During the first five months of this year, China’s CPI growth was range-bound between 4.9% and 5.5% since breaking through the high-inflation threshold of 5% in November last year. Due to such signs of stability, some market participants had begun to expect inflation to be brought under control by tightening measures, even though consumer prices remained at elevated levels. However, CPI soared to a three-year high of 6.4% in June and prices also increased 0.3% over the previous month, triggering worries that inflation would worsen. The jump in inflation in June was mainly attributed to food prices in general and pork prices in particular. Hence, food costs have become the bellwether in CPI fluctuations.
I. Food costs – dominated by cyclical factors
Food price is without doubt the main driver of CPI growth. In the first half of this year, CPI averaged 5.4%, a rise of 2.1 percentage points over last year’s annual average of 3.3%. Food costs accounted for 1.4 percentage points, or two thirds, of this increase, soaring to 11.8% in the first half of this year from an annual average of 7.2% for 2010. More important, food price has increasingly greater impacts on inflation. In June, food price jumped 14.4%, compared with an 11.7% growth rate in May and accounting for 0.8 percentage points of the 0.9 percentage points, or 89%, increase in CPI from May to June. In other words, food price accounted for nearly 90% of the rise in inflation in June. Therefore, understanding the nature and features of food price fluctuations has become the key to determining future inflation trends.
It should be noted that food price has been a main driver of CPI growth for a long while. According to the National Bureau of Statistics, over the last decade the average annual rise in food price reached 5.1%, 3 percentage points higher than overall CPI and accounting for 1.63 percentage points, or 78%, of overall CPI growth. Clearly, food price has decisive impacts on inflation. Due to its importance in influencing inflation, food price has contributed to over 70% of CPI growth during both low-inflation periods and high-inflation periods. Most people do not realize the magnitude of this impact during low-inflation periods only because the average growth rate in food prices has been only 1 percentage point above overall CPI when inflation is mild. On the other hand, during high-inflation period, food price rise rapidly and register a growth rate that is 6.5 percentage points above overall CPI growth, propelling the rise in inflation rates.
Nevertheless, food price fluctuates and is highly cyclical. Over the past ten years, food price experienced three major cycles. The first cycle took place between 2001 and 2004, during which the growth rate in food price rose from practically unchanged in 2001 to 9.9% in 2004 and subsequently dropped rapidly below 3%. The second cycle took place between 2005 and 2008, during which the growth rate in food price skyrocketed to 14.3% in 2008 from 2.3% in 2005 and subsequently dived below 1% following the financial crisis. The third cycle is currently ongoing and dates back to 2009, during which the rise in food price soared to 14.4% in June of this year from 0.7% in 2009. At the peaks of these three cycles, food price drove CPI higher by 3.2, 4.6, and 4.3 percentage points, accounting for 82%, 78%, 67% of overall CPI growth, respectively. Although their contribution appears to be diminishing, food prices have consistently accounted for over two thirds of CPI growth. There are three salient features in this latest food price cycle.
The first feature is the key role that the soaring pork price have played. In contrast to the last cycle which was driven by grain price, the latest cycle was led by pork. Last year, due to the relatively low prices of pork (the ratio of pork/grain prices is lower than the breakeven point of 6:1) and the outbreak of disease, the number of live pigs decreased 1.2%, exacerbated by mismanagement in market channels. As a result, the quantity of pork supplied on the market dropped 0.5% in the first half of this year, compared with an average annual growth rate of 5.7% between 2008 and 2010. Consequently, in June, pork price rose 57.1% YoY accounting for 4.6 percentage points, or 30%, of the rise in food prices. Clearly, pork price has become one of the main reasons of food price fluctuations. Not only has the rapid and excessive rise in pork price directly lifted CPI by 1.37 percentage points, it also has the potential of raising costs for food processors and retailers that count pork as their raw material, pushing inflation higher still. The dramatic rise in pork prices has undoubtedly become the first and foremost driver in this latest food price cycle.
The second feature is the impact of abrupt climatic changes including frequent floods and droughts. In the second quarter, extremely severe droughts in the Yangtze River caused the demise of lots of fish and considerably curtailed the output of aquatic products. As a result, supply declined and prices rose. Aquatic products have a similar weight with pork in the CPI index, and its price rise of 13.9% in June lifted CPI by 0.32 percentage points. By contributing 1.1 percentage points to the increase in food prices, the rising costs of aquatic products have become another major driver in this latest food price cycle.
