China Domino

27 May 2011
Economics
Beyond the Cycle
www.sgresearch.com
Inflation Themes
The China Domino has Fallen!
The evolution and persistence of inflation in China and its consequences.
Chief Asia Economist
Glenn B. Maguire I am sure you have heard about it. Indeed, you have probably helped spread it. I have!
(852) 2166 5438
glenn.maguire@sgcib.com The whispers of policy makers, economists and market players all suggest a new “Domino
China Economist Theory” is being conjured up. This time it is inflation, not communism, that will inevitably
Wei Yao
(852) 2166 5437 topple all over the globe. As China moves into a cycle of generating autonomous structural
wei.yao@sgcib.com
inflation, it is widely anticipated that China will export this inflation to the rest of the world.
Senior Asia Economist
Joseph Lau
(852) 2166 5441 Like any other economic variable in China it comes as no surprise that the nature of
inflation is changing.
joseph.lau@sgcib.com
Since 1978, as China engineered a historically unprecedented
Research Associate
David Tam
urbanisation and industrialisation path, both in terms of scale and velocity, the drivers of
(852) 2166 5436
Chinese inflation have also been changing. In each of China’s five major expansionary policy
cycles, inflation has been the consequence. It appears that Chinese policy makers have not
fully learnt the lessons of these lessons.
High-powered money creation and/or broader monetary growth led by investment

booms have been at the heart of all inflation cycles. They are clearly the leading culprit in
China’s current inflation cycle. Beijing has over relied on quantitative tightening, price
capping, and regulation to contain inflation. That has not only failed to solve the medium term
inflation problems but also create allocative inefficiencies given the mispricing of prices –
including interest rates and the yuan.
The proportion of China’s inflation that is structurally determined has ratcheted higher
over previous expansionary cycles. Indeed China’s ambitious 12 Five-Year Plan is
th
inherently inflationary. Inflation is the natural consequence of rebalancing.
These developments have profound global consequences. The enormous outward shift in
the global economy’s supply curve that came with China’s WTO accession and the army of
millions of workers it added to the global labour force has come to an end. A better balance
of expenditures in the Chinese economy will engineer an outward shift in the global demand
curve. In the post-crisis world we would suggest that the global supply curve has become
more inelastic. That is, it has steepened and has a lower propensity to shift out further.
Hence, the faster China rebalances, the greater the inflation it will generate.
Macro Commodities Forex Rates Equity Credit Derivatives

Please see important disclaimer and disclosures at the end of the document
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Inflation Themes
Contents
A new domino theory. ................................................................................................................................................................ 3
The first domino. Chinese inflation .............................................................................................................................................. 5
Changing drivers of inflation in China .................................................................................................................................... 6
From mahjong to dominos ............................................................................................................................................................ 7
China’s five inflation cycles ....................................................................................................................................................... 7
Early days: China’s three cyclical inflation waves. .................................................................................................................. 8
Cycle 1: 1987-89. China comes perilously close to hyperinflation. .................................................................................... 8
Cycle 2: 1993-94. Deng Xiaoping overstimulates the economy. ........................................................................................ 8
China’s unusual deflation episode: 1998-2001...................................................................................................................... 9
Cycle 3: 2003-04. The first inkling of structural inflation ..................................................................................................... 9
Cycle 4: 2007-08. Food demonstrates its weight ............................................................................................................... 10
Cycle 5: 2010-??. China enters a new inflation paradigm .................................................................................................... 10
Why the fifth cycle is different? ............................................................................................................................................ 11
Not even China can escape Friedman’s monetarist dogma. .............................................................................................. 13
SG’s model of Chinese inflation – key inputs.......................................................................................................................... 14
The arrival of structural inflation! ................................................................................................................................................ 15
Urbanisation, surplus labour and Lewisian turning points ..................................................................................................... 15
History is replete with lesser examples of the China episode ............................................................................................ 15
China is urbanising at a faster pace than previously thought. ............................................................................................ 15
Is China’s move to structural inflation really that unique? ..................................................................................................... 16
China has reached its first Lewisian turning point .............................................................................................................. 17
However, the second Lewisian turning point is a long way away. ..................................................................................... 17
Productivity differentials square the hole ............................................................................................................................... 18
The productivity gains of urbanisation ................................................................................................................................ 18
Wage efficiency & productivity will prevent manufacturer flight ............................................................................................ 19
Urbanisation’s contribution to inequality prompts faster minimum wage gains ............................................................... 19
Urbanisation now involves two-way flows of labour and capital. .......................................................................................... 20
Labour flows outwards and capital flows inwards. ............................................................................................................. 20
The catch-up to developed world living standards may be surprisingly quick .................................................................. 20
Are commodity prices now structural determinants of Chinese inflation? ............................................................................ 21
China’s liquidity legacy ............................................................................................................................................................... 22
Why has China printed so much money and, more importantly, why does it continue to do so? ....................................... 22
Has policy error contributed to inflation in this cycle? ........................................................................................................... 23
Is the PBoC slow in response? Yes and no. ........................................................................................................................ 23
The limitation of quantitative tools....................................................................................................................................... 24
Rate hikes have to step up, but now is not a good time ..................................................................................................... 25
The right cures: fiscal tightening and a new currency regime ............................................................................................... 26
What next? ................................................................................................................................................................................... 30
Global inflation dynamics are changing .................................................................................................................................. 30
2 27 May 2011
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Inflation Themes
A new domino theory.
Proving that you can fool most of the people most of the time, the domino theory was
promoted by various US administrations as a justification of US intervention during the Cold
War period of the 1950s to 1980s. The theory was hardly rooted in any serious political-
economy school of thought. As an example, referring to communism in Indochina, U.S.
President Dwight D. Eisenhower put the theory into words during an April 7, 1954 news
conference:
“Finally, you have broader considerations that might follow what you would call the "falling
domino" principle. You have a row of dominoes set up, you knock over the first one, and what
will happen to the last one is the certainty that it will go over very quickly. So you could have a
beginning of a disintegration that would have the most profound influences.”
Indeed, Eisenhower went on to argue at that April 1954 news conference that the fall of
Vietnam, would eventually lead to the fall of French Indochina – Burma, Thailand and
Malaysia. Just as the dominoes impressively and relentlessly topple in those game shows
hosted by Japanese university students, the domino theory postulated that Japan, Taiwan, the
Philipiness, Australia and New Zealand would be next.
Really? I mean really?
Whilst we suspect that most conservative western policy makers struggle with the
expectations augmented Philips Curve that postulates an inverse relationship, that is a policy
trade off, between the unemployment rate and inflation, could you just imagine the policy
implications of the new domino theory?
Would Ben Bernanke and Tim Geithner have to express their preference for the right mix of
communism and inflation at their confirmation hearings? Would the Beige Book, in fact, be a
Red Book? Would the World Trade Organization (WTO) finally be empowered with the policy
teeth to vigorously pursue anti-dumping legislation against cheaply built and inherently
unstable dominoes?
In our interactions with clients, peers and policy makers, we note a growing concern that the
decoupling of emerging markets in the post-global crisis period may morph into these new
engines of growth being engines for inflation. Given the world’s reliance on China as the
lowest labour cost assembler, if wages, inflation and the exchange rate in China are all rising
quickly, the structural inelasticity of supply poses problems for the rest of the world.
Quite simply, the domino theory of 2011 is that when China comes under the influence of
inflation, the surrounding countries, those with the most immediate trade ties, would also fall
to inflation. It will only be a matter of time till those economies with the greatest trade ties;
indeed the entire world has succumbed to the great inflation cascade emanating from China.
Here is how the dominos will fall.
The first domino is China creating autonomous structural inflation: China’s domestic
inflation accelerated at an unprecedented pace at the end of 2010 and policy makers remain
well behind the curve. As China engineers its economy to a more domestically focused one,
its demand curve is shifting outwards and the global supply curve has been inelastic in
response. That domino has already fallen and is the focus of this paper.
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Inflation Themes
The second domino to fall is proffered to be that China will then export this inflation to
the rest of the world. This dynamic seems as inevitable as gravity itself.
The multi-decade process of globalisation now sees China and every other economy in the
world in a nebulous web, intertwined on so many levels. The course of China’s rebalancing;
the course of Chinese inflation in particular, will have a profound effect on the rest of the
world.
With a growing risk of price-

The second domino. China CPI leads US core goods CPI
wage spirals in the emerging
world, there is a chance that 10
China CPI (LHS)
5
US Core CPI ex services, lagged by 20 months (RHS)
inflationary pressures could 4
8
surface in the US. After all,
3
emerging Asia exerted 6
2
significant downward
4 1
pressure on US core inflation
over the past 15 years. We 2 0
believe that those secular -1

