights differences in inflation formation and shows that the NKPC provides a reasonable description of the inflation process only for the coastal provinces. A probit analysis suggests that the forwardlooking inflation component and the output gap are important inflation drivers in provinces that have advanced most in marketisation of the economy and have most likely experienced excess demand pressures. These results have implications for the relative effectiveness of monetary policy across the Chinese provinces.

Inflation hits 11 year high

Articles on the new inflation figure:

China's inflation rate hits 11-year high [Reuters]

BEIJING (Reuters) - China's annual consumer price inflation hit an 11-year high in November, with new signs that price pressures are spreading from food to the broader economy, raising the prospect of more aggressive monetary tightening.

China Inflation Reaches 11-Year High, Trade Gap Grows [Bloomberg]

Dec. 11 (Bloomberg) -- China's inflation accelerated at the quickest pace in 11 years and the trade surplus swelled, underscoring government concern that the world's fastest-growing major economy is at risk of overheating.

Even the new inflation rate of 6.9% masks considerable differences across products - food for example climbed 18.2 percent. Non-food prices rose 1.4 percent. Utility prices rose 5.6 percent.

The miz across this products spells trouble for the poor. Social unrest can not be far away.

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Further tightening of monetary policy

China continues to be concerned with the effects of an overheating economy.

The answer? To tighten monetary policy but what does that really mean?

China is currently worried that inflation that has been rampant in the food sector will spillover into the rest of the economy.

The primary tools that China is employing is tightening of bank lending (growth of bank lending has slowed from 17 to 13% - still high).

Interest rates have risen 5 times but with little effect. The question is how high will interest rates have to go? I suspect a lot higher.

China acts to tighten economy [FT]

China has announced it has shifted its monetary policy stance from "prudent" to "tightening" in another sign that Beijing is concerned about the acceleration of an economy already growing at double-digit rates.

The decision, formally taken at an annual economic conference in Beijing this week, signals growing concern that investment, the prime driver of growth, is picking up pace again on the back of rising construction.

The government is also concerned that inflation, which has so far been confined to food, could spill over into other sectors. The change in language symbolises such concerns and will give policymakers, including the central bank, greater leeway to dictate the lending practices of local financial institutions.

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The government's most important policy tool to keep construction in check is curbing the rate of growth in bank lending, from about 17 per cent year on year so far in 2007, to about 13 per cent in 2008. This will have a limited impact on overall investment, as about half of it is now funded through retained earnings, and only about a third to 40 per cent through bank lending.

There is no sign that profits as a source of funding are about to be choked off, with earnings of listed companies in the Shanghai market rising 74 per cent year on year in the third quarter and by 89 per cent in Shenzhen.

China has already raised interest rates five times this year, mainly in an effort to keep pace with inflation, with little appreciable impact on the real economy.

"You may see more rate hikes, depending on how the inflation figures pan out," said Mr Anderson.

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Statistics: FDI up 13%, inflation hits 11 year high

Two news stories catch the eye today. The more worrying concerns inflation. As this quote states:

China has a history of relatively mild price increases spiralling into double-digit inflation.

This should not be taken lightly. For all the governments pledges to "intervene" to ensure price stability the Chinese government should be warned that getting the cat back in the bag after it has been let out is not so easy. The problems with diesel shortages demonstrate this. Without price increases the suppliers of fuel are making a loss. So economics dictates that they will cease to supply fuel - result shortages. Therefore, it China wants the fuel to flow it needs to increase prices - firms need to make a profit or will shut. Capitalism (from which China has done so well recently) works both ways.

Moreover, there is nothing like a bit of food price inflation to really get the government worried about social unrest. A lack of food more than anything is liable to get people onto the streets. These are relatively large values for such staple foods.

Food prices rose 17.9 per cent in October from a year earlier, with pork up 54.9 per cent, fresh vegetables rising 29.9 per cent, and eggs up 14.3 per cent.

China inflation back at 11-year high[FT]

Chinese headline inflation rebounded to its highest level in more than a decade in October driven by soaring food prices, spurring expectations the central bank will continue taking steps to cool the red-hot economy.

