Inflation Threatens China's Growth

China is seeing the highest price increases in over two years, and this has officials worried. While the official consumer inflation rate was 4.4% for October, a 10% rise in food prices is having a huge impact on poorer households. The domestic media is filled with stories of hoarding by both producers and consumers.

The government has responded with a small interest-rate increase and some hikes of the reserve requirement, though rates on demand deposits have not budged at all. More action is needed. A resolute drive to slow growth of the money supply will stop the hemorrhaging of household savings due to inflation. As an added bonus, it may also wean China off of its heavy dependence on investment-driven growth.

The recent bout of inflation may seem mild in comparison to the double-digit price rises in the 1980s and '90s. But the social impact may be almost as severe. According to research by a Chinese government think tank, poorer households now face inflation that is twice the overall rate because their consumption basket is dominated by food items, which have seen the most rapid price increases. So even though wage gains seem robust, many households are seeing flat or negative increases in purchasing power.

Household savings have also been eroded by government policies to control deposit interest rates. After the recent 0.25-percentage point lending-rate hike, the rate paid on demand deposits did not budge. Even without inflation, depositors are paid artificially low rates because the government prevents banks from setting their own deposit rates. In times of inflation, households, especially poorer ones with money mainly in demand deposits, suffer negative returns on their savings.

Savings in demand-deposit accounts today yield negative returns after adjusting for inflation, for a real return of about -4%. Even net of inflation, deposits in a one-year time deposit earn -2%. Meanwhile, banks are earning large margins, and borrowers of medium- to long-term corporate loans, which tend to be state-owned or state-dominated firms, are borrowing at an inflation-adjusted rate of about 2%. Given that households currently have more than 11 trillion yuan ($1.7 trillion) in demand deposits, an annual inflation rate of 4% this year would in effect see the transfer of over 400 billion yuan ($60 billion) from these households to banks and corporate borrowers, both dominated by the state.

This erosion of poor households' purchasing power goes directly against the goal of "raising the income of medium and low income urban and rural residents," as outlined by the Party plenum last month. Given that nominal wages for a large number of households remain relatively flat, continual inflation alone will drive many into destitution. The pressure from negative earnings on savings has driven richer households to speculate in the real estate and stock markets. Rising inflation has further incentivized all households to begin stockpiling food and commodities such as gold. Food hoarding, if sufficiently widespread, can further increase inflationary pressure.

Although inflation might have been boosted by some recent supply shocks, the rapid expansion of the money supply in recent years, especially the spectacular explosion of lending last year, is the root cause. Thus, a key ingredient of future inflation fighting will be to slow down substantially the expansion of money supply.

In the past, the Chinese government has successfully stifled inflationary pressure via the imposition of a resolute credit ceiling on banks. Today, regulators would also need to monitor closely the expansion of trust products and the inflow of hot money. The People's Bank of China and the China Banking Regulatory Commission have all the tools necessary to fight inflation. A combination of interest rate hikes, a credit ceiling, a freeze in trust product issuance and aggressive sterilization of foreign exchange inflows can halt inflationary expectations and stop the erosion of household savings. China's top leadership, however, needs to make clear its collective determination to fight inflation in order to give these measures credibility.

To be sure, the sudden slowdown in credit expansion will cause illiquidity in some investment projects and slowed real-estate construction. Nonperforming loan ratios may rise as cash-starved projects become unable to meet interest payments.

In the medium term, however, the policy will pay benefits. Macroeconomic retrenchment credibly commits the government to both low inflation and a less investment-intensive growth path by cutting off liquidity from a large number of projects. Local authorities will learn that they can no longer pursue growth based mainly on adding new investment projects financed by bank loans and bond issuance.

In the mid- to late-1990s, cash-starved local authorities became much more open to privatization, allowing private firms to dominate sectors previously monopolized by state-owned firms. The competition that resulted was good for the economy. Repeating that process will not be painless, but past experience has shown that resolute macroeconomic retrenchment can put China on a healthier path for growth.

Mr. Shih is associate professor of political science at Northwestern University and author of "Factions and Finance in China" (Cambridge University Press, 2007). A related editorial appears today.
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