The third feature is the impact of the rapid rise in food import price. According to the Food and Agriculture Organization of the United Nations, its global food price index reached 238 in February, an all-time high since the agency started monitoring food prices in 1990 and 11.5% higher than the 213.5 points reached during the peak of the 2007-2008 food crisis. Wheat prices doubled in six months, pork prices rose 25% in a year, while sugar reached a 30-year high. Although the global food price index in June was marginally lower than the peak reached in February, it was still 39% higher compared with the same period last year. Due to the rise in global food prices, import prices of food staples denominated in U.S. dollars rose significantly in the first half of this year. The prices of grain, soybean, cooking oil, and dry fruits rose 43.9%, 30.4%, 40.3%, and 18%, respectively. The 5% appreciation of the RMB against the U.S. dollar since the beginning of this year is obviously ineffective in mitigating the transmission effect of rising global food prices on domestic CPI.
Nonetheless, it should be noted that the current rise in food prices cannot be attributed to cyclical factors only, as some structural factors are also playing a role, especially when it comes to grain prices. For a long time, the Chinese government has promised to purchase excess supplies at pre-determined prices. As a result, grain prices have been in a long-term upward trend, even moving in opposite direction with food prices at times. For instance, during the global food crisis between 2007 and 2008 when global grain prices skyrocketed, domestic grain prices rose at annual rates of 6.3% and 7% even though domestic food prices rose 12.3% and 14.3%. On the other hand, when global grain prices are relatively stable, domestic grain prices tend to rise consistently. For example, when global grain prices started declining in 2009, domestic grain prices rose 5.6% even though domestic food prices only rose 0.7%. In addition, in June, food prices rose at a fast and furious rate. However, in spite of dramatically higher global grain prices, domestic grain prices only rose at a rate of 12.4%, which was basically unchanged from the growth rate of last year. Therefore, for both food and grain which is the most heavily weighted item in the CPI index, prices are mainly influenced by structural factors even though cyclical factors are also a determinant (for instance, the rise in grain prices last year was greater than that of the 2007-2008 period). China’s agricultural policy has created a special mechanism that helps maintain consistently higher prices of grains. Although the magnitude of grain price growth was 100% greater than that of the CPI during the last five years, such price changes remain a sort of structural fluctuation that is mainly attributable to the supply and sales mechanism of grains.
Food production costs, especially agricultural production costs and labor costs, are another structural factor that influences food prices. According to China Industrial Information, starting last year, the growth in prices of factors of agricultural production has picked up pace. At the end of March of this year, prices of the ten main factors of agricultural production rose 6.9% from the same period last year. Fertilizer prices rose 7.2%, mechanical oil for agricultural production rose 8.9%, feedstuff rose 5.8%, and agricultural production services rose 6.3%. Meanwhile, in the first half of this year, salary income of rural residents drastically rose 20.1% from the same period last year, considerably outpacing labor productivity growth in the manufacturing sector. Although this dynamic would help narrow the income gap between rural and urban areas, in the short term, such high growth rates will surely exert more upward pressure on food prices.
To summarize, as the main driver of current CPI growth, food prices are influenced by cyclical as well as structural factors, with cyclical factors being the major determinant. Furthermore, to the extent that the impact of cyclical fluctuations on food prices can be eliminated, food prices will be adjusted to a reasonable level and rising inflation will be brought under control.
II. Non-food prices – determined by structural factors
In contrast to food prices, non-food price fluctuations are mainly determined by structural factors, especially changes in costs. Non-food prices rose only 1.4% last year, but its rise accelerated to 2.7% in the first half of this year, lifting overall inflation by 1.9 percentage points and accounting for 35% of the rise in CPI. Although non-food prices rose only 1.3 percentage points faster than last year, they represent about 70% of CPI weights, lifting CPI by 0.91 percentage points and accounting for 43% of the rise in inflation in the first half of this year. Clearly, while food price increases have a massive impact on living standards, the effect of non-food prices on CPI is far from negligible. Two items in particular influence non-food prices considerably.
The first item is residential, including utilities such as water, electricity, and fuel, residential rent, and construction and renovation materials, factors that are greatly influenced by real estate prices. As property prices rose considerably in the past two years, residential prices increased 4.5% last year, lifting CPI by 0.68 percentage points and becoming the second main driver of the index after food prices. In the first half of this year, the rise in residential prices accelerated to 6.3%, lifting overall price level by 0.95 percentage points and accounting for 18% of the rise in CPI. This impact is comparable to that of pork prices on CPI. Many people do not feel strongly about the rise in residential prices only because the rise was not as rapid as that of pork prices and people are less sensitive to non-food prices. However, given the significant weight of residential prices in CPI and the underestimation of housing consumption services, the impact of residential prices on private consumption and purchasing power should be no less than that of pork prices, which are considered as the main culprit of inflation.