The consumer price index rose 6.5 per cent in October from a year earlier, matching August’s 11-year high, after a brief reprieve in September when inflation dropped to 6.2 per cent.

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He blamed global oil and food price increases and said the government would ensure price stability. ”We have methods to ensure supply, we will take many different measures to stabilise prices,” a report on the central government Web site quoted Mr Wen as saying.

China has a history of relatively mild price increases spiralling into double-digit inflation.

Food prices rose 17.9 per cent in October from a year earlier, with pork up 54.9 per cent, fresh vegetables rising 29.9 per cent, and eggs up 14.3 per cent.

Non-food inflation was 1.1 per cent, affected by the government’s decision to raise tightly controlled pump prices for petrol, diesel and jet fuel by 10 per cent in late October.

That was the first rise in 17 months and came in response to shortages that have spread across the country as refiners cut production in the face of huge losses resulting from the difference between record high crude prices and government-fixed pump prices.

Some parts of the country are still reporting diesel shortages that some have blamed on outlets hoarding supplies in the expectation of another price rise.

Higher oil prices helped push producer price inflation up to 3.2 per cent in October from a year earlier.

Analysts now expect the central bank to continue raising interest rates and to introduce more forceful measures to rein in bank lending, which expanded by the largest margin ever in October.

The central bank has already lifted interest rates six times this year and raised the proportion of deposits banks must hold in reserve nine times to an all-time high of 13.5 per cent.

On a more encouraging note, FDI inflows are higher again. However, such inflows can cause their own problems not least upward pressure on inflation and increasingly large foreign exchange rate reserves.

China's foreign direct investment up 13.2% in Oct. [The China Post]

BEIJING -- Foreign direct investment into China rose 13.2 percent in October compared with the same month a year ago, the government said Monday.

Foreign enterprises invested US$6.8 billion in China last month, the commerce ministry said in a statement on its website.

The figure was up from US$5.3 billion in September. In the first 10 months of 2007, foreign direct investment rose 11.2 percent from the same period in 2006 to US$54 billion, the commerce ministry said.

Last year actual foreign investment in China was US$69.5 billion, down 4.1 percent from 2005.

Foreign direct investment, along with booming exports, are among the top factors resulting in China's massive build-up in foreign exchange reserves.

The foreign exchange reserves, the largest in the world for more than a year, hit US$1.43 trillion by the end of September, according to the most recent data.

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Rising Fuel Prices in China

A round-up of fuel price related articles. This is an important issue - China is investing heavily in Africa to secure oil stocks in the future. This is a problem that may persist for some time.

This statistic shows how quickly things can turn around with this trade switch indicating how much China has grown since 1993.

China is the second-largest crude oil consumer after the US and although it was a net exporter as recently as 1993 it now relies on imports for nearly 50 per cent of its crude supply.

This quote shows clearly the problems that can occur when strict government controls are in place. Something that Taiwan and many other East Asian countries are also experiencing.

The current shortages, particularly of diesel, result from a combination of high global oil prices and strict government controls, causing huge losses for Chinese refiners that must pay more for oil but cannot raise prices at the pump.

With the Olympic games around the corner there is sure to be a lot more column and blogger inches devoted to this subject.

Beijing raises pump prices as shortages bite [FT]

Faced with worsening fuel shortages across the country Beijing raised petrol, diesel and jet fuel prices at the pump by almost 10 per cent on Wednesday, in an effort to boost domestic supplies and exorcise the spectre of social unrest.

The policy reversal came as shortages spread to the capital, which is usually immune from the country’s periodic supply crunches.

But the government is unwilling to allow prices to rise too much because of a morbid fear of spiralling inflation, which has a history of toppling governments in China and is currently running at a 10-year high, above 6 per cent.

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Analysts say the increasingly independent state oil giants are playing a high-stakes bluffing game with the government in which they chase profits by exporting refined products instead of supplying the domestic market.

This has created shortages that force the government to choose between doing nothing and risking incidents like the one in Henan, or raising prices at the risk of triggering a backlash among ordinary citizens that could escalate like the recent protests in Burma, which started as a reaction against a fuel price increase.

