INFLATION SPIKE GETTING ATTENTION FROM LEADERSHIP, MEDIA,

UNCLAS SECTION 01 OF 03 BEIJING 005578

SIPDIS

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: ECON EFIN PGOV ETRD EINV CH
SUBJECT: INFLATION SPIKE GETTING ATTENTION FROM LEADERSHIP, MEDIA,
AND PUBLIC


SUMMARY
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1. (SBU) With CPI inflation hitting a ten-year high of 5.6 percent
in July, there is now widespread concern among the public, extensive
coverage in the media, and evident attention from China's senior
leadership to rising prices. The spike over recent months is
generally viewed as resulting from short-term food price shocks, but
some economists are also drawing attention to excess liquidity and
other structural factors that could lead to a longer-term and more
chronic problem. Premier Wen Jiabao has become publicly involved,
in particular engaging in a series of activities related to
addressing rising pork prices. Septel lays out the continuum
between viewing the inflation issue as a supply-shock problem, a
monetary policy challenge, or both. END SUMMARY

INFLATION HITS 5.6 PERCENT IN JULY
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2. (SBU) CPI inflation accelerated to 5.6 percent year-on-year in
July to mark China's largest increase in prices since February 1997.
The July figures were prefaced by a steady build up in CPI
inflation through the first half of 2007, with June registering a
33-month high at 4.4 percent. Prior to 2007, the CPI had been
holding steady at 1.5 percent per year in 2005 and 2006. Many
analysts now project China's CPI to reach between 3.5 and 4 percent
this year.


3. (SBU) Core inflation remains quite low, however, and non-food
prices increased only 0.9 percent in July year-on-year after rising
1.0 percent in June. Food prices surged 15.4 percent in July,
accounting for the lion's share of the CPI increase (approximately
one-third of China's CPI basket is derived from food prices). In
particular, rising demand for pork (for which the price increased by
45.2 percent) and eggs (30.6 percent) has driven food inflation.
Corn prices also have increased dramatically with rising demand for
livestock feed and ethanol for biofuels. In addition, vegetable
prices increased 18.7 percent in July following recent flooding in
South China.

INFLATION UNDER THE MEDIA MICROSCOPE
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4. (SBU) The CPI increases have attracted increasing media attention
with inflation-related articles running on a daily basis. The July
CPI surge was a front-page headline in the Beijing News (Xin Jing
Bao),with a full page devoted to coverage on the inside. In one
article, Beijing University Economics Professor Song Guoqing stated
that the CPI increase demonstrates an obvious trend towards
overheating in the economy. Xin Jing Bao had first warned in a May
30 article that food price increases were beginning to exert
inflationary pressure. A July 31 editorial in the English-language
China Daily stated that policymakers are increasingly challenged on
how to strike a balance between stabilizing prices and refraining
from undue market intervention.

GOVERNMENT FOCUSED ON MANAGING EXPECTATIONS
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5. (SBU) In order to address the public's concern, the Chinese
Government has sought to reassure consumers during July and August.
Warning that "inflationary risks are trending higher," the PBOC's
2nd Quarter report pledged to moderately tighten monetary policy in
order to keep a lid on prices and prevent expectations of rising
inflation. Tackling the supply side, a State Council circular on
August 2 aimed to boost pork supplies and mitigate food inflation by
establishing a subsidy system for sows and providing sow insurance.
(Note: The General Manager of New Hope Group, one of China's
largest livestock feed processors, told Econoff on August 7 that the
regulation would have a positive impact on pig production. End
Note.)


6. (SBU) The State Council also took measures to offset costs for
the poorest citizens in both urban and rural areas, issuing new
regulations on the minimum standard of living allowance (dibao),
raising the subsidy in urban areas by RMB 15 (USD 2) in July and
then announcing in August that the benefits under the new national
dibao program for rural areas should take local food prices into
account. Ma Kai, Chairman of the National Development Reform
Commission (NDRC),however, tempered expectations that welfare
subsidies would be sufficient to offset rising prices, stating at a
work conference on July 30 that prices would continue to rise in the
face of demand pressures.


BEIJING 00005578 002 OF 003


PREMIER WEN'S PERSONAL INVOLVEMENT
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7. (SBU) Premier Wen Jiabao has become increasingly focused on CPI
concerns in the months since the pork price shock was first
reported. With a view towards maintaining social stability, Wen's
activities have focused on pork prices and have included the
following:

--On May 26, Wen visited pork production facilities and markets in
Shaanxi Province and met with provincial officials to discuss price
control efforts.

--On June 13 and again on July 25, Wen chaired separate State
Council Working Conferences where he focused on stabilizing pork
market supply.