0
forces are starting to reverse. -2
To be sure, China has already -2
-3
been exerting upward
-4 -4
pressure on US headline 00 02 04 06 08 10 12
inflation in recent years by Source: Global Insight, SG Cross Asset Research/Economics
pushing up prices of energy

and industrial metals. More recently, this has spread to food and cotton prices. Could
manufactured goods be next? The Chinese price-wage dynamic certainly points in that
direction.
To use the USA as an example, see the chart above, to the extent that Chinese import prices
begin to rise, this gives US producers’ a bit more pricing power. These knock-on effects take
a while to materialise, hence the 20-month lag between Chinese CPI and US core goods CPI
(the lag to US import prices from China is much shorter, at just 4 months). Therefore, this is
not a risk for US inflation in 2011, but one we should be more alert to 2012.
The second domino is in the process of falling.
The third domino is teetering. With domestic inflation rising in China and the pace of Yuan
appreciation stepping up in Q2-11, China looks set to export its inflation to the rest of the
world. Import price indices from China, for the developed economies, are turning up and
given the “stickiness” of supply, the world will remain a China “price-taker”. That is, the past
two decades of outsourcing that turned China into the world’s factory were long term trends.
Manufacturing production cannot simply be transplanted quickly to another economy.
For the global economy, the positive supply side shock that occurred with China’s WTO
accession has now, at the very least being halted. China’s policy of rebalancing its own
economy more towards domestic growth now sees China engineering an outward shift
in the global demand curve. The first inflation domino has tipped, how many more will
follow?
This paper looks in detail at the first domino.
4 27 May 2011
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Inflation Themes
The first domino. Chinese inflation
In this thematic, we present an analysis of Chinese inflation in three parts. First, we look back
and examine the lessons China should have learnt from its previous Money Supply,
Investment and Inflation nebulas. Second, we look at the relative performance of China’s
inflation in this high growth period to similar periods in Japanese and South Korean economic
evolution. Finally, we analyze the liquidity dynamics of this inflation cycle and conclude that
the tools that the Chinese government has been adopting are not sufficient and efficient to
tackle inflation.
Inflation accelerated over 2010 at the fastest rate ever. Most significantly, this fifth cycle
shows the broadest price pressures of any previous inflation cycle. Inflation expectations are
rising rapidly and as a part of rebalancing are likely to embed at a higher level than has been
the case previously.
As a surplus economy, we do not believe that China has moved through its Lewisian
turning point and as the capital stock has grown significantly under the recent stimulus
package, it therefore takes large, persistent and sustained growth in demand to push
inflation above its trend. China has closed its output gap for some time, and state-
sponsored wage increases are contributing to a significant demand-pull inflation dynamic.
This is augmented by a fairly broad cost-push dynamic across a whole range of goods.
We note that South Korea and Japan tolerated higher levels of inflation during their
corresponding periods of rapid urbanisation and industrialisation. Indeed, given the stark
difference in real exchange rate behaviour over these periods, South Korea and Japan may
well have adopted inflation as a policy choice to more rapidly converge prices and living
standards towards developed economy norms.
Growth is running above potential Inflation is above, and will move further above, trend
Real GDP YoY - SG Forecast Inflation - SG Forecast

YoY% and HP-Trend YoY % and HP-Trend
16 10
8
14
6
12
4
10
2
8
0
6 -2
Jun-1995 Jun-1999 Jun-2003 Jun-2007 Jun-2011 Jun-2001 Jun-2003 Jun-2005 Jun-2007 Jun-2009 Jun-2011
Source: CEIC, SG Cross Asset Research
At the macro level, we still find China to be a surplus economy in terms of both labour
and capacity. At the micro level we find important determinants of frictional or more
structural inflation including skills mismatch and a productivity deficit relative to income
growth.
Besides, the monetarist nightmare of torrid money growth and a poorly policed shadow
banking system that continues to siphon high-powered money into the real economy
and the capital market. This, following the greatest counter-cyclical stimulus exercise of all
27 May 2011 5
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Inflation Themes
time as China threw its entire banking system at arresting the exogenous shock of the 2008
financial crisis, is China’s “Legacy Issue” just as public debt is Europe’s.
What should the government do about inflation? The government may have to tolerate the
higher structural inflation as Japan and Korea did. However, higher trend inflation makes their
job more difficult, as additional cyclical factors could easily boost the inflation to
uncomfortable levels. In current cycle, we think the administrative and monetary policies that
have been adopted so far are either sufficient or efficient in addressing the inflation problem.
Eventually, faster Yuan appreciation is needed. A rapid appreciation, along with some one-
off revaluations of the Yuan, may be the perfect antidote to China’s inflation problems. But for
the rest of the world, that antidote will see China “export” its endogenous inflation as an
exogenous shock to the rest of the world. The bitter backwash that the rest of the world must
swallow of monetary and fiscal policy normalisation will be all the more sour with some
Chinese flavoured inflation added to the brew.
Changing drivers of inflation in China

Domestic liquidity conditions to remain loose for
sometime given constrained monetary policy
tools that are reaching their effective limits.
Inflation
Cyclical The positive output gap narrows or closes on a
The cyclical part of this bumpy path as growth returns to trend.
inflation cycle will be much
more difficult to contain, due to
the liquidity legacy created in
Inflation expectations continue to rise and remain
past two years and continued highly sensitive to high frequency purchases
strong appetite for such as food.
investments.
Capital inflows to remain persistently strong if
yuan continues to appreciate at gradual pace.
Yuan determination mechanism is expected to

move away from a crawling peg to a more
flexible mechanism.
Food and Energy: China is moving into a period
of structurally higher demand for food and energy
as a result of urbanisation.
Urbanisation: we expect urbanisation in China to
Inflation
continue at a rapid pace, driving housing growth
Structural and therefore, demand for materials and
We now find increasing resources.
evidence that a growing
proportion of China’s inflation Income: continues to increase on the back of
is structural. This will provide a
floor, or base, that means mandated minimum wage increases that are now
headline inflation (structural + approaching 20% yoy.
cyclical) will trend higher.
Potential Growth in China will fall in coming years
as the economy matures.
High labour productivity growth may be hard to

sustain if inward foreign direct investment slows.
Know your traffic signs: Stay Alert. Potential Problem. Needs to be better controlled.
Source: SG Cross Asset Research/Economics.
6 27 May 2011
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Inflation Themes
From mahjong to dominos
China’s five inflation cycles

China has had five significant inflation cycles and each have common culprits.
 Been preceded by a significant acceleration in money supply growth.
 The second derivative of CPI (that is the acceleration or deceleration in inflation) has turned
positive coincidentally with negative real deposit rates.
 Administrative measures, such as price capping, RRR hikes and interest rate hikes have not
been successful tools in containing inflation in previous cycles.
First, let’s revisit China’s previous cycles so that we can examine in more detail what makes
this fifth cycle unique.
China’s five inflation cycles
Five Inflation Cycles

CPI YoY%
30
25
20
15
10
-5
1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
Source: CEIC, SG Cross Asset Research/Economics
The structural underpinnings of inflation in China have become apparent in the third and
fifth cycles.
 In the third cycle, 2003-04, productivity growth fell below wages growth as the credit crunch
following the 2001 US recession led to a marked slowdown in FDI into China and the
productivity lifting technology and skills transfer that went with it.
 The fifth cycle, 2011-12, is again marked by wages growth overtaking productivity growth,
but the distinction is that China’s marginal worker now appears to be moving through the
tipping point of subsistence spending and into discretionary spending. This has led to a
structural shift (to the right) in the demand curve of Chinese households for goods such as
consumer staples, food and clothing; which continue to have an upward sloping supply curve.
Indeed for many of these goods, or their commodity inputs, supply curves are quite steep, if
not inelastic due to physical and finite constraints on resources.
 The crucial dynamic that differentiates the fifth cycle is the Legacy Issue of China’s own
version of quantitative easing, which used the commercial banks as fiscal agents to pump
liquidity into the real economy. The increase in the money supply by around 40% of GDP over
the course of 2009-10 was simply unprecedented.
 China’s liquidity problem is endogenous and cannot be adequately tackled with existing
policy tools. Maintaining a targeted exchange rate has significantly reduced China’s scope for
monetary policy, as the Mundell-Fleming trilemma would suggest, most evident in rising
inflation and the failure to fully sterilise hot money inflows.
27 May 2011 7
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Inflation Themes
Early days: China’s three cyclical inflation waves.

China’s first three inflationary cycles were cyclical. In the two decades following Deng
Xiaoping’s modern economic reforms, China displayed persistent “boom-bust” cycles through
which periods of unsustainably high economic growth were followed by periods of over-
tightening, austerity and slower growth. Deflationary episodes however, were the exception,
not the rule.
China’s inflation and growth cycles in these two decades closely track the broader pattern of
the political-economic business cycle. Expansionary and inflationary phases have typically
accompanied significant decentralising reforms and relaxed administrative guidance to both
the industrial and financial sectors. Indeed, the expansionary and inflationary phase of the
cycle has often accompanied significant institutional reforms, with policy kept too lax in order
to accommodate these reforms.
In these early episodes; transport and energy, or more generally, capacity bottlenecks were
the first warning signs that inflation was building up a considerable head of steam. They were
also usually a prelude to the subsequent overtightening of policy, slower pace of reform and
halting of the decentralization process.
Cycle 1: 1987-89. China comes perilously close to hyperinflation.

Monetary supply growth accelerated dramatically after the 1984 National Party Congress,
which rubber-stamped many new reform packages and spending initiatives. Overheating of
the economy became apparent in 1985 and the government adopted counter-cyclical policies
in an attempt to cool the economy. Fears that policy had over-tightened were unfounded and
the subsequent loosening of monetary policy in 1986 became strongly pro-cyclical.
This was early days for Chinese policy makers so we should not be surprised that policy error
played an important role in contributing to the inflation dynamic. The government’s decision
to liberalise the price system in an attempt to contain inflation had the opposite effect,
exacerbating the situation. As one of China’s first strong inflation dynamics, inflation
expectations became unhinged and panic buying and hoarding of goods immediately after
price liberalisation pushed inflation to its cycle peak of nearly 30% yoy.
Lessons Learnt: Policy was too slow to react as policy makers were focused more on the
yoy change in inflation, rather than the actual sequential developments in inflation. Price
liberalisation is not necessarily an appropriate tool to contain inflation. Finally, inflation
expectations are real and powerful.
Cycle 2: 1993-94. Deng Xiaoping overstimulates the economy.

