China conquers inflation--Premier Wen says so (and what does that mean?)

06/24/2011 6:47 pm EST


Jim Jubak

Founder and Editor,

China has beaten inflation. How do we know? Chinese premier and Communist Party secretary Wen Jiabao said so in an Op-Ed piece running in the Financial Times today. “We are confident price rises will be firmly under control this year,” he wrote.

Is it true? Can China really have conquered inflation even though the annual inflation rate stepped up to 5.4% in May from 5.3% in April?

It’s good to be skeptical about any government’s inflation claims, including Wen’s. Governments collect and calculate their own inflation numbers and they’ve been known to cheat when it serves their political purposes. (It’s sort of like a football game where the team with the ball can decide what qualifies as a touchdown.) Nobody who pays the family bills in the United States, for example, believes that the core inflation rate is really just 1.5% as the government claims. In Argentina where the official rate of inflation is just 3.2%, it is now a crime, punishable by a hefty fine, to publish a different inflation estimate. Private economists estimate the inflation rate is actually 23.5% and headed higher.

Knowing that this year marks national celebrations of the 90th anniversary of the Chinese Communist Party and that the country is facing an important leadership transition in 2012-2103, it is reasonable to wonder if China might be cooking the inflation books.

But in looking for the truth of what Wen wrote, it’s important to pay attention to exactly what he claimed. He didn’t say that prices won’t continue rising or even that the 5.4% inflation rate in May would be the top for the year. What he said was the government policies to control inflation are working and that the government will have inflation under control this year.

And that isn’t too far from what non-government economists are predicting. They see signs that industrial production growth is moderating and that inflationary pressures at the wholesale level are easing. The majority opinion right now is that inflation will peak sometime in 2011 at around 6% and then start to decline.

For investors I’d argue that confirming the absolute truth of Wen’s victory statement isn’t that important over the next 12 to 18 months. If the government starts to behave as if it believes inflation has been conquered—even if it hasn’t—over that time period China’s financial markets will respond as if that belief is true. So if the People’s Bank of China stops raising interest rates after another hike or two, if it stops increasing bank reserve requirements after another move or two or three, if the government declares victory in its battle to damp new loan growth, then in the short term China’s stock markets will climb because the fear of higher rates, higher reserve requirements, and tighter loan restrictions will stop weighing down stocks. The central bank has raised reserve requirements 12 times and interest rates four times since the beginning of 2010.

(In the longer term, if China really doesn’t have inflation under control, the People’s Bank will have to take more drastic steps in 2013. Which is why many economists peg 2013 for the real risk to China’s economy.)

It’s certainly no surprise that stocks in China rallied on Wen’s statement. The Shanghai Composite Index climbed 2.2% at the close for the market’s biggest gin since February 14. The index, which is still down 10% from its April 18 high, rose 3.9% for the week. Stocks in the Shanghai index trade at 12.8 times forward earnings per share against a 15.9 multiple at the end of 2010.

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