PROMINENT ECONOMIST SEES CHALLENGE IN RESPONDING TO

UNCLAS SECTION 01 OF 02 BEIJING 000855 SIPDIS SIPDIS SENSITIVE STATE FOR EAP/CM AND EEB/OMA TREASURY FOR OASIA/DOHNER USDOC FOR 4420 STATE PLEASE PASS USTR FOR STRATFORD E.O. 12958: N/A TAGS: ECON EFIN PREL EINV CH SUBJECT: PROMINENT ECONOMIST SEES CHALLENGE IN RESPONDING TO DOMESTIC HEAT VS. OVERSEAS COOL REF: BEIJING 800 SUMMARY -------------- ¶1. (SBU) On March 6, the Vice President of the National Development and Reform Commission's Academy of Macroeconomic Research, Ma Xiaohe, characterized elevated inflation as a challenge that will outlast recent food supply shocks. Five consecutive years of double-digit GDP growth has boosted demand for labor, agricultural inputs, energy, and other raw materials (both domestic and imported),underpinning current price increases. This trend, coupled with rapid expansion of the money supply due to continued large balance of payments surpluses, will make inflation "hard to control." However, the headline CPI should moderate over the coming months as production increases in some of the food items that experienced supply shocks. Government tightening to contain inflation and excessive investment growth may take hold just as external demand for China's exports slows, mandating a need to be "cautious." On fiscal matters, Ma said the government's number one challenge is ensuring the proper targeting of funds as they pass through multiple levels of government. His recent travel to the U.S. to study comparative public finance left him impressed with the transparency of budget formulation and debate, a quality that might prove helpful in reducing waste in China's own system. END SUMMARY INFLATION: IT'S NOT JUST ABOUT FOOD -------------- ¶2. (U) On March 6, the Vice President of the National Development and Reform Commission's Academy of Macroeconomic Research, Ma Xiaohe, discussed inflation, monetary policy, and fiscal reform with Fin MinCouns and Econoff. ¶3. (SBU) Ma agrees with analysts who forecast a rise in the consumer price index (CPI) over the coming months, followed by a decline as food price increases, which account for 85% of the rise in the headline inflation rate, play themselves out. This pattern will result from "base effects" (there won't be additional supply shocks) as well as increased production in response to higher prices. However, Ma characterized elevated inflation as a longer-term challenge that will be "hard to control," with roots in five years of double-digit growth coupled with rapid expansion of the money supply resulting from a large and growing balance of payments surplus. ¶4. (SBU) Ma said that a sustained economic expansion has increased price pressure for domestic inputs to agriculture, industry, and services. Wages are rising rapidly, a wealthier population is consuming more food, and expanding industries are using more energy. Meanwhile, China is also importing inflation through its growing demand for raw materials, petroleum, and foodstuffs sourced abroad. Ma cited white goods as an example, telling the story of a friend who was warned that, as a result of higher steel prices, he would pay more for a refrigerator if he took delivery a month later. CPI WILL MODERATE -------------- ¶5. (SBU) Ma named three reasons that the rise in the headline CPI will moderate six to eight months from now. First, farmers are increasing pork and agricultural production in response to higher prices. Second, monetary tightening now in process will slow the growth of domestic demand. Finally, a downturn in trade partner economies will reduce external demand. (Comment: Although China has declared a "tightening" posture, real interest rates have fallen over the last year, the RMB is hardly appreciating on a trade-weighted basis, and money supply growth in January was at a 20-month high, so there is far to go if a change in monetary conditions is to slow domestic demand, as Ma suggests. End Comment.) TIGHTENING MEETS SLOWING EXTERNAL DEMAND -------------- ¶6. (SBU) Ma said that Chinese financial institutions have little direct exposure to U.S. subprime issues, but there is risk to China of declining external demand -- and this could occur at the same time as China tightens its domestic policies. Ma said that China will need to be "cautious" and attentive to international conditions as i makes economic policy decisions over the coming months. Despite the widening spreading between Chinese and U.S. interest rates due to cuts by the U.S. Federal Reserve, China still has some "space" to raise its own, asserted Ma (ecoing a point made tat day BEIJING 00000855 002 OF 002 by PBOC Governor Zhou). Raising interest rates, however, risks attracting even greater capital inflows, adding to a "vicious circle" of money supply expansion leading to further investment in productive capacity (particularly in the tradable sector),leading to an increase in the current account surplus that would then draw in another round of capital inflows. UTILITY IN SOME INFLATION -------------- ¶7. (SBU) In response to a question from Finatt, Ma acknowledged there is utility in China tolerating moderate inflation somewhat above that in advanced economies. (Note: Many developing economies with protracted high rates of economic and productivity growth in the manufacturing sector tend to have higher inflation rates, particularly in services. This can help rebalance growth by providing an appreciation of the real exchange rate and inducing investment in services). Ma suggested that from a macroeconomic perspective, inflation that remains below double-digits is not problematic. However, Ma noted that even moderate rates of inflation present political challenges as it hurts poorer households the most; it is common in China for poorer families to spend more than half their income on food. Ma stressed that the government must be prepared to help low income households cope. (Comment: Senior officials from the National Bureau of Statistics have also noted that China's limited social safety net contributes to its low tolerance for inflation.) 2008 BUDGET AND REFORM -------------- ¶8. (SBU) The 2008 budget released at this week's National People's Congress projects an overall expenditure increase of 23% and is notable for its even larger increases in social services: 45% for education, 25% for health, and 24% for social security. Ma said China's greatest fiscal challenge is ensuring that funding is not mismanaged as it passes through multiple layers before reaching intended beneficiaries. To address this, the government is resorting when possible to direct payments to county governments (bypassing provinces) and specific earmarks for items such as teacher salaries. However, most expenditures cannot be controlled in this manner. With regard to the education increases, Ma shrugged off criticism in the media that the funds would not go where most needed, stating that the target will be to finance compulsory education in Central and Western provinces, including teacher salaries and school facilities. ¶9. (SBU) Ma traveled to the U.S. and Canada last fall to conduct a study on comparative public finance. He spoke highly of his Washington meetings, singling out the Office of Management and Budget. During the U.S. visit, he was struck by the public manner in which the federal budget is formulated. In his view, China might draw value from studying this process as it may promote cost control and limit waste. COMMENT -------------- ¶10. (SBU) China's economic policy makers have been debating whether to tighten monetary policy to fight inflation or keep it more relaxed in the face of slowing external demand -- and so far, tightening has won the battle of words (but not necessarily deeds, as we noted above). Ma's comments to us, along with those of with Dr. Jiao Jinpu, Acting Director General of the People's Bank of China (PBOC) Research Bureau (reftel),demonstrate that government-affiliated economists are carrying the central government's tune about inflation being the top economic priority yet are mindful that once the impact of one-time supply shocks plays out over the coming months, concern may shift to the consequences of slowing export growth. There is on one hand a case to be made that inflation will prove persistent given high rates of money supply growth, but on the other, solid ground for concern that lower productive capacity utilization due to the continued high growth of investment and weakening external demand will prove deflationary. The Fed's easing further constrains the PBOC's ability to raise interest rates. As Premier Wen highlighted in his recent speech, 2008 is shaping up as a "most difficult year" for macroeconomic policy formulation and implementation. RANDT