“The government will be under enormous pressure to keep fuel prices low at least until after the Olympics next year,” says Gordon Kwan, head of China energy research at CLSA in Hong Kong. “They can’t have sad faces, let alone street riots or fuel shortages, in Beijing with Bush and Putin here to watch the games.”

China hikes fuel prices as long lines form at gas pumps and shortages disrupt trucking [China Post]

BEIJING, China -- China raised gasoline and diesel prices Thursday by about 10 percent to curb demand amid shortages that have caused long lines at filling staions and disrupted trucking in key export areas.

and finally, a China bloggers view of events from 30th and 31st October a good 2 or 3 days before the FT got hold of this story.

Fuel shortage spreads [China Financial Markets]

Hidden inflation? [China Financial Markets]

Certain regions in China are experiencing shortages in diesel fuel. I heard first from my students and then in the press that in parts of coastal China gas stations are rationing the amount of diesel they sell. This often happens when price controls clash with underlying inflation – instead of showing up in higher prices, inflation shows up as shortages.

I believe that the last time gasoline prices were set by the authorities, oil was trading around $60 a barrel. Unless oil prices drop substantially in the near term I would expect that there might be pressure on the government to let gasoline prices rise, thereby showing up in the non-food component of CPI inflation. Perhaps more worrying, to see inflation spread from food to transportation may lead to a rise in inflationary expectations. All eyes will be on October inflation numbers, which I believe should be released in less than two weeks.

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IMF on global growth

China gets a good mention in the lastest IMF news letter.

Emerging Markets Main Engine of Growth[IMF]

China is now the single most important contributor to world growth, in terms of both market and purchasing-power-parity (PPP) exchange rates.

Its economy continues to grow at breakneck speed, turning it into a driving force in the global economy.

Market exchange rates are those prevailing in the foreign exchange market, while the PPP exchange rate is defined as the rate at which the currency of one country needs to be converted into that of another country so as to be able to purchase the same amount of goods and services in each country. Use of PPP exchange rates gives a greater weight to emerging market economies in the global growth aggregates.

China's economy gained further momentum in 2007, growing at 11½ percent, and is expected to grow by 10 percent in 2008. Other emerging markets are also growing strongly. India continued to grow at more than 9 percent in 2007, and Russia grew by almost 8 percent.

In fact, these three countries alone accounted for more than one-half of global growth over the past year. Other emerging market and developing countries have also maintained robust expansions. Rapid growth in these countries counterbalanced continued moderate growth in the United States (see "IMF Forecasts Slower World Growth in 2008").

Looking ahead

Emerging market countries are reaping the benefits of careful macroeconomic management over the past decade and are benefiting from favorable external conditions, including high commodity prices. But there are uncertainties about the outlook.

In China and India, growth may not slow as anticipated if recent monetary policy tightening proves insufficient to cool domestic demand growth. But the main downside risk is that continued turbulence in global financial markets could disrupt financial flows to emerging markets and trigger problems in domestic markets. This is particularly a concern in countries with large current account deficits and substantial external financing needs. And recent buoyant activity and rising commodity prices (see related article on commodity prices) are leading to tightening resource constraints, which could put upward pressure on inflation.

But despite these and other risks linked more directly to the global outlook, the IMF expects emerging markets to remain strong in the foreseeable future.

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IMF on Global Imbalances: What Next?

Simon Johnson of the IMF has a new blog that, as you can imagine, never strays too far away from issues related to China.

In today's post he talks about the impact of Global Imbalances and how they might be corrected. The blog has started well and I hope Simon Johnson can keep it this level of blogging productivity. Given his lofty position one can not help wondering whether he shouldn't have more important things to do. However, putting a cheery face on the IMF could be considered good public relations.

This is a well argued post that I agree with almost entirely.

Global Imbalances: What Next?

I took part in a frank discussion over global imbalances very early Sunday morning, organized by Anton Brender and Florence Pisani of Dexia. The topic was their book on this issue and -- most important -- what could follow, particularly after the summer's financial turbulence.

