The Downside to China’s Massive Growth: Inflation

chinese growthChina is continuing to expand at rates well beyond the world’s other industrialized powers.

The Organization for Economic Cooperation and Development (OECD) predicts that China will grow its economy by 9.7% in 2011 and 2012, which, while lower than the previous rates, is still well above the global average of 4.2% and 4.6% in 2011 and 2012, respectively. In the third quarter, China’s GDP increased 9.6%.

I view the growth of China over the past decade as akin to the Industrial Revolution that started in the United Kingdom in the 18th century and spread to Europe, the U.S., and globally.

Yet, with all the growth come rising prices or inflation. The consumer price index (CPI) was at a sizzling 5.1% in November, up from 4.4% in October. China has not seen inflation at these levels in over 25 years. The target is three percent, so inflation is clearly a problem that is serious and will require higher interest rates down the road.

Prices across the board have been rising in the country. Food prices are surging across the country due to the higher commodity prices. In October, food prices surged 11.7%.

The reality is that, when a country is growing at the rate China has been, it is not unreasonable to see inflation. The country is placing a cap on essential foods such as cooking oils to try to help the many poor people.

Real estate values, while rising at a lower rate, continue to move higher despite the government’s efforts to tighten the flow of money via higher bank reserve ratios. China increased the bank’s reserve ratio to 18.5%, representing the fifth increase in 2010 and the third in over a month. This does not appear to be working and the government may need to increase interest rates to dampen the lending demand.

China estimates that it has targeted about US$1.05 trillion in bank lending in 2011, which still appears to be relatively high, but lower than the expected $1.35 trillion in 2010. Some economists feel that the lending should be in the US$975-billion to US$1.0-trillion range for 2011.

In what I view as a bold move, China decided to increase the top range of its inflation target to four percent from the previous three percent. Imagine the Federal Reserve doing this!

In my view, this strategy indicates to me that the Chinese policy makers there are less inclined to tackle surging inflation via higher interest rates; they would rather increase the target to absorb it. Yet, with inflation surging to a whopping 5.1% in November, the government has much work ahead of it.

Nonetheless, my gut tells me that higher interest rates will likely be around the corner in China.