Deng Xiaoping’s famous 1992 tour of the southern provinces achieved many things.
Unfortunately, a perilous flirt with hyperinflation was one of them.
The 1993-94 inflation cycle has many similarities to the present cycle. First of all, China faced
an exogenous shock that significantly curtailed its export-led growth model. The Tiananmen
Square incident of 1989 saw almost universal trade sanctions imposed against China and the
government had to respond by stoking domestic demand. Using the banks as fiscal agents,
lending for real estate and other investments, particularly in Southern China, where the first
Special Economic Zones were located, surged over the course of Deng’s mandated
investment boom.
8 27 May 2011
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Inflation Themes
Again, inflation expectations became unhinged, particularly as food prices started to rise
dramatically. China had a de-facto food security policy so that substitution of domestic
production with foreign production was not automatic. Moreover, with trade sanctions in
place, this was not possible at the time anyway.
With grain prices, in particular, soaring, farmers began to hoard grain and were unwilling to
sell it into the Chinese market in 1994. This combination of hoarding, which was not only a
grain dynamic but more general across all food produce, strongly exacerbated the upswing of
the inflation cycle.
Lessons Learnt: Food inflation is a particularly powerful dynamic in China when unleashed,
complicated by China’s political reluctance to import food. Inflation expectations, again, are
very powerful dynamics. On the demand side, they can lead to panic buying as in the 1987-
88 cycle. The 1993-94 cycle also demonstrated that inflation expectations can work on the
supply side with suppliers withholding stock in anticipation of even higher prices in the future.
When both of these dynamics combine, the inflationary consequences can be profound;
indeed, this was one episode where China ventured very close towards hyper-inflation.
China’s unusual deflation episode: 1998-2001.

From an historic standpoint, China’s deflationary episode from 1998-2001 appears to have
been one singular sensation. It certainly doesn’t suggest that the Chinese economy has had
binary price dynamics previously, that is, it either had inflation or deflation. The episode is
explained purely by supply and demand
Massive decline in employment
dynamics at the time.
No of Employee: State Owned
Person mn
In the lead up to WTO ascension in 2001, 110

105
China departed from its social contract with 100
its proletariat workers to an unprecedented 95

90
degree. To ready State-owned enterprises
85
(SOEs) for participation in the global trade 80
75
arena, massive job shedding and
70
investment in new plant and equipment 65
occurred over this period. This is perhaps 60

Mar-1995 Mar-1999 Mar-2003 Mar-2007 Mar-2011
the only episode where China’s supply Source: SG Cross Asset Research
capacity has raced well ahead of actual
demand. In short, deflation was triggered by a classic over-supply problem.
Cycle 3: 2003-04. The first inkling of structural inflation

This is the first example of structural inflation emerging in China. China has been able to
sustain double digit wages growth for several decades as its productivity has grown so rapidly
and its demographics have been so favourable. One of the key inputs into Chinese
productivity has been Foreign Direct Investment and the technology transfer and skills transfer
corresponding with that investment. China is somewhat unique in this case, in that its rules
on FDI are quite strict and facilitate a rapid transfer of new technology and skills. Indeed, it is
not uncommon for a new SOE, or State-sponsored enterprise to open shortly after a foreign
enterprise is established, producing very similar goods with very similar technologies (i.e.
reverse engineering of imported technology) and enjoying all the benefits of State support,
including not having to remit profits as dividends.
One of the readily observable dynamics following a credit crunch is the abrupt slowdown in
foreign direct investment, particularly that FDI originating from the developed economies.
After the tech-wreck recession of 2001, US foreign direct investment into China slowed
27 May 2011 9
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Inflation Themes
markedly in 2002-03. As a result, Chinese productivity growth waned below that of wages
growth in 2003-04 and a structural pick up in inflation was the result.
Lessons Learnt. Rapid income growth is all well and good, but productivity growth must
remain firm.
Cycle 4: 2007-08. Food demonstrates its weight

The inflation dynamic of 2007-08
was another episode where China’s Food inflation and the CPI
de-facto food security policy did Food Inflation is not Hogwash
more harm than good. There are a 25
range of policies — a hangover from 20
the Mao Zedong era — that 15
maintains China should be able to 10
feed its domestic population entirely

5
with domestic production. So, when

0
the supply of the major protein staple
-5
in the Chinese diet was sharply Mar-2001 Mar-2003 Mar-2005 Mar-2007 Mar-2009 Mar-2011
curtailed, as millions of pigs died of CPI YoY Food Inflation YoY
the “blue ear” virus, China did not Source: SG Cross Asset Research
resort to importing frozen pork from

other countries. Instead, it encouraged farmers to rapidly rebuild their pork breeding stocks.
Lessons Learnt. Once again, given its high weighting in the CPI basket, food inflation is a
powerful dynamic in China. Its ability to unhinge inflation expectations is particularly robust.
Price capping does not work when there is a significant and genuine hit to supply.
Substitution policies have to be introduced at this time. Lifting reserve requirements ratios or
interest rates will not boost the supply of pigs.
Cycle 5: 2010-??. China enters a new inflation paradigm

As of March 2011, inflation is showing unprecedented breadth and considerable momentum in
China. The State-sanctioned investment boom engineered in November 2008 is still running
and China’s demand for the world’s bulk commodities remains particularly high. At the same
time, the attempt to rebalance the economy away from investment/exports towards
consumption, facilitated by hefty minimum wage increases, is triggering significant first time
demand from Chinese households for cloth, higher calorific content food, and cheap
domestically produced consumer durable goods. All this has been a pretty heady mix for
inflation, which hit a 32-month high of 5.4% yoy in March.
From a cyclical point of view, there are most probably four factors behind the current inflation
cycle. First, the cyclical rebound from the global slowdown where China appears to have led
the recovery. Second, the ultra-expansionary monetary policy of the advanced economies is
being imported via the exchange rate mechanism. Third, the extraordinary fiscal policy
support that China created itself. Finally, higher commodity prices as a result of generous
liquidity conditions globally and the investment-led nature of fiscal stimulus globally, but
particularly in China.
10 27 May 2011
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Inflation Themes
This current price cycle is different from 2007-08 Narrower dispersion indicates broader-based inflation
% YoY Sum of squares F-test statistic
CH CPI: Headline
2002-04 2006-08 2009-10 2002-04 2006-08 2009-10
25 CH CPI: Food
CH 324.1 901.4 231.2 10.2 20.7 4.9
CH CPI: Energy
20 CH CPI: Housing
HK 1,368 327.1 10,310 23.1 9.7 10.0
IN 88.2 113.9 1,815 8.3 2.8 20.3
15 ID 418.4 983.7 543.4 15.4 23.1 22.4
JP 6.4 445.3 50.7 1.7 43.8 1.3
10
KO 263.1 735.8 156.0 12.4 20.4 3.7
5 MA 710.3 1,106 501.3 32.1 11.8 1.9
PH 133.4 293.8 374.0 5.7 8.3 5.4
0 SG 237.1 355.1 40.9 6.3 2.2 0.4
TA 107.4 609.0 372.0 4.8 15.9 3.8
-5
TH 2,400 1,453 501.3 54.8 13.9 1.9
-10 VN 195.4 2,889 280.3 4.0 12.6 2.5
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Note: Statistical variance between food, housing, energy and non-durable components of
inflation during past three inflationary cycles; the smaller the test statistic, the higher
degree of covariance between drivers.
Source: CEIC, SG Cross Asset Research Source: SG Cross Asset Research
Why the fifth cycle is different?

We must stress that the fifth and current inflation cycle is not just a food dynamic as many
believe. The Fifth Cycle is a much more broad based inflation impulse than any of the cycles
that went before it. In the table above, we conduct an analysis of variance of the major
subsets of the consumer price basket. For all of Asia, the dispersion of inflation in the various
subsets is much lower than the 2006-08 cycle, but this is particularly the case for China. As
the table above shows, the dispersion of inflation in the various sub-sets of the CPI has fallen
sharply. That is, inflation is more uniform and broadly based than in previous cycles.
Though it may sound technical overkill, if we take the third-difference in China’s CPI, which is
the rate of change of the rate of change (i.e. how fast Chinese inflation is accelerating), we can
see that at no time in China’s modern economic history has inflation built up such formidable
momentum.
Trend inflation to be higher as China rebalances The consequence of lessons forgotten. Inflation accelerated
over 2010 at the fastest rate ever.
160 China CPI Third Difference in the CPI

2001=100 60
140
50
120 40
30
100
20
80 10
0
60
-10
40 -20
-30
20
-40
0 -50
1991 1995 1999 2003 2007 2011 1985 1990 1995 2000 2005 2010
The fundamentals in this current inflationary cycle are different from the 2007-08 period, but
there are passing similarities. The food price dynamic is the most obvious common
characteristic between the two cycles, albeit the current one is still well short of the highs seen
in 2007-08. Yet this inflation cycle is also more broad-based than in 2007-08 with the
dispersion of inflation components being considerably tighter this time. With the exception of
energy, this confirms that China is experiencing a more general rise in the price level in this
cycle, while the fourth cycle of 2007-08 was almost singularly a food inflation dynamic,
27 May 2011 11
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Inflation Themes
supplemented by an exogenous energy price event, which eventually led to wider pressures
for pass-through to a range of goods derived from energy or food.
Government policy, however, does appear to have been more successful in the fourth cycle
than in the previous cycles. Inflation peaked five months before the Lehman Brothers collapse
so we can’t tap that as the cause for China’s inflation slowdown in late 2008 and 2009. Still,
the onset of the global financial crisis ensured that there was no risk of price pressures re-
emerging (the average length of inflation up cycles in China is 23 months) and the emergence
and persistence of large output gaps in the rest of the world — around 75% of the global
economy was in recession — effectively disguised rather than treated the underlying causes
of the 2007-08 inflation cycle. Moreover, the National Development and Reform Commission
(NDRC) went to extraordinary lengths to regulate prices over this period. At the peak of price
regulation, we believe that over 70% of the Chinese CPI basket was set by the NDRC.
This cycle is still getting started or nearly run through? Wage rises have stayed ahead of food costs
1986-88 1991-94 1999-2001
2,400
2002-04 2006-08 2009~11 2,200
140 Food CPI level
CPI price level, rebased at
2,000
Index level, 1986=100
135 Urban income level