My main argument was that the first phase of global imbalances is likely over. In this phase, the primary imbalance was between the US current account deficit on the one hand and current account surpluses in oil producing countries, Japan, China and few other places. The main issue, which Anton and Florence make clear in their book, was one of flows, i.e., how to get capital from countries that were saving "too much" (or at least more than they wanted to invest) to the US, which was saving "too little" (or less than it was investing.)

We should of course keep in mind that during this first phase, a number of things changed. For example, initially -- in the late 1990s -- US firms invested more than they saved and this accounted for most of the US side of the imbalance. More recently, since around 2000-2001, US firms have saved more than they invested but US households have reduced their savings. So things change in the nature of this imbalance, and it has in the past been dangerous to make predictions about behavior.

Still, it now appears likely that US households will save more -- after all, few now expect property prices to continue to rise and other asset prices might also be regarded as high. This doesn't have to be a big, rapid or disruptive change, but it will likely raise savings in the US and help take the current account down to 5 1/2 percent (or smaller?) in 2008.

But if the US current account deficit is smaller, what does that imply for other countries' current accounts? Remember, that savings and investment have to add up around the world. So if the US has a smaller deficit and we want to sustain broadly the same level of world growth, either someone else has to come up with a deficit (which is large enough to make a difference) or the surplus countries have to reduce their surpluses.

But oil prices are now unexpectedly high and oil producers, who are trying hard to spend, will almost certainly have large surpluses in the near term than previously thought. Japan has zero or close to zero inflation and growth is not so very strong, so its interest rates remain appropriately low. This will likely prove consistent with a continued surplus -- although this has been driven by high savings in the corporate sector; they have reduced debt levels over the past 10 years so they are now very similar to other OECD countries, but it is not clear that they will now go out and spend more.

Now, contrary to some impressions, China is actually experiencing an appreciation in its real exchange rate -- mostly due to high inflation. In its Multilateral Consultation plan, China expressed the intention of rebalancing the economy more broadly (away from investment and exports and towards consumption), but including exchange rate flexibility. Even so, based on what we have seen in the past few months, a robust Chinese current account surplus is the foreseeable future. This is based on very strong performances, profits and savings in the corporate sector -- really the results of successful development. But still, in the near term, this part of the global imbalances is not getting smaller.

So again, if the US current account deficit goes down, and the surpluses do not go down, whose deficit will go up? This is the very big question of the day. How this question is answered is likely to have a first order impact on global growth.

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Heat in the workshop: Chinese export prices on the rise

FT article looking at how the famous "Chinese price" is coming under increasing upward presure.

What is remarkable is that the last 5 years have seen "deflation" until the recent rises. No wonder Western manufactures were feeling squeezed and were moving production to China in their thousands.

One interesting observation is that the reason prices were so low for so long and why prices have taken so longer to pick up speed is the relocation of factories from the coastal hubs to the less developed regions where there is still a plentiful supply of cheap labour and improving infrastructure.

Here is a quote I never thought I would see:

"We have stopped our sock production because we can't find enough workers."

Even in China the economics of scarcity hold. More importantly there is also a shortage of skilled labour that may be more pressing and requires the Chinese government to invest more heavily in the domestic education system.

Heat in the workshop [FT]

The "China price", that once unbeatable benchmark retailers pay for the products made in the world's workshop, is not what it used to be. Data compiled by statisticians in China, Hong Kong and the US all show that, after at least five years of deflation, Chinese export prices have begun to creep up over the past 18 months.

"China's era of exporting deflation to the world is coming to an end," says Jing Ulrich, Hong Kong-based chairman of JPMorgan's China equities business. "Manufacturers are raising their average selling prices and feel confident they can pass on any future [cost] increases. Pricing power has returned to a number of industries due to consolidation, the closure of smaller producers with poor environmental and safety records and natural attrition over the past half-decade, when many manufacturers faced severe margin compression."

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Jonathan Anderson, an economist at UBS, cites Hong Kong statistics because "they are closest to the Chinese factory gate". These show the China price inflating at about 3 per cent a year.

