China’s economic transition & inflation shock Xu Sitao Chief Representative, China, The Economist Group Director, Global Forecasting, China,, Economist Intelligence Unit

Key points China’s inflation scare Asset bubbles: causes, policy measures and implications Policies to improve social welfare Risk scenarios & Investment implications

3 Diagnosing inflation Short term concerns focused mostly on food. Supply shocks could send prices higher; PBOC’s target (4%) looking hard to achieve The impact of food prices is over-estimated but the effect of services is under-estimated; the net-effect is under-estimation of inflation Source: EIU & CITI Factor price normalisation will put upward pressure on prices for electricity, water, other utilities, wages and cost of capital etc.

China’s exit strategy is being executed

Discussion on inflation, labor market & demographic dividend Inflation, if mainly caused by food, would benefit farmers, but urban poor would be worse off, Is inflation caused by demand or supply?

Factor price normalisation is underway What are factor prices? Why is normalisation good for China? Will normalisation result in inflation? Examples: fuel prices, Hukou system, interest rate deregulation Sequencing Will inflation scare affect normalisation?

Housing market remains robust despite repeated anti-speculation policies Strong housing market is being underpinned by lack of other investment choices & liquidity Recent policies in Beijing tighten scope for non-residents to enter market Other policies aim to reduce leverage Shanghai and Chongqing are experimenting with property taxes Beijing – the only city to pledge price reductions of properties

“China is Dubai times 1,000, if not a million.” --- James S. Chanos Erdos, Inner Mongolia Is this the end of the Chinese economic miracle?

Why short China… (according to James Chanos) Land prices surged faster than property prices in some Tier 2 cities. This is backed up by Ministry of Land & Resources data for recent years. Therefore, we expect margin pressure for developers that entered such Tier 2 cities in recent years. Oversupply approaching; Tightening measures extended to Tier 2 cities. Consequences of bubble bursting (banking sector, related industries, consumers, external impact…)

China’s 12 th Five-Year Plan: Shift: from quantity of growth to quality of growth and sustainable development 1/3 of PM Wen’s Govt work report speech focused on livelihood of common people Pledge to significantly increase stock of low income housing Reiterate inflation target of 4%

Prepare for Currency appreciation RMB appreciation occurring in both real and nominal terms Real appreciation (China’s tolerance of inflation) will take center stage the next a few years A rise in the value of the RMB is consistent with factor price normalisation

Pros Trade surplus shrinks but is still significant in absolute terms Foreign reserves rise despite promotion of outbound investment Politicization of issue in US: House of Reps Currency Reform for Fair Trade Act; Krugman’s “Taking on China”; Samuelsson’s “Stand up to China” Growing international pressure on China to implement “exit strategy” and support global rebalancing (especially after the quake in Japan) Without exchange rate adjustment, asset bubbles may grow RMB Revaluation – Ongoing debate (in the wake of shocks from oil and quake) Cons Revaluation hampers recovery of export industry RMB is already appreciating against the Euro on trade-weighted basis due to sovereign risk Widening inflation differentials between China and the US will result in a stronger RMB in real terms Labor shortages and price reforms will increase pressure on thin export profit margins China should not have to “pay” (by revaluation) for global imbalances arising from irresponsible monetary policies in other countries

A Chinese Prescription: A more open capital account while a relative stable RMB RMB’s is likely to appreciate less than the market has discounted China will come up various creative ways of exporting her vast savings Interest rate reregulation is imminent

Discussion & debate on fiscal reform Is China a high-tax country? Likely changes on personal income tax (why so much attention?) Discussion on property taxes The link between fiscal reform and financial deregulation Goalpost of public finance reform Political and social factors affecting tax cut

Risks, policy responses & Unintended consequences Risks of stagflation in the developed countries and heightened inflation in the emerging world; Contradiction between housing-for-the-people and local governments’ dependence on revenues from property; Forced appreciation of the RMB, triggered by QE3 (Japan’s experience in the ’80s) when China is facing persistent upward pressure on labour wage rate