KEY POINTS:
What makes China's worst inflation scare in a decade doubly dangerous is its deceptively harmless appearance.
Many analysts are inclined to write it off as a temporary food shortage, when it actually stems from a serious money glut.
The annual inflation rate zoomed to 5.6 per cent last month, the highest in more than 10 years. Food prices jumped 15 per cent, driven by a 45 per cent surge in meat and poultry.
Non-food prices, by contrast, remained well contained, rising just 0.9 per cent from a year earlier.
It might be erroneous to make light of China's inflation challenge just because the gains are occurring in food, rather than "core" - or non-food - prices. It might be equally facile to view the surge in inflation as transient, caused by supply shocks such as floods and the "Blue Ear", a respiratory illness that has killed thousands of pigs in China.
As Liang Hong, an economist at Goldman Sachs Group in Hong Kong, puts it, "although supply-side disruptions may lead to upward price pressures, the buoyancy of demand plays a key role in determining actual price movements".
Surplus liquidity in China - the deluge of money entering the country through its record trade surplus - is now showing up in food costs, which account for a third of the Chinese consumption basket.
And just as monetary authorities around the world have been forced to respond to high oil prices by raising interest rates, the People's Bank of China, too, will have to come up with a credible monetary-tightening program to deal with expensive food.
"While elsewhere liquidity is sharply contracting as sub-prime problems spread, China is still experiencing excess liquidity," says Jing Ulrich, the Hong Kong-based chairwoman of China equities at JPMorgan Chase & Co.
Chinese interest rates have risen three times this year. On six occasions the central bank has asked lenders to set aside larger reserves. All of this has been grossly inadequate.
UBS AG economist Jonathan Anderson says that unless the pace of the central bank's foreign-exchange accumulation slows, China can keep tightening banks' reserve requirement by 50 basis points every month for two years with no effect whatever on their present liquidity balance.
China's policy options look increasingly limited.
A major revaluation in the yuan is probably the only course left now to ensure that the Chinese economy doesn't end up as seriously overheated as it was in 1994.
As long as the yuan remains undervalued, China won't increase interest rates significantly because it might attract even higher quantities of speculative capital inflows through, among other routes, over-invoicing of exports.
And that may give a further unwarranted boost to money supply, which grew 18.5 per cent in July, the fastest pace in more than a year.
The Chinese Government seems to think that the correct way to tackle food-price inflation is to "stoke the farmers' enthusiasm in raising pigs," which is what it seeks to do by subsidising as much as 80 per cent of the cost of insuring sows.
This won't make an iota of difference. Even if pork prices stabilise, inflationary pressures will simply shift, perhaps to wages and services. The current subdued pace of gains in non-food prices may also alter quickly.
The case for aggressive monetary tightening is compelling.
China's stock market, the world's best-performing this year, is already a bubble. If more and more Chinese pull money out of their bank accounts to buy equities, hard-landing risks for investors will only increase.
The authorities in China simply can't afford to be fooled by the benign facade of the inflation statistics.
- Bloomberg