starting m onth to 100
1,800
130 Rural income level
1,600
125 1,400
120 1,200
115 1,000
800
110
600
105 400
100 200
95 0
1986
1987
1988
1989
1990
1991
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
1992
0 5 10 15 20 25
Months into the inflation upcycle
Source: CEIC, SG Cross Asset Research Source: CEIC, SG Cross Asset Research
This government intervention to cap prices is particularly noticeable in the most politically
sensitive subset of prices – food prices. We also note that China’s food price escalation did
have a similar profile to 2007-08; a pause in inflationary momentum at the 11-14 month point
into the upswing, likely caused by government intervention measures to cap rises. However, a
second phase usually emerges and extends the food price cycle by at least another 12
months, though this could be considerably longer (the 1991-94 cycle lasted six years).
So far, the 2009-11 food price cycle remains moderate in comparison to the 2006-08 and
2003-04 food inflation cycles and is modest compared to the most severe food inflation cycle
in 1988-89. Still, there is no sign yet that food prices have come under control, and we would
not have a significant disagreement with many analysts, indeed policy makers, who now argue
that food price inflation is indeed a structural, not cyclical dynamic.
The political response to food inflation also becomes one of the most important defining
features of the Fifth Cycle in that powerful structural dynamics (rapid income growth etc) are
being offered in response to cyclical inflation pressures. The political response appears to
have shifted to rely on wages hikes to absorb the burden of inflation, rather than using
administrative measures, especially as China becomes less of a price taker and more of a
price setter, especially in the global commodity space due to its role as the dominant importer
and consumer.
12 27 May 2011
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Inflation Themes
Labour demand exceeds supply Minimum wage growth increasingly faster than CPI
City Labour Markets: Demand-Supply Ratio CPI versus Minimum Wage Growth
PY=100,
1.10
20
1.05 18
1.00 16
14
0.95
12
0.90
10
0.85 8
0.80 6
4
0.75
2
0.70
0
0.65 -2
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
0.60
Mar-2001 Mar-2003 Mar-2005 Mar-2007 Mar-2009 Mar-2011 CPI Year Average % Shanghani & Beijing - Avg growth in Minimum Wage %
Source: SG Cross Asset Research
A further cyclical consideration is that the Chinese labour market is considerably tighter in the
Fifth Cycle compared to all four previous inflation cycles. The ratio of labour demand to
supply hit a record high of 1.07 in the first quarter, up from 1.01 in Q4-2010. This quarterly
survey of job centres in 100 cities is clear evidence that China’s labour market is very tight and
tightening further. Rural wage growth accelerated to 13% yoy in Q1 2011 from 10% yoy in Q4
2010. In response to the tightening labour market and the healthy gains in rural wages,
provinces have to raise minimum wages by a significantly faster amount to attract surplus
rural workers back into city jobs. Thirteen provinces and cities raised minimum wages by an
average of 21% in Q1 2011. Wages growth of this magnitude will continue to feed into higher
manufactured goods prices.
Not even China can escape Friedman’s monetarist dogma.

The list of causes for China’s current
Many play parts, but money has the leading role
inflation run-up seems to be a long
Statistical Significance
Contributions to
one, and so far we have only CPI run-up in 2010/11
considered the cyclical drivers of Inflation Expectations 3.28 0.73
Output Gap 9.62 0.47
inflation. In order to quantify the Money growth 3.39 1.24
contributions from each factor, we Commodity prices 4.90 0.75
CNY NEER 8.64 0.75
have developed a model for China’s
from smallest significance/contribution to most
headline inflation since 2001. The Source: SG Cross Asset Research/Economics
most statistically significant factors,

as our model suggests, are the output gap lagged by one quarter, CNY nominal effective
exchange rate lagged by four quarters, global commodity price, money growth lagged by four
quarters, and inflation expectation lagged by one quarter (please refer to the Appendix).
Compared to the big inflation cycle in 2007-08, the most distinct factor this time around is
money growth. Back then, the economy overheated badly on strong investment dynamics, but
money supply growth was much more muted at 15~17% yoy. This time, the economy is not
as overheated as in 2007, but liquidity bubbles, resulting from China’s bank lending tsunami,
have more than compensated for the role of a sizable positive output gap, by being the No.1
inflation contributor.
For your information, the key inputs and outputs of our top-down fundmantal China inflation
model are printed on the following page.
27 May 2011 13
F179665
Inflation Themes
SG’s model of Chinese inflation – key inputs

SG model of China’s CPI
10 % yoy 10 90
%, yoy
8 CPI Headline
8 CPI Headline
CPI: SG Model
Inflation Expectations (lagged by 1Q, RHS) 80
6
6
4
4 70
2
2
0
60
-2 0
-4 -2 50
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
10 3 10 35
%, yoy % of potential GDP %, yoy % , yoy
8 CPI Headline 2 8 CPI Headline

Output Gap (lagged by 1Q, RHS) M2 grow th (lagged by 4Q, RHS) 30
6 1 6
25
4 0 4
20
2 -1 2
15
0 -2 0
-2 -3 -2 10
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
10 80 10 -10
%, yoy % , yoy %, yoy % , yoy
CPI Headline 60 8
8 -5
IMF commodity index (RHS) 6
40
6 0
4
20
4 2 5
0
0
2 10
-20
-2
0 -40 CPI Headline 15
-4
CNY NEER (lagged by 3Q, RHS, reverse scale)
-2 -60 -6 20
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: CEIC, Bloomberg, SG Cross Asset Research/Economics
14 27 May 2011
F179665
Inflation Themes
The arrival of structural inflation!
Urbanisation, surplus labour and Lewisian turning points

History is replete with lesser examples of the China episode
Modern economic history, particularly that of North Asia from the 1940s through to the early
1990s, is abundantly rich with evidence that rapid development can be engineered via the
process of centrally planned urbanisation and industrialisation. Japan and South Korea stand
as guiding lights of this process though, through the less kindly tint of hindsight, the ultimate
success of these rapid industrialisation policies has been questioned. The most important
dynamic, that millions were lifted out of a life of poverty in an unprecedentedly short period of
time, is often overlooked. It should, however, be a clear benchmark by which the success of
development policies is measured.
China is urbanising at a faster pace than previously thought.

The two most powerful and evidentially transformative examples of rapid urbanisation in the
past century are that of Japan after the Second World War and South Korea shortly after the
end of violence on the Korean peninsula. The evidence is indisputable. At the time, the
urbanisation and industrialisation of Japan was without precedent. It was only the South
Korean experience that surpassed this. Then from the modern economic reforms of Deng
Xiaoping, announced in 1978 to China’s dramatic and irreversible accession to the WTO in
2001, the greatest multi-year migration of people in history ushered in the largest poverty
reduction outcome ever achieved.
One of the most important results of China’s census, released in late April, is that the pace of
urbanisation has been significantly quicker than previously thought. As of the end of 2010,
49.7% of the population lived in urban areas. That is 3 ppt, or 44 million people, higher than
the National Bureau of Statistics’ last estimate for 2009. More importantly, it is well above the
standard United Nations projections for 2010. This means that China will achieve a very
important milestone in its development: over the course of 2011, a majority of China’s
estimated 1.35 bn people will become urbanised.
However, a significant and important qualification is that four in every ten urban residents did
not hold a local registration, known as a hukou, up from three in ten urban residents in the
2000 census. One of the most difficult variables to capture in China is the size of the so-
called highly mobile migrant workforce. Indeed, given the size of this population and the fact
that it is so mobile, it can often be considered the “marginal worker” in terms of changes in
employment and changes in labour costs. Hence, the actual urbanisation rate could be lower
than 40%, if we exclude those who work in cities but do not settle there.
It is here that we must stress that an urbanised population greater than 50% is NOT the same
as the economy having moved through its Lewisian turning point. China is still around two
decades away from reaching the type of urbanisation rates that characterised Lewisian turning
points in Japan and South Korea during their most rapid periods of industrialisation.
The most significant differentiating factor, in the Chinese case, is that the pace of
industrialisation does not necessarily match the pace of urbanisation. Migrant workers, who
do not hold hukou registration, are not necessarily economically active in urban areas though
they may actually be physically located there.
27 May 2011 15
F179665
Inflation Themes
Pace of urbanisation and real wages growth China’s Lewis turning points: one down and one to go
18 13
20 Nom inal Wage Growth, % YoY
16 12
14 11 Urban Lewis
18
12 10 Turning Point
10 9 16
Rural Lewis
8 8 Turning Point
6 7 14
4 6
2 5 12
0 4
-2 3 10
-4 2
-6 1
8
1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
Urban Rural
Real Wages YoY % LHS
6
Urban Population Growth - Rural Population Growth RHS 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Is China’s move to structural inflation really that unique?