The second item is services, including medical and health, transportation, communication, entertainment, and education and cultural services as well as parts of the residential items listed above. Due to the rapid rise in wages, the rate of increase in services prices more than doubled from the 2% rate of last year to 4.1% in the first half of this year, lifting overall inflation by 1 percentage point and accounting for almost 20% of the rise in CPI. In general, prices of service items are affected by wages, utilities, and commercial rents. These prices are very difficult to bring down after reaching a higher level, falling into the category of structural inflation driven by costs.
III. Forecast on future inflation trends
During the current rapid increase in consumer prices, cyclical factors driven by food prices account for half the increase, with structural factors driven by non-food prices accounting for the other half. Because structural factors have long-lasting and relatively stable effects, in order to predict the future trends of CPI, one needs to focus on food prices in general and the rapidly rising and excessive pork prices in particular. There are three likely trends.
The first trend is that pork prices are likely to be stabilized. The cycles of pork price fluctuations are relatively short. The recent rise in pork prices has pushed the pork/grain price ratio above 8:1, far higher than the breakeven point. The much higher expected profits are likely to increase the scale of pig-raising activities and the supply of pork on the market. Meanwhile, the government has recently introduced five measures to promote pig production, including spending 2.5 billion Yuan on supporting the establishment of standardized pig-raising farms, providing pig raisers with a 100 Yuan subsidy per fertile female pig, and injecting a large amount of funds into the establishment of a public disease prevention system for pigs. The effect of these measures should be noticeable within a year. In fact, since February, the number of live pigs in stock has increased each month, with the number of fertile female pigs in stock rebounding in May. Moreover, the government is going to release some of its pork reserves to lower prices. As a result, pork prices are likely to become increasingly stable in the second half of this year and decline to normal levels next year.
The second trend is that grain prices will come down. In spite of the adverse impact of inclement weather including droughts followed by floods, there has been a bumper crop this summer, and summer grain production rose 2.5% from last year. In comparison, summer grain production last year decreased 0.3%. This larger supply is expected to help stabilize domestic grain price movements. Future grain prices will be mainly determined by the magnitude of the coming autumn harvest. If autumn grain production continues to be stable, the relatively high prices of grain in the past two years are likely to return to normal levels, with growth rates reduced to single digit.
The third trend is that since reaching a new high in February, global food prices have become more stabilized in recent months and even started to decline. The increase in domestic import price of food staples has also slowed down, with the prices of some items even beginning to drop. For instance, the average price of grain imports in June declined 13.4% from its peak in March, with the average import price of soybeans also dropping 3.4%. Meanwhile, prices of some factors of agricultural production have declined from recent highs. For example, the import price of pesticides in June dropped 7.8% from its level in March, relieving some pressure of imported inflation.
Faced with the threats on economic growth and social stability posed by high inflation, since last year the PBOC has raised reserve requirement ratios 12 times to a record 21.5%. On top of that, it has hiked interest rates 5 times and implemented a series of administrative measures in order to mitigate the rising trend of inflation. However, it should be noted that the current phase of inflation is the result of cyclical as well as structural factors. Controlling liquidity will help mitigate the rapid and excessive rise in inflation but will not be able to solve the problem in the short run, especially when it comes to food prices for which demand is inelastic. As pork prices are not likely to fall until next year, food prices are expected to remain elevated in the short term. Nevertheless, as measures aimed at increasing production and supply of food items such as pork are being undertaken, and considering the rapid increase in food prices in the second half of last year had formed a high base level, rise in food prices will slow down in the second half of this year and especially in the fourth quarter. Food price increases are expected to further decelerate next year, bringing down CPI from recent highs.
To summarize, as the future cyclical impact of food price fluctuations are likely to be mitigated or even eliminated, the inflation trend should stop worsening. However, since the increase in labor and residential costs are structural issues, and considering the added uncertainty over the RMB exchange rate, mainland China is expected to face long-term inflationary pressures. The inflation problem that occurred during China’s rapid economic growth needs to be tackled by promoting and expediting adjustments of economic structures.