--Wen made front page news after he visited two Beijing agricultural
wholesale markets on August 4 and stated that the CPI increase has
caused concerns for all walks of life.


8. (SBU) According to Wang Tongsan, Director of the Institute of
Quantitative and Technical Economics at the Chinese Academy of
Social Sciences (CASS),Wen's interest in the issue has been
important to demonstrate to the public that the leadership is
concerned about rising prices. The current preoccupation of most
government officials on their own political futures in the run-up to
the National Party Congress, however, suggests that the government
is not likely to implement new measures to curb inflation until
November, stated Wang.

FIVE REASONS TO BE CONCERNED
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9. (SBU) Wang agreed with other analysts that the pork price spike
is temporary and serves only as a trigger for the recent CPI
increase. However, he also pointed to structural factors that could
lead to a "more and more serious" long-term inflation problem. He
discussed five underlying economic factors that raise concern:

--cost-push inflation: as indicated by the increase in the CPI now
being higher than the PPI for the first time in recent memory;

--demand-pull inflation: as demonstrated by excess growth in the
money supply and residents' income rising faster than the GDP growth
rate for the first time in several years;

--energy savings and pollution reduction targets: these will
increase the cost of production;

--rapid growth in the economy: (especially investment growth) GDP
grew at 11.9 percent in the first half of the year, a rate generally
viewed as above longer-term potential. Investment growth was more
than double GDP, at approximately 25 percent; and

--the rise in international prices for oil, grain, and milk as well
as other staple products.


10. (SBU) According to Wang, CPI inflation will not break through 5
percent in 2007 but may reach 4 percent. He referred to China as
"entering an inflationary period," which he said would become a
problem for the Central Government's macroeconomic regulation
efforts. Wang dismissed the argument that the low core inflation
figure indicates that the inflation problem is limited to food
products, stating that the CPI reflects price increases that impact
the lives of average Chinese and thereby affect social stability.
It is also important to acknowledge that the CPI as an instrument
does not accurately capture all inflation in the economy, he said.
Asset prices (especially stocks and real estate) are also causes for
concern, he said.


11. (SBU) Wang expressed concern for inflation's impact on China's
rebalancing efforts, but he does not believe there will be a
significant influence on export prices. He instead reiterated the
oft-heard view that China needs to increase domestic consumption by
increasing residents' incomes. Raising domestic consumption in
rural areas will be particularly important for minimizing the impact
of price increases. Subsidies to farmers, however, might be
counterproductive as they cause consumption demand to rise and
trigger inflation in the countryside.

INVESTMENT BANKS INTERESTED BUT NOT CONCERNED...YET
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BEIJING 00005578 003 OF 003



12. (SBU) UBS, JP Morgan, and Citibank all have expressed interest
in China's CPI in recent weeks, but none have said China currently
has a persistnt inflation problem. With most of the inflatin to
date coming from meat and eggs -- both commodities that are
susceptible to temporary supply shocks due to disease -- the
evidence points to a short-lived inflationary episode, wrote UBS's
Jonathan Anderson in a recent research note. After the July CPI
figures were announced on August 13, JP Morgan's Asian Economic
Research team, supporting a widespread view, stated that the spurt
in food prices might keep headline CPI elevated in the near term but
is not likely to persist.


13. (SBU) In question is whether the CPI figures merely reflect a
supply side shock or suggest a deeper problem brewing related to
excess liquidity entering the economy. The economists are by and
large focusing on the former and are not arguing that China's robust
GDP growth (11.9 percent in 1H07) or rapidly accumulating foreign
exchange reserves (over USD 1.3 trillion) suggest that overheating
or an increasing money supply are behind a new inflationary trend.
Several analysts stated, however, that problems may be on the
horizon. Goldman Sachs observed after the People's Bank of China
(PBOC) issued its 2nd Quarter Monetary Policy Report that recent
anecdotal evidence suggests that inflationary pressures are
spreading rapidly into other consumption items. Credit Suisse also
cautioned that high headline inflation potentially could impact
inflationary expectations and eventually affect non-food items in
the long run.

COMMENT
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14. (SBU) Post will continue to follow China's CPI story as it
unfolds with future reporting to focus on the impact of price
increases in rural areas, the potential for exporting inflation, and
the monetary policy response. Chinese leaders clearly are concerned
not only about the impact of price increases on macroeconomic
regulation but also potential ramifications for social stability.
For now, the food price spike appears to have triggered short-term
inflation, but price fluctuations over the long-term will continue
to merit attention. END COMMENT.

PICCUTA