There is no rulebook for best economic practices when an economy rapidly industrialises and
urbanises. There are precedents in Asia however with Japan and South Korea paving the
way.
The idea that China was approaching its Lewisian turning point, that is, had moved through
the point of surplus labour, and that, rapidly rising real wages would reflect the new labour
market dynamics in China were arrested by the global financial crisis. The issue of wages and
surplus labour drew ever more attention over the course of 2006 and 2007, particularly as the
economy was growing well above potential, but the recessionary impact of the financial crisis
and the sharp reduction in demand for Chinese exports in late 2008 and early 2009 led to a
large and sharp reduction in demand for labour in the coastal provinces.
Though no doubt severe, the pull-back in labour demand reversed surprisingly quickly.
Indeed, the shortages of unskilled labour and rising real wages returned with extraordinary
strength in 2010 in response to the expansionary monetary and fiscal policy put in place.
More so, due to the labour-intensive infrastructure projects that were put in place in the
central and western provinces; lower housing and living costs coupled with abundant job
prospects temporarily reversed migrant labour from rural to coastal areas. This dynamic of
rural to urban labour migration has been one of the key structural underpinnings of China’s
rapid productivity growth over the past two decades.
Chinese inflation in the modern economic period Relative performance of inflation during high growth periods
30 35
Consumer Price Index China (2000)
25 CPI: % Y oY 30 Japan (1960)
25 Korea (1970)
20
5 y ear av erage
20
15
15
10
10
5
5
0
0
-5 -5
1985 1990 1995 2000 2005 2010 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
16 27 May 2011
F179665
Inflation Themes
Relative performance of wages during high growth period Relative urbanisation during high growth periods
500 90 Population: % Urban

Real Wage Index
450 80
China (2000)
400 Japan (1960)
70
350 Korea (1970)
60
300
50
250
200 40
Korea (1965) China (2000)
150 30
Japan (1950)
100 20
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 5 10 15 20 25 30 35 40 45 50 55 60 65 70
Relative performance of GDP during high growth periods Relative performance of GDP per capita during high growth
periods
20 450
China GDP Y oY % (2000) Japan GDP Y oY % (1960)
China (2000) Japan (1960)
400
15 Korea GDP Y oY % (1970)
Korea (1970)
350
10
300
5 250
200
0
150
-5
100
-10 50
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
China has reached its first Lewisian turning point

China reached its first Lewis turning point back in 2003. The income gap between rural
migrant workers and agricultural labourers has provided a powerful incentive for the latter to
try to find better-paid non-farm jobs. The massive labour flows out of rural areas eventually led
to labour shortages in agricultural sectors starting in 2003 and 2004. Since then, rural wages
have been growing significantly faster than urban wages. Between 2004 and 2010, the
average wage growth was 3.5 ppt higher in rural areas than in urban areas. As rural regions
supply the low-skilled labourers, fast-rising rural wages largely determines the wage growth in
those industries that relies on marginal workers. This is why we have heard so many stories
about labour shortages in the export-oriented coastal cities, especially in years when food
inflation makes rural jobs more appealing.
However, the second Lewisian turning point is a long way away.

Although migrant workers earn only about USD1,500 per year on average, the income gap
between them and agricultural labourers provides a powerful incentive for the latter to try to
find better paid non-farm jobs. Naturally, this competition in the labour market suppresses
non-farm wages: whereas labour productivity in non-farm sectors increased by 10-12%
annually in the past 15 years, migrant workers’ real wages have increased by only 4-6% per
year. As a result, income disparity between low-end labour, on the one hand, and
professionals and investors, on the other, has also increased.
27 May 2011 17
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Inflation Themes
Another sign that China still has a big surplus of labour is the stagnant income growth for
college graduates. Around 6 million students complete their tertiary or higher education every
year in China. It seems they are not exactly riding the tide of rising wages as rural migrant
workers. The Chinese Academy of Social Sciences, one of the leading think-tanks in China,
showed in its report on China’s Population and Labour that salaries of those much better
educated graduates are not much higher than the wages of rural migrant. The mismatch
between supply and demand of white-collar jobs reflects the underdevelopment of China’s
service sector. In 2010, services contributed to 43% of China’s total GDP, which was much
lower than the levels Korea and Japan reached during similar phase of development.
All this means that the process of industrialization in China still has a long way to go.
According to research published by the US Bureau of Labor Statistics in 2009, Chinese
manufacturing workers' hourly wage was only USD0.81 in 2006 or 2.7% of comparable costs
in the US, 3.4% of those in Japan, and 2.2% of those in Europe. After five years of growth,
inflation, and currency appreciation, we estimate that the wages of Chinese workers are still
just around 5% of the levels in the G3. If assuming an annual wage growth of 15% for another
decade and cumulative 20% appreciation of the yuan, China’s wage level could approach
25% of the G3 — still an ocean apart.
To reduce farm labour to 10% of the labour force (the point at which, judging by historical
experience elsewhere, China may achieve worker-farmer wage equilibrium), the economy
needs to create about 150 million new non-farm jobs. Even if the economy continues to grow
at 8% per year, China might need 20-30 years to reallocate agricultural labourers and reach
“full employment”. But this requires generating eleven million new jobs every year, including
five million for farmers leaving the countryside.
Productivity differentials square the hole

The productivity gains of urbanisation
There is one simple reason why China has been able to sustain such a long period of real
wage growth without generating a wage-price inflation spiral. It is simply to do with the
marginal output of rural and urban employment. China has been engineering the greatest
human migration of all time as it rapidly urbanises its previously large rural peasantry.
The productivity of the rural and urban workforces is starkly different. Farms are collectively
owned with little incentive for individuals who do not possess land rights to significantly boost
their output as the profits or gains are socialised. What we find then is that when a worker
moves from rural to urban employment, the total output of the economy rises significantly.
There is a significant increase in urban output, but little or no reduction in rural production. It
is then just a simple process of arithmetic; rural productivity also rises as you have the same
output with less workers.
The specific economic characterisation of this dynamic is that for a surplus economy, there is
significant redundant rural labour; hence the marginal product of labour in rural areas is very
low, if not zero.
The evidence of labour shortages on the Eastern seaboard became apparent in early 2010
and labour shortages were more generally recorded across cities in the central and western
provinces by the beginning of 2011. As many migrant workers had left the cities to find jobs in
the central and western provinces, with its considerably cheaper living and housing costs;
wages had to rise significantly in the coastal provinces to attract these workers back. Hence,
what we find with the global financial crisis, that led to a temporary reversal or rural to urban
18 27 May 2011
F179665
Inflation Themes
migration and the China stimulus package, is not so much an acceleration of urbanisation but
a resumption of a trend that had been interrupted by the impact of the global crisis on the
manufacturing heartland of the Eastern seaboard.
Indeed, we are probably just one decade into this multi-decade dynamic of real wages starting
to rise in urban areas on the back of productivity differences. China’s nominal wages
essentially fluctuated with inflation for the first two decades of the reform period with only
small increase in real wages. It was with WTO accession, and China’s rapid march up the
value added chain, that saw real wage growth start to lift sharply. Indeed, real wages growth
has been running in double-digits from 2000 onwards. Until 2003, real wages grew less
strongly than average productivity; but in 2004 and 2005 wages growth ran ahead of
productivity.
China can sustain higher wages growth due to outstanding productivity growth
15
Real wage growth, in %, 2005-07
CN
10
ZA
KR
5
CZ
BR HU Productivity growth, in %, 2005-07
0
MY PL
CL TR
-5
ID
-10
-5 0 5 10 15
Wage efficiency & productivity will prevent manufacturer flight

The key question that arises from China’s recent wage dynamics is whether the Chinese
labourer becomes too expensive for cost minimising multinational or platform companies.
China’s export juggernaut represented the very apex of decades of globalisation and
exponential improvements in real-time distribution management. Parts could be produced in
various countries of Asia, and then assembled into final goods in the country with the lowest
labour costs. For over a decade, that has been China and the result of this has been China’s
subsuming of the Asian trade surplus into its own trade surplus as the final assembler and
exporter of goods.
Are wages now rising at such a pace that the economy is at risk of the manufacturing sector
becoming flighty? Vietnam, Bangladesh and even Mozambique show little reluctance or
hesitation to replicate the China growth model, taking advantage of their even cheaper labour
costs to become the new final assembler at the end of the Asia supply chain.
Urbanisation’s contribution to inequality prompts faster minimum wage gains

The two-decade process of urbanisation has underpinned the formation of China’s army of
low cost workers but it has also contributed to growing income disparity in China. Indeed, the
extent of income disparity, as most evident in the complete inability of non-urban residents to
be able to access the property market, became a serious social tension in 2010, thereby
27 May 2011 19
F179665
Inflation Themes
prompting the government to embark on more pro-actively support rural incomes and income
growth, including a gargantuan economic housing building program and interventions in the
labour markets (at various levels) to force minimum wages higher.
The rapid wages growth we are seeing — in some provinces, minimum wages have increased
by more than 30% — is part of a multi-pronged strategy aimed at reducing inequality. Beijing
and Shanghai, for instance, announced a second round of wage increases this year and other
provinces are likely to be forced to follow suit in order to retain or attract labour. But there is a
very important distinction that should not be overlooked: the minimum wage is normally much
lower than the effective or the actual wage that is paid in China. As such, the dramatic
increase in wages has not changed the fundamental relationship between wages and labour
productivity, which remains extremely high. So, despite the strong gains in headline wages,
the efficiency of wages remains high.
Urbanisation now involves two-way flows of labour and capital.

