China's inflation rate rises but economic output slows

The inflation rate in China has surpassed the government's 3% target, creating a policy dilemma for Beijing. The annual rate of consumer price inflation rose to 3.1% in May, the National Bureau of Statistics said. More importantly, producer price inflation - the cost of goods at the factory gate - hit 7.1%.

But industrial output slowed, leaving the Chinese authorities with the tough decision as to whether they should raise currently low interest rates. Output from the country's millions of factories and workshops rose 16.5% in May from a year earlier, down from a growth rate of 17.8% in April.Urban fixed investment - a measure of construction of houses and factories - also slowed in May, while bank lending fell 17% versus the previous month.

A spokesman for the statistics bureau admitted that the pressure on inflation was "rather big", but said prices would be controlled. Higher food and housing prices were mainly to blame for the acceleration in inflation.

'Bubble' economy

The high inflation figures raise two concerns, according to Michael Pettis, finance professor at Peking University's Guanghua School of Management. "The first, well-noted concern is whether we are on a rising inflation path," he told the BBC, explaining that the jump in producer prices may feed into higher consumer prices later. What is talked about less is that real interest rates are going down," he added. The "real" interest rate is the difference between the actual interest rate and the inflation rate.

CHINESE DATA IN FULL

Change vs same period in 2009:

	May	April
Consumer prices	+3.1%	+2.8%
Producer prices	+7.1%	+5.9%
Industrial output	+16.5%	+17.8%
Retail sales	+18.7%	+18.5%

	Year to May	Year to April
Urban fixed investment	+25.9%	+26.1%

Inflation is on the rise, but deposit rates and lending rates are being held artificially low by the Chinese authorities. This means that Chinese households find the value of their savings eroded by inflation, while speculators and state-owned companies are able to borrow extremely cheaply.

Mr Pettis estimates that low interest rates in China transfer 5%-10% of GDP from households to borrowers each year. He also thinks that cheap borrowing is creating a bubble economy, with borrowers making bad investment decisions and creating overcapacity.

"We have a bubble in real estate. We have a bubble in infrastructure. We have a bubble in manufacturing capacity," he said. "Even Chinese art prices are the highest since Japan in the 1990s." But Beijing will be keen to move very slowly on interest rates, for fear that a sharp rise in rates could burst the bubble and plunge the economy into recession.

Yuan pressure

The latest figures have been released as China comes under renewed pressure from the US to revalue its currency, the yuan. The yuan has been pegged to the US dollar since 2008. US politicians say that China keeps its currency artificially cheap, and this gives it an unfair trade advantage. Trade data released on Thursday showed that Chinese exports in May had jumped by nearly 50% from a year ago, while the US trade deficit widened further in April.

US Treasury Secretary Timothy Geithner told a congressional committee on Thursday that distortions caused by China's currency stance were "an impediment to the global rebalancing we need". Meanwhile, Congress is preparing a bill that will impose targeted trade sanctions on China in retaliation for its yuan policy.

Trade question

"If the US gets tougher on China, it will be a green light for everyone else to adopt beggar-thy-neighbour policies," says Mr Pettis. He says that trade relations are being brought to a head much more quickly than expected by events in Europe. With the EU now committed to cutting budget deficits, and the euro falling rapidly, Europe is set to start running a big trade surplus in the coming months.

But if Europe and China both want to run big trade surpluses, that begs the question of who will run the necessary trade deficit and buy their exports. The noises coming from the US suggest that Washington is no longer willing to play the role of "consumer of last resort" that it did during the last boom.

"Europe is forcing a rapid adjustment in global [trade] imbalances," says Mr Pettis. "China needs its adjustment to go slow. But the question is does the US have the political willingness for this any more?"