The Hindu Business Line : China faces food prices driven inflation

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Mumbai Feb. 3 The most important of the Chinese fourth quarter figures released recently was inflation, which rose from 1.9 per cent in November to 2.8 per cent in December, the highest since February 2005.

Food prices boost inflation, not only in India but in China too. But for China, inflation has implications vastly different from what it is for India.

Inflation in China is important, not because of interest rates, but because it raises the risk of faster moves in the currency (Renminbi - Rmb), Macquarie Research stated in a report. There has been pressure on China to revalue its currency, but the response has been slow.

Rising food price inflation could be the key that was missing in 2006 for making the currency move faster, an expert said.

Food prices do matter for policy. As the rise in inflation was because of food prices, and as with oil, central banks usually try to look past shifts in inflation caused by volatile food prices.

But China's central bank (PBC) could view the development differently - indeed, from a currency point of view, argues Macquarie Research.

Single biggest item

Food is still the biggest single item in China's CPI basket, having a weightage of around 30 per cent. Given that grain prices in China are being pushed by the broader lift in global soft commodities prices, the spike might not be short-lived.

The last bout of inflation in China, in 2003-04, was also due to food prices and the PBC did react then, pushing up (eventually) interest rates. By depressing real interest rates in China's banking sector, the rise in the CPI risks further inflating China's stock market bubble, the report argued.

It may be pertinent to remember that in October 2004, deposit rates were increased by 27 bps in part to stem a fall in deposit growth, which was forcing property prices up. At that point though real interest rates for depositors was already negative.

Now deposit growth has also slowed, with money this time flowing into the stock market; and yet, in recent months, real interest rates have been positive. Now that they are turning negative the PBC will worry that the outflow of deposits will only increase, further boosting already high share prices.

Impact on currency

So, the real significance of rising inflation is not for interest rates but for the currency, Macquarie argues adding that faster appreciation would reduce inflation by easing the cost of grain imports, and also cutting China's link with the surge in global soft commodity prices.

While officials are likely to use administrative measures in the first place to dampen food prices, Macquarie Research is forecasting a 5 per cent change in Rmb.

But continued inflation would raise the risk of a faster move and this clearly benefits asset plays in China, the report asserted.