Labour flows outwards and capital flows inwards.
A simple way to think of the change of the inputs into production as a result of urbanisation is
simply to think of labour and capital as a two lane highway. We will ignore the Solow residual
for the time being and assume that capital flows are travelling in one lane and that labour
flows are travelling in the other.
The early period of modern economic reform, indeed the latter stages following China’s
accession to the WTO, were characterised by a one-way flow of both labour and capital (more
in the form of bulk commodities) from the interior regions to the coastal provinces.
November 2008 turned out to be a dramatic turning point for this dynamic with Beijing
engineering a rapid and profound reversal of this unilateral flow in both labour and capital.
The instigator for splitting the flow was the massive State sponsoring of financial transfers
from the State banking system to the workers and companies, via the State utilising the banks
as fiscal agents, primarily to lend to SOEs and Local Governments.
As early as 2009, it became obvious that both capital and labour flows were following financial
transfers into the interior central and western regions. This proved to be the powerful
foundation for the capital and labour flows that were to follow. Financial transfers from the
coast to interior regions, via government fiscal allocation, improved infrastructure, including
education (higher skilled workers), transport (more accessible workers) and public goods
(schooling, hospitals etc), to improve the quality of life in these regions.
The catch-up to developed world living standards may be surprisingly quick

China’s real manufacturing wages in US dollars in 2010 were about 7.6 per cent of those in
the US. Korea was a little below that at 5.2 per cent in 1975, yet some 20 years later, it had
risen to 50% of the US. With reference to the charts above, the pertinent question is will it
take more or less years for China’s labour costs to rise to half that of the US?
A third important factor is the rate of wage inflation. The role of wages in inflation dynamics in
emerging markets has received attention from two major angles. One is that an exogenous
wage shock can lead to cost-push inflation if the monetary authorities follow an
accommodative policy. The other is that the backward-looking indexing mechanism, by which
current wages follow past inflation, can give rise to strong persistence effects. Dornbusch and
Fischer (1993) note two specific features of the indexation mechanism in the high- to
moderate-inflation economies that could produce such effects. First, indexation encourages
longer-term contracts, which make the inertia effect particularly strong. Second, the typical
20 27 May 2011
F179665
Inflation Themes
indexing formula tends to make real wages a negative function of inflation, implying that real
wages and unemployment increase when the inflation rate is reduced. The resulting output
cost may discourage authorities from engaging in a process of sustained disinflation. In
addition, the wage indexation mechanism may play a role in the transmission of exchange rate
movements to inflation, since the frequency with which wages are revised tends to increase
when the inflationary pressures are driven by exchange rate depreciation (Leviathan and
Piterman, 1986). This has been an important factor in the inflation episodes of some of the
Latin American and transition economies, where devaluation-induced inflation has had higher
persistence effects than inflation driven by domestic factors.
Are commodity prices now structural determinants of Chinese

inflation?
It is not difficult to understand the reason for our expectations of generally rising commodity
prices. It is simply a result of several billion people living in emerging economies that are
gaining economic clout and improving their standards of living, often in an extremely
commodity-intensive way. This generational shift in global consumption patterns leading to a
secular rise in commodity prices was temporarily thrown off course by the Great Recession of
2008, but the longer-term direction is clear.
A common argument for ignoring commodity prices when calculating or predicting longer-
term measures for inflation is that these prices “mean revert,” meaning large rises in prices are
followed by equally large drops. We think this is true to the extent that we do not expect
continued 80% increases in grain prices like we saw in 2010 or the 50% rise in oil prices we
saw in the first half of 2008. Both those rapid increases in prices were due to special weather-
related factors that exacerbated the fundamental long-term tightening in natural resources
that we are living through (although they do underline the points that supply lines are generally
stretched and weather patterns are becoming more volatile). We feel that although commodity
prices may show tendencies to revert to a “mean,” the mean itself is not static, but rather a
moving and, in our opinion, a rising target.
Hence, as far as “mean reversion” in commodity prices goes, we would say that “history does
not repeat, it rhymes”. Rapid rises are likely to be followed by modest pullbacks; however, five
years from today, prices are likely to be higher on average than they are today.
27 May 2011 21
F179665
Inflation Themes
China’s liquidity legacy
Though there is clearly a changing interplay between the structural and cyclical drivers of
inflation, China also has its very own legacy issue from the global financial crisis that is
proving extremely difficult to control. Ultimately, the excess liquidity in the Chinese economy
– and it is enormous – will contribute to either asset price inflation or goods price inflation,
most probably both!
China’s broad money doubled in the last four years and reached CNY72 trn at the end of
2010, equivalent to 182% of nominal GDP. The PBoC is currently locking up more than one-
third of total money supply through required reserves and central bank bills. However, the
remaining two-thirds (or about 130% of GDP) still look disproportionally generous.
Why has China printed so much money and, more importantly,

why does it continue to do so?
Recounting how China prints so much money is essentially the history of its impressive
investment booms. Indeed, the three periods of sharp acceleration in money growth since
1990 has well coincided with the three big investment booms. The first one occurred in
1992~1993 after Deng Xiaoping’s southern tour. The second boom occurred in the lead up to
and shortly after WTO ascension. The latest boom was the direct result of Beijing’s four-trillion
yuan fiscal stimulus in 2009, a response to the global crisis. In each of the three investment
cycles, money supply and domestic investment moved in lock step.
Investment and money supply, which comes first? The egg, the China inflexible currency regime is taking monetary policy
chicken or the frying pan? hostage
100 Investments' contribution to GDP growth (%) 40 600 10

Y oY change in FX reserv es (USD bn)
M2 (%yoy, RHS)
500 CPI (% Y oY , RHS) 8
80
30
6
400
60 4
20 300
2
40
200
0
10
20 100 -2
0 0 0 -4
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
The state share of Chinese economy has declined over years, but the authorities are not
getting any less efficient in ramping up credit growth. On the demand side, local governments
are fully motivated to boost growth with grand city plan and mega infrastructural investments;
on the supply side, the commercial banks are well rewarded with easy profits guaranteed by
the regulated wide spread between deposit and lending rates. Risk is less of a concern, as the
system seems to be working under the implicit assumption that all these projects are backed
by the full-faith of the cash-rich central government. Hence, on a scale from one to ten, if the
central government aims to achieve seven or eight, the results usually turn out to be ten. This
explains why China is so prone to overshoot money growth.
The still rigid currency regime is another mechanism in place that makes liquidity management
PBoC’s job more difficult than otherwise. Maintaining a targeted exchange rate has
22 27 May 2011
F179665
Inflation Themes
significantly curtailed China’s scope for monetary policy, as the Mundell-Fleming trilemma
would suggest, to address domestic inflation objectives. China has been running large trade
surpluses and capital account surpluses for almost a decade, which implies appreciation
pressures on the yuan. In order to keep its currency from appreciating too fast, the PBoC has
been forced to print CNY20 trillion since 2001 to keep up with the demand for the yuan. The
central bank has diligently sterilised 80% of such money. The quickening pace of FX reserve
accumulation and the rising cost of sterilisation are posing huge challenges to liquidity
management going forward.
So in a nutshell, China’s excessive money growth is a function of its own highly imbalanced
growth model, which relies on cheap credit and competitive exchange rate to boost
investments and exports. Hence, the inflation problem is also one of the symptoms of China’s
imbalance illness, and the right cure is probably not just cyclical monetary tightening like in a
typical economic cycle.
A tough war against excessive liquidity
45 China's own
% of nominal GDP
version of
40
Increases in Money Supply QE
35
o/w increases in FX reserves
30
25
Capital
inflows to
20
pose more
15 challenges
10
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Has policy error contributed to inflation in this cycle?

Is the PBoC slow in response? Yes and no.
Despite all sorts of signs of asset bubbles and economic overheating, rate hikes didn’t kick off
until after CPI inflation exceeded 3%. This cycle extends the tradition of being too late. All the
rate cycles since 2000 lag inflation cycles in terms of timing or magnitude, or both. In 2004,
interest rates were not moved at all, yet CPI inflation approached 6%. In 2007, interest rate
started to normalize after CPI inflation rose above 3%. Because of the delay, the real deposit
rate remained negative for 24 months and bottomed at -4.56%.
In spite of this poor track record of rate decisions, we still think the PBoC
China’s inflation and monetary tightening cycles
% CPI RRR Interest Rate
has been trying quite hard to be a good central bank. After all, as a non-
zero to peak bottom to peak bottom to peak independent central bank, the PBoC needs approval for each interest rate
2003/04 5.3 1.5 0.25
2007/08 7.9 8.5 1.89
decision from the State Council.
2009~11 5.1 4.5 1.00
Source: CEIC, SG Cross Asset Research/Economics Among the policy tools at its disposal, the PBoC has much more say in
decisions for required reserve ratios. Plotting the year-on-year change in this
ratio against headline CPI and we note that its movement has followed the inflation cycles
strikingly well since 2003. In each cycle, the central bank started hiking the RRR at the very
27 May 2011 23
F179665
Inflation Themes
beginning of the inflation run-up and didn’t hesitate to drive it higher as inflation continued
untamed.
“Great” tolerance for negative real interest rate RRR hikes are used proactively
5 Real Deposit Rate, % 1 7 10

Y oY change in RRR (%)
4 0.9 6
24 months 8
13 months CPI (% Y oY , RHS)
3
16 months so far... 0.8 5
2 0.7 4 6
1 0.6 3
4
0 0.5 2
-1 0.4 2
1
-2 0.3 0 0
-3 0.2 -1
-4 0.1 -2
-2
-5 0 -3 -4
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: CEIC, PBoC, SG Cross Asset Research
Between January 2010 and May 2011, the People’s Bank of China has hiked the required
reserve ratio eleven times, and the benchmark lending and deposit rates four times. But, the
problem of inflation and asset bubbles remains. It seems this cycle is very difficult to contain
with only monetary policies
The limitation of quantitative tools