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The wonder, however, is that the China price has not been accelerating at a much faster clip - as it would have to before China's export juggernaut began to slow. The country's January-September exports grew 27 per cent to $878bn (£432bn, €620bn). As Jim Leonard, a Boston-based trader for East West Basics, a trade sourcing company, puts it: "Volume covers a lot of sins."

One answer to the riddle can be found in southern Jiangxi province. The region is famous for being the cultural homeland of China's Hakka or "guest" people, whose name derives from their itinerant history. But county governments in the area, near where Mao Zedong and his ragged band of peasant rebels began their Long March to power, are now playing host to a new generation of migrants - factory owners from Hong Kong, Taiwan and further afield, all seeking cheaper bases for operations away from China's coastal manufacturing hubs.

"We treat the companies that invest in our industrial park as gods," says Zhong Xuhui, vice-chief of Longnan county. "We assign a government official to serve each big company, helping it prepare administrative documents. Companies in our park don't waste their time and energy on paperwork."

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Labour, land and power costs in the Pearl and Yangtze deltas, for example, have been rising at double-digit rates. There have been exponential price increases for essential raw materials such as copper and petroleum-based plastics. Now China's general level of inflation is setting off alarm bells in Beijing, having touched 6.5 per cent in August.

Adding to these pressures, the renminbi has appreciated by 7 per cent against the US dollar ever since it was allowed, three years ago, to drift from its mooring of Rmb8.30 to the greenback.

Mr Anderson argues that this last phenomenon is largely academic in export sectors where factories are merely turning around imported - and therefore often US dollar-denominated - components. But that has not stopped exporters from trying out the excuse anyway, especially last year when the renminbi crawled past the Hong Kong dollar, which is still pegged to its US counterpart at a rate of HK$7.80. And why not, asks Mr Leonard, who sources houseware products for American retailers. "You'd be crazy not to ask."

"Increasing labour and raw material costs are having a significant impact on my business," says Yu Zhonghua, owner of a hat and sock factory in Yiwu, in the Yangtze River Delta. "We have stopped our sock production because we can't find enough workers. Three or four years ago, we could easily find workers to make socks for Rmb900 [$120, £59, €85] a month. Now, even if we pay Rmb1,400-Rmb1,500, they think the job is too tiring and the pay not enough. Other small sock makers face the same situation."

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The fact that the China price has barely budged relative to its underlying cost pressures is partly a reflection of how fat life was for China-based exporters - most of them owned by Hong Kong, Taiwan and other overseas investors - through the 1990s and the first few years of this decade. Stephen Green, a Shanghai-based economist with Standard Chartered, recently visited some of his bank's manufacturing clients in Shenzhen, across the border from Hong Kong, and says that net furniture margins there have fallen from an "unnaturally high" 30 per cent a few years ago to a more reasonable 10 per cent.

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"It's hard to find skilled workers here [in Longnan]. That hurts our efficiency," he adds. While it takes three months to train a worker in Longnan, highly skilled workers can be poached from the Pearl River Delta's much deeper talent pool. The monthly wage rates at Top Form's three China factories sum up their capabilities: Rmb1,600 in Shenzhen, Rmb1,200-1,300 in Nanhai and Rmb1,000 in Longnan.

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"[Manufacturing] activity is moving away from the coast," agrees Bruce Rockowitz at Li & Fung, a trade sourcing company with 16 offices on the Chinese mainland. "Where the product is today is not where it was yesterday. You can't look at [China] as one country. We look at it as a multi-country sourcing area."

Yet change beckons even for relatively new-found destinations such as Longnan. "In the beginning, we didn't choose what type of companies came here," Mr Zhong, the county's vice-chief, says in his thick Hakka accent. "But now we don't want companies that need lots of labour, consume too much electricity or occupy large tracts of land. We now welcome capitalintensive and high-tech companies."

When Top Form arrived in Longnan, hundreds of people would queue outside its gates looking for work. Now a gathering of 30 or 40 workers would be considered a good-sized crowd. As Mr Ho says: "We can never stick to one place for good. For now it's Jiangxi. But Jiangxi may not be competitive in five years' time. Maybe our next factory will be even further inland."

