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The Right Way to Beat Chinese Inflation

WASHINGTON, DC – High inflation is threatening social stability in China, soaring from 3.3% in March 2007 to 8.3% in March 2008. As a result, the People’s Bank of China has raised interest rates substantially and increased banks’ reserve requirements. The trick for the Chinese government will be to quell inflation in a way that does not compromise its long-term goal of continued strong economic growth. The risks are high.

China’s accelerating inflation reflects a similar climb in its GDP growth rate, from the already high 11% in 2006 to 11.5 % in 2007. The proximate cause of price growth since mid-2007 is the appearance of production bottlenecks as domestic demand exceeds supply in an increasing number of sectors, such as power generation, transportation, and intermediate-goods industries. 

Sustained robust growth and rising aggregate demand have also caused production bottlenecks outside of China, most notably in the agricultural commodity and mining sectors, which have helped lift oil prices to more than $100 per barrel. Adding to these woes are two other inflationary factors: first, Porcine Reproductive and Respiratory Syndrome (PRRS, or “blue-ear disease”) has been killing pigs – China’s main meat source – nationwide, and, second, terrible storms in January reduced the supply of grain and vegetables.

In these circumstances, continuing to raise borrowing costs would be a mistake. To be sure, the prolonged rapid increase in Chinese aggregate demand has been fueled by an investment boom, as well as a growing trade surplus. Thus, lowering inflation would require reducing the growth rate (if not the level) of these two demand components. But Chinese policymakers should focus more on reducing the trade surplus and less on reducing investment spending – that is, they should emphasize renminbi (RMB) appreciation over higher interest rates to cool the economy.