The quantitative approach of monetary tightening is almost certainly reaching its limit.
Between 2004 and 2010, the share of FX reserves sterilised by required reserves and open
market operations declined from nearly 100% to around 80%, while the required reserve ratio
was raised from 7% to 18%. Yet, China’s current economic circumstance demands even
more!
In 2010, FX reserves accumulation contributed to 25% of the increases in broad money

supply. And, that share was substantially higher in recent quarters at 48.5% in Q3 2010, 77%
in Q4 2010, and 40% in Q1 2011. This suggested that a complete sterilisation needs a reserve
ratio of 40%! Apparently, it is unrealistic and impractical to solely rely on quantitative tools to
even tackle the flows. In other words, the PBoC hasn’t yet started to deal with the existing
huge money stock.
China could continue its current approach of quantitative tightening, but not likely for much
longer. Although the PBoC has made it clear that there is no limit to the level of the RRR, we
think 25~30% is probably the practical maximum level for the RRR, given banks’ loan-to-
deposit ratio requirement at 75%. If the RRR is raised beyond that level, even the state-owned
banks will have difficulty managing their day-to-day operations. Such level would cripple the
fluidity of the entire banking system.
Sterilisation is also not without cost to the PBoC. The interest rate paid by the PBoC on
required reserves is at an all-time low of 1.62%, which is 50 bps higher than 3-year US
Treasury bonds. Open market operations are even more costly to the PBoC, with the yield on
3 month note at 2.92% and that on 1 year bills at 3.31%.
A more troubling thought is that it seems capital inflows are set to pour in going forward.
There was no trade surplus in Q1, and so the USD300 bn addition to the already gargantuan
stock of FX reserves was almost completely due to surpluses under the capital account. China
24 27 May 2011
F179665
Inflation Themes
is clearly caught up between necessary further steps in exchange regime liberalization and
also necessary quantitative tightening. China’s trade surpluses may decline as domestic
demand continues to expand faster than external demand recovers. But, net income under the
current account is likely to increase, and capital account surpluses are seen to widen when
China opens up capital account and appreciate the yuan gradually. Hence, we think the pace
of FX reserves accumulation would remain very concerning to the PBoC in near term.
The PBoC has sterilised 80% of the inflows Bank lending quota fails to contain credit growth
120 % of FX reserv es 16 Total social financing (credit supply)

Required reserv es PBoC bills & notes CNY trn
14
100
12 others
80 10 stock market
8 corporate debt
60 acceptance bills
6
4 trust loans
40
2 bank lending in FX
20 bank lending in CNY

0
-2
0
2004 2005 2006 2007 2008 2009 2010
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Rate hikes have to step up, but now is not a good time
China needs to raise interest rates. The regulated benchmark deposit and lending rates in
China is just too low. The ten-year average real deposit and lending rate between 2001 and
2010 was merely 0.8% and 2%, respectively, nearly 3% lower than other Asian economies
and developed countries.
From a cyclical perspective, China could not achieve a proper normalization in monetary
conditions without lifting interest rates much higher. In an environment of abundant liquidity, a
negative deposit rate would continue to encourage households and corporate to look for more
profitable investments, thus fuelling asset bubbles. Price caps so far have created a whack-a-
mole game between speculators and the government as liquidity shifts from one asset class
to another. As property tightening intensified in the past 12 months, we have seen bubbles
emerged or emerging in various markets, spreading from equity market, domestic commodity
market, a number of storable food items, arts, and even Chateau Lafite Rothschild Wine.
From a structural view point, suppressed interest rates lie at the heart of excessive money
supply and economic imbalance. As the chart below shows that there is a fairly good
correlation between the relative size of money stock and the relative level of lending rates. If
we view nominal GDP growth rate as a macro gauge of average economic return in a certain
economy, the spread between this growth rate and the interest rate should be a logical
measure of the appropriateness of the interest level in this economy. China has a substantially
lower average interest rate relative to its nominal GDP growth compared to major emerging
and developed economies, and it also has one of the largest money stock (% of GDP).
Low deposit rates mean that households are implicitly subsidizing investments, making some
inefficient projects financially viable. This distorted price signal compromises the efficiency
level of capital allocation and the entire economy. Together with China’s political structure,
more capital gets channelled to less efficient state-related enterprises, and more efficient
private players get squeezed and crowded out. Over time, the overall productivity growth will
be affected. Initially, generous money growth mostly drives up domestic demand (investment
27 May 2011 25
F179665
Inflation Themes
and consumption), creating positive output gap. As profitable physical investment projects
runs out, the excessive money will be increasingly channelled to fuel asset bubbles and
general inflation. The danger is stagflation. This cycle resembles this scenario more than any
previous cycle, with less overheated economy but same elevated inflation.
Suppressed interest rates encourage efficient borrowing But interest rate hikes invite capital inflows
250 Broad Money 300 China 1y r benchmark lending rate 160

% of GDP, 2010 TW - HK best lending rate (bps)
120
200 200 HK's f inancial institutions' claims
CHINA on Chinese corporate (%y oy , RHS) 80
UK 100
JN 40
150 KR SI MY
TH VN 0 0
100 EU
AU
-40
IN -100
US PH
50 MX -80
NZ ID -200
Nominal GDP growth - Lending rate
2001-10 av erage, % -120
0
-300 -160
-6 -4 -2 0 2 4 6 8 10 12
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: CEIC, SG Cross Asset Research
China should boost the cost of capital not only for the sake of cyclical inflation problem, but in
order to address economic imbalance as well. And so interest rate hikes should continue and
should continue even after inflation peaks out in this cycle. Otherwise, excessive money
growth and inflation will be a recurring issue and haunt Chinese policy makers over and over
again in the coming decade.
But, it is not a very good time for sizable interest rate hikes, due to the problem of
capital inflows. The combination of four benchmark interest rate hikes and less credit supply
has driven market interest rates 30~60% higher. More and more Chinese companies are
tapping international bond markets and Hong Kong’s banking system for funding, so that they
can circumvent the mainland’s lending curbs and higher interest rates altogether.
According to Dealogic, China corporate have borrowed USD12.2 bn from international

investors so far this year, more than five times the amount raised during the same time last
year. Based on current trajectories, it shouldn’t take much longer to break the full-year record
of USD15.8 bn set in 2010. In addition, Hong Kong’s commercial banks’ total outstanding
loans to China’s non-financial corporate doubled between January 2010 and January 2011.
This upsurge even caught the attention of the Hong Kong Monetary Authority, the city’s de
facto central bank, who issued a warning about potential liquidity risks associated with such
lending.
Therefore, interest rate hikes seem to offset some of the efforts of the quantitative tightening.
Besides, as the yields on central bills, the cost of sterilisation needs to move up with
benchmark interest rates, rate hikes also makes open market operation more costly. The
PBoC is faced with a big dilemma with very small leeway in its choice of monetary policy tool.
The right cures: fiscal tightening and a new currency regime

Therefore, this cycle of inflation and excessive liquidity will be very difficult to contain with only
monetary policies. Monetary policy tightening could effectively squeeze small medium
enterprises and cause some growth deceleration, but as long as the insatiate demand for
investment and credit is not properly addressed, inflation would be a recurring issue.
26 27 May 2011
F179665
Inflation Themes
Another important implication is that the monetary policies are basically taken hostage by
inflows, and the inflexible yuan is the root cause. Beijing has now accepted that it is the
current exchange rate mechanism that is proving to be problematic from a liquidity
perspective.
In order to sterilise inflows, the balance sheet of the PBoC has swelled to nearly CNY27trn,
equivalent to 65% of China’s GDP and 50% bigger than Fed’s total assets, while China’s
economy is only one-third of the US. FX reserves account for 85% of total assets. On the
liability side, financial institutions’ reserves and central bank’s own bills account for 53% and
16%, respectively.
If FX reserves add USD200~300 bn every quarter, which has been the pace since Q3 2010,
the PBoC will be forced to print CNY1.1~1.8 trn in high-power money every quarter and
CNY4.4~7.2 trn in a year. This alone would contribute 6~10 ppt to M2 money growth. The
accumulation not only makes the management of FX reserves even more onerous, but also
adds immense amount of inflationary pressures to already concerning trend. No wonder the
PBoC Governor Zhou Xiaochuan recently admitted candidly that the “excessively rapid
accumulation” of China’s FX reserves was “already beyond [any] necessary and reasonable
level”.
This path will be more and more damaging to the Chinese economy. The most likely outcome
for China seems to be a combination of nominal appreciation as well as inflation. But in
addition to long-term structural productivity growth pressures, China appears to be trapped in
the perfect storm of inflationary pressures. Given the potential for social and political
disruption from high inflation, as we have seen, most famously in the 1987-88 inflation
episode and the culmination of that unrest at Tiananmen Square, Beijing may be in the
process of rethinking the inflation-appreciation trade-off. Thus, yuan nominal appreciation
may be closer at hand, and stronger than expected.
This policy stalemate leaves China with no other option but to finally reform the exchange rate
mechanism. We believe that the reform would centre on a new exchange rate mechanism that
aims to allow currency appreciation whilst deterring some of the damaging and, now,
unmanageable speculative inflows. The daily trading band would be widened to allow the CNY
to move more significantly on an intra-day and intra-week basis to introduce more volatility.
Sporadic large adjustments in the fixing (either way) could be employed as a further tool
against speculation.
Though such volatility seems to be anathema to the mantra of exchange rate gradualism, the
fact that the yuan is being rapidly adopted as an invoicing currency for intra-emerging market
trade will reduce the stress on Chinese exporters and importers of the rise in USD volatility. It
is notable that China has recently launched yuan options trading in the interbank market. This
indicates preparedness for rising exchange rate volatility and more effective hedging against
that.
In the near term, persistent expectations for more yuan appreciations may only lead to more
capital inflows. However, without currency reform China will remain trapped in disruptive
liquidity-driven cycles. Conventional and highly constrained policy tools have reached their
use-by-date. A reformed exchange rate mechanism is a qualitatively superior policy tool that
will much better address China’s current policy stalemate.
Once again, history provides a useful benchmark. In its industrialisation period, Japan
allowed the real effective exchange rate to appreciate by nearly 50% over the first decade of
27 May 2011 27
F179665
Inflation Themes
rapid growth and this kept inflation stable at just over 6% during this period. The OPEC oil
shocks complicate analysis after this period. In contrast, South Korea ran with a persistenly
weak currency policy and paid the consequences of this with inflation averaging nearly 15%
during its first decade of rapid growth.
Relative performance of inflation Relative exchange rate performance
35 220
Consumer Price Index China (2000) Real Effective Exchange Rate
30 200 China (2000)
Japan (1960)
180 Japan (1960)
25 Korea (1970)
Korea (1970)
160
20
140
15
120
10
100
5 80
0 60
-5 40
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Like South Korea, but not to the same extent, China has run a self advantagous exchange rate
policy allowing the currency to initially depreciate in real terms immediately after world trade
organisation ascension to rapidly facilitate the creation of its highly competitive export sector.
Over the past five years, however, the real effective exchange rate has appreciated byu nearly
20%. Again, this is mirrored in the inflation profile, with inflation on a steady rising trend
during the soft currency period, and inflation only falling after the exchange rate appreciated in
real terms.
Now or never? What will China’s new exchange rate regime

