By Caijing guest economist Huang Yiping
Realated article: China July CPI Down 1.8% Year-On-Year

(Caijing.com.cn) China's consumer and producer price indexes, major gauges for inflation, fell in July, pointing to greater deflationary pressure. Indeed, overcapacity will make price hikes, or inflation, almost impossible in the foreseeable future.

But soaring asset prices fueled by excess liquidity and infrastructure projects recently launched under the government's economic stimulus package will eventually jeopardize macroeconomic stability – unless policies are adjusted now. 

Widespread concerns about inflation have recently been based on three conditions: a falling CPI, which may bottom out by the end of this year; record bank lending in the first half, which pushed up inflation expectations; and soaring world commodity prices, which may trigger domestic inflation – a scenario that seemed to be supported by recent increases in rice and meat prices.

But then CPI in July fell 1.8 percent year-on-year, following a 1.8 percent decline in June. At the same time, the nation's PPI failed to rise in line with international commodity trends, falling 8.2 percent year-on-year in July.

Exports, which contributed to about 35 percent of China's gross domestic product, have fallen about 20 percent this year, resulting in massive overcapacity. China's experience from the past 10 years indicates that deflation always follows a decline in exports.
 
Until the major developed economies recover, China faces a low probability of inflation. And without a recovery in the developed economies, commodity price increases cannot be sustained.

It is not entirely accurate for market watchers to see a rise in PPI as a prelude to a CPI increase. When the economy is stable, PPI can expect to rise before CPI starts climbing. But if domestic demand is weak, a low CPI will drag down PPI. During 2004 and '05, when China tightened its macroeconomic policies, a falling CPI brought down PPI.

Although inflation dangers seem remote in the short term, China's current loose monetary policy and stimulus plan should not be maintained over the long term. The real economy is rebounding and showing strong momentum. Although urban fixed-asset investment growth in July slowed from the first-half level, growth during the first seven months of the year still approached 33 percent. A nationwide GDP growth rate of 8 percent, driven by high investment growth, has nearly been secured.

The biggest risks now are linked to asset price bubbles and the heavy-handed stimulus package. Many experts oppose macroeconomic policy adjustments. But the essence of macroeconomic policy is to predict and adjust when needed. Anything else could cause turbulence in the economy.
       
A fine-tuning of monetary policy has already started, although the government denied it last weekend. New lending plummeted to 360 billion yuan in July from 1.5 trillion yuan in June, according to the latest central bank data. But any policy changes that affect interest rates or bank deposit reserve ratios may not be made until 2010.
 
Fiscal policies need to be modified, too. Proactive fiscal policies have led to a quick rebound for the economy. But too much government-backed investment could lead to inefficiency and crowd out private investment, doing harm to sustained economic growth. Many new infrastructure projects involve long-term commitments, making it hard to alter expansionary policies in the short term. And once the global economy recovers, China's economy could easily overheat.

It may not be time to end the stimulus plan. But it is definitely time for fine-tuning.

Full article in Chinese: http://www.caijing.com.cn/2009-08-11/110222722.html