ECONOMIC ANALYSIS OF CHINA'S INFLATION

Financial Times recently reported that Chinese central government's intention to curb the inflation aims at the introduction of a unique tax on exporters of grain. The report says that exporters of 57 types of grain will have to pay a temporary tax between 5 and 25 percent.

The major reason for imposing an internal tax on grain exporters has been argued by the attempt to develop an explanation for a surgining inflation in China. Previously, the Ministry of Finance imposed a 13 percent rebate on China's grain producers in a move to increase domestic supply. In November, the inflation hit 6,9 percent accordingly.

China's consumer inflation is driven by food prices which rose 18,2 percent recently. The reason for high food prices is determined by global conditions of demand. China has been facing significant GDP growth.

The growth has been driven by a surge in domestic and global demand which put a cyclical pressure on commodity prices. The fundamental law of economics is the scarcity of resources. Each event that affects the behavior of supply and demand, also affect the equilibirum where the prices are set. In previous year, there have been particular shocks that relatively affected the behavior of world prices. For examples, natural droughts and harvest shortages reduced the supply and lifted input prices respectively.

Though the proposed tax on grain exporters is only temporary, it could hardly be supported by sufficient arguments. There will definitely be an upward pressure on prices unless the exporters give up the marginal gain. Chinese grain market is marred by subsidies and regulation. The additional taxation would further distort the allocation of scarce resources. The producers would harder find the information needed for the free production of goods where different types of grain are included as an input resource.

Given the current analysis of the behavior of food price, higher food prices which caused a surge in inflation, are temporary (link). Various attempts to influence the prices by subsidies, regulation and food quotas are economically irrelevant for two reasons: (1) such incentives cause the lack of information about the production and (2) policy-induced incentives increase the marginal cost of production. Given the conditions of perfect competition, prices equal the marginal cost.

China also proposed a 25 percent fuel tax to limit domestic consumption. Ceteris paribus, fuel prices would increase. However, there are various incentives to introduce a tax on fuel consumption. The most significant argument is that fossil fuels cause a negative effect on global warming and that therefore, fuel tax is justified. Despite the fact that China is world's No.1 air polluter, the reduction in the dependency on fossil fuels takes time. In this case, car producers will face a significant cost-induced shock because of changes in the pattern of production and technological restructuring.

The use of alternative means of energy will induce cost distortions given the magnitude of relatively high fixed costs subject to production plants and technological equipment. Chinese authorities reported that one of the major sources of inflation were higher oil prices. The answer to the question how to curb oil prices and therefore an important inflation pressure is not government intervention and various incentives such as subsidies to oil companies, oil quotas and protectionism. The fact is that oil demand is highly inelastic and that only a shift in demand will calm oil prices.

If the price coefficient of demand for oil is situated onto the interval between 0 and 1, then price increase maximize the intended utility of oil producers, because an increase in the price of oil by about 1 percent, increased the income of oil producers. China is a current leader in global economic growth. It's GDP per capita is growing rapidly, after being adjusted for inflation. A decade of high growth rate invisibly modified the conditions of oil demand. Driven by optimistic estimates and assumptions, the demand for oil became quite inelastic and there each price increase, does not reduce the welfare of oil producer. If the oil demand were prone to relative price changes and elastic, oil producers would have less manoeuvre to lift the price at the margin since such a step would inevitably reduce their income.

Chinese central bank lifted baseline interest rates six times in previous year. Such steps were normally expected due to the need to normalize the magnitude of particular shocks such as rapid economic growth which is highly related to the surgence of inflation. Keeping oil prices artificially low, and providing subsidies to oil refiners to compensate for losses due to global oil prices, is quite risky. Such a move would be justified if there were particular externalities and positive effects but in China's case, the protectionism arrives at the price of market dynamics and holding-back everyday shocks that are quite common in market economy.

Taxing grain producers, imposing tax rebates, giving subsidies to farmers and oil refiners is an inadequate measure to curb the inflation. The flexibility of domestic market to balance the signals of production, prices and consumption is an essential tool as a response to sudden shifts and macroeconomic shocks. Also, regulation makes information asymmetric, making the supply side of the economy worse-off. Subsidies to farmers distort the free mechanism of price establishment.

Inevitably, there is a negative dash on consumer prices. In economics, there are different judgements of subsidies, temporary taxes and tax rebates. Each one of those measures is mismatched by the information signalized by the producers. Fighting the administrative barriers, the establishment of competitive law, deregulation of all sectors of the economy and market liberalization are, by historic and current evidence, the best way to fight the temporary shocks and pressures as well as inflation which is a monetary phenomena.

Rok SPRUK is an economist.

Copyright 2008 by Rok SPRUK