look like?
China’s present case and the historical example of South Korea and Japan decades earlier
clearly indicate the important linkage between the exchange rate policy chosen and inflation.
Japan, which allowed its currency to appreciate the most in real effective terms recorded the
most benign inflation. South Korea, which kept its currency artificially low, had persistently
high inflation.
China is now at the point where, as we outline above, its conventional policy tools are
reaching their limits. They have one policy tool which we believe has not been used effectively
enough to date – the exchange rate.
There are many things counter-intuitive about the behaviour of the Yuan. We often hear that
the yuan is held steady during periods of international uncertainty, but have a look at when the
pace of yuan was the fastest. As hot-money became either more risk-adverse, or indeed
dried up, at the beginning of the financial crisis in 2007-08, this was the period when China
chose to accelerate the exchange rate at the fastest pace in its post-float history. When hot
money is abundant, on the other hand, China dramatically slows the pace of Yuan
appreciation. This is a handy tool for deflecting, if not punishing, speculators, but it can wreak
havoc with the inflation profile for an economy that is a price-taker in its import markets.
With the required reserve ratio and lending rates reaching their practical limits, and therefore
becoming constrained policy tools, it would be an extremely risky policy to continue to run
such a speed-variant exchange rate policy. Indeed, such a policy could introduce even
28 27 May 2011
F179665
Inflation Themes
greater volatility into China’s inflation profile. Moreover, the faster pace of yuan appreciation
is certain to attract speculative capital inflows. Unfortunately for China, a fast pace of yuan
appreciation may help contain the domestic inflation problem, however, it only exacerbated
the domestic liquidity problem.
What would the new CNY regime look like?
CNY/USD
8.5
7.5
7 Two-way
movement in
wider band
6.5
6
2004 2005 2006 2007 2008 2009 2010 2011
For this reason, we believe one of the key elements of any exchange rate reform is the
inherent ability for China’s exchange rate mandarins to be able to punish and ultimately
dissuade speculators.
As China’s usual policy tools, lending rates and the RRR, reach their effectiveness limit later
this year, we expect China to undertake exchange rate reform, or a partial further liberalisation
of the exchange rate determination mechanism, to facilitate the use of the yuan as a more
effective policy tool to tackle inflation.
That reform will involve an initial 5% positive revaluation and a widening of the fluctuation
bands. This will give the currency mandarins the ability to engineer significant two-way moves
in the currency that will ultimately dissuade speculation and hence thwart the problem of
liquidity attraction that a simple yuan appreciation policy would invite.
The times they are a–changin’ in China and there is one remnant of the policy toolbox that is
looking quite dated: the exchange rate. It is time for China to more proactively use the
exchange rate as an inflation fighting tool, however a reform of the yuan determination
mechanism is necessary for that.
We expect that reform to occur in the fourth quarter of this year.
27 May 2011 29
F179665
Inflation Themes
What next?
As a simple thought-exercise, think back to last year and what your forecasts for activity and
inflation were in 2011? Like us, you have probably found activity has evolved as expected.
Inflation, on the other hand, appears to be universally stronger than even some of the most
bearish commentators were forecasting.
Global inflation dynamics are a-changin’ too

There are complex interplays at work that are likely to pan out over years, if not decades.
Though it would be a brave forecast to suggest that the “great moderation” was in fact
reversing, it certainly appears that something more profound is occurring than it having simply
ended.
The strongly uni-directional pressures on the global demand and supply curve that were a
feature of recent decades of globalisation were arrested by the global financial crisis. Some of
these pressures have been halted whilst others are, in fact, reversing. The ascension of China
to the WTO in 2001 was perhaps the most profound development in economics in recent
decades as it caused a massive boost to the global labour supply whilst constraining wages
growth in the developed economies. In short, the economic ascension of China, as the peak
of all that was considered benign in globalisation, flattened the global Phillips Curve to such
an extent that the output-inflation trade-off for the developed economies had skewed to such
an extent that much higher output could be tolerated without generating inflation.
New pressures on global supply and demand as old pressures reverse
Demand Supply
Price
Tighter Capital Supply
Asian Consumers
Finite Commodities
Commodity Demand
Protectionism
Deleveraging Climate change
Big government New Technologies

Policy
Regime
Ageing populations Deregulation
The major consequence of China’s policy response to the global financial crisis is that it is
now engineering an outward shift in the global demand curve. Is there any reason to believe
that the outward shift China engineers in the demand curve will be any less profound than the
supply curve shift it engineered a decade ago?
We still find the global supply curve to be relatively inelastic. It is thus a most unfortunate
paradox that the very policies China will use to rebalance its economy to more sustainable
growth will ultimately export inflation to the rest of the world.
30 27 May 2011
F179665
Inflation Themes
ECONOMICS
Global Head of Economics
Michala Marcussen
(44) 20 7676 7813
michala.marcussen@sgcib.com
Euro area
Klaus Baader James Nixon Vladimir Pillonca Michel Martinez
(44) 20 7676 7609 (44) 20 7676 7385 (44) 20 7676 7863 (33) 1 42 13 34 21
klaus.baader@sgcib.com james.nixon@sgcib.com vladimir.pillonca@sgcib.com michel.martinez@sgcib.com
United Kingdom Scandinavia / Switzerland Poland

Brian Hilliard Anatoli Annenkov Jaroslaw Janecki
(44) 20 7676 7165 (44) 20 7762 4676 (48) 22 528 41 62
brian.hilliard@sgcib.com anatoli.annenkov@sgcib.com jaroslaw.janecki@sgcib.com
Americas
Aneta Markowska Alejandro Cuadrado Rudy Narvas Brian Jones
(1) 212 278 66 53 (1) 212 278 73 13 (1) 212 278 76 62 (1) 212 278 69 55
aneta.markowska@sgcib.com alejandro.cuadrado@sgcib.com rudy.narvas@sgcib.com brian.jones@sgcib.com
Asia Pacific
Glenn Maguire Takuji Okubo Wei Yao Joseph Lau
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Research Associates
Lydia Boussour Martin Rose Mehreen Khan Ramzi Berrima
David Tam Samuel Slama Alexandre Donna
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High-powered money creation and/or broader monetary growth led by investment

inherently inflationary. Inflation is the natural consequence of rebalancing.

Macro Commodities Forex Rates Equity Credit Derivatives

A new domino theory.

Really? I mean really?

Here is how the dominos will fall.

With a growing risk of price-

believe that those secular -1

pushing up prices of energy

The second domino is in the process of falling.

This paper looks in detail at the first domino.

The first domino. Chinese inflation

Real GDP YoY - SG Forecast Inflation - SG Forecast

Source: CEIC, SG Cross Asset Research

Changing drivers of inflation in China

Yuan determination mechanism is expected to

High labour productivity growth may be hard to

From mahjong to dominos

China’s five inflation cycles

China’s five inflation cycles

Five Inflation Cycles

Source: CEIC, SG Cross Asset Research/Economics

Early days: China’s three cyclical inflation waves.

Cycle 1: 1987-89. China comes perilously close to hyperinflation.

Cycle 2: 1993-94. Deng Xiaoping overstimulates the economy.

China’s unusual deflation episode: 1998-2001.

In the lead up to WTO ascension in 2001, 110

its proletariat workers to an unprecedented 95

occurred over this period. This is perhaps 60

Cycle 3: 2003-04. The first inkling of structural inflation

Cycle 4: 2007-08. Food demonstrates its weight

more harm than good. There are a 25

range of policies — a hangover from 20

the Mao Zedong era — that 15

maintains China should be able to 10

feed its domestic population entirely

with domestic production. So, when

curtailed, as millions of pigs died of CPI YoY Food Inflation YoY

resort to importing frozen pork from

Cycle 5: 2010-??. China enters a new inflation paradigm

Why the fifth cycle is different?

160 China CPI Third Difference in the CPI

Source: CEIC, SG Cross Asset Research/Economics

135 Urban income level

Source: SG Cross Asset Research

Not even China can escape Friedman’s monetarist dogma.

most statistically significant factors,

SG’s model of Chinese inflation – key inputs

8 CPI Headline 2 8 CPI Headline

The arrival of structural inflation!

Urbanisation, surplus labour and Lewisian turning points

China is urbanising at a faster pace than previously thought.

Is China’s move to structural inflation really that unique?

500 90 Population: % Urban

Source: SG Cross Asset Research

China has reached its first Lewisian turning point

However, the second Lewisian turning point is a long way away.

Productivity differentials square the hole

Wage efficiency & productivity will prevent manufacturer flight

Urbanisation’s contribution to inequality prompts faster minimum wage gains

Urbanisation now involves two-way flows of labour and capital.