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Inflation in China - a global issue?

Good summary of the causes and consequences of an increasingly inflationary China.

Thomas Pally has nailed down the feedback mechanisms at work and also highlights the influence of stock and property asset bubbles that are working against current Chinese efforts to curb inflation.

It is inconceivable that China is not aware of these issues - the question then is how much more will the currency appreciate and will it be too little too late.

China's inflation policy stirs the world [Asia Times Online]

China's government recently announced that inflation hit a 10-year high of 6.5% in August. This increase in inflation is directly related to global trade imbalances, yet China is trying to control inflation without addressing that problem.

That carries two consequences. First, it is doubtful this strategy can work, which likely signals rising Chinese inflation. Second, the strategy aims to shift the onus of global trade adjustment on to the United States, which may come back to haunt China and the global economy.

China's current inflation is a textbook case of prolonged undervaluation of a fixed exchange rate in tandem with export-led growth. As such, significant exchange rate revaluation should be a central element of its anti-inflation policy.

However, instead of making such an adjustment, China's authorities are hoping to control inflation by exclusive reliance on tighter domestic monetary policy. It is doubtful this strategy can succeed because it leaves intact the inflationary impulse from China's trade surplus and undervalued exchange rate.

One important contributing factor in China's inflation is the rise in global commodity prices, including oil and base metals, which are now feeding through into prices. Food prices are also on the rise because of increased global prices for wheat and corn. Furthermore, China has been hit by a virulent outbreak of swine flu that has decimated its hog population, driving up the price of pork, which is China's favored meat.

In coastal areas, which have been the hub of China's export-led growth, wages have started going up in response to rising living costs and to the gradual elimination of extreme surplus-labor conditions.

Most important, China is beset by significant asset-price inflation that borders on an asset-price bubble. This asset-price inflation is the product of massive expansion of the money supply caused by China's trade surplus and foreign-investment inflows.

Dollars earned by Chinese exporters have flowed back to China and been converted into local money by the central bank, which has bought them at the fixed exchange rate to prevent appreciation.

Holders of these money balances have then bought stocks and real estate to gain higher returns and to protect against potential inflation. This has driven up real-estate prices, triggering a massive construction boom that has in turn caused inflation.

The implication is clear. China is suffering from imported inflation caused by higher global commodity prices, domestic-demand inflation caused by excess demand in export industries, and asset-price inflation due to an increased money supply caused by China's trade surplus.

The undervalued exchange rate is a key culprit, since it contributes to excess demand in export sectors, and it also drives the money-supply increase via the trade surplus - which has hit record highs in 2007. That suggests significant exchange-rate revaluation should be a central component of China's anti-inflation strategy.

Moreover, revaluation would also diminish the impact of global commodity-price inflation because commodities are priced in US dollars, so that a revaluation lowers their domestic price in yuan.

Instead, China has chosen to rely exclusively on monetary tightening, raising interest rates and reserve requirements on bank deposits. This strategy is unlikely to work. First, there is already significant asset inflation and extensive debt-financed speculative investment, which means the monetary authorities are constrained from sufficiently meaningful tightening for fear of triggering a financial collapse.

Second, raising reserve requirements on bank deposits lowers the return on deposits and makes them less attractive. That provides an incentive for depositors to spend their money or invest elsewhere, which spurs more inflation.

Third, and most important, continuation of China's undervalued exchange rate means continuing trade surpluses and large inflows of foreign direct investment, which means further monetary expansion in China.

Putting the pieces together, the picture is one of rising Chinese inflation, and with that comes the risk of inflation-triggered social and political problems. In this regard it is worth recalling that the Tiananmen Square disturbances of May 1989 were in part caused by industrial-worker unrest over erosion of living standards by inflation.

As for the global economy, China's anti-inflation policy and continued refusal to adjust its exchange rate place the burden of trade-imbalance adjustment squarely on the US. This adjustment will likely happen via recession, and there are signs that process may already be under way. This is a sub-optimal approach that could injure all.

Thomas Palley is founder of the Economics for Democratic and Open Societies Project.