Can China avoid a crash?

China is taking aggressive action to curb inflation and engineer a soft landing for its economy. Will the measures work? And how will they affect the rest of the world? Simon Wilson reports.

What's happened?

On Christmas Day, China raised its key interest rate by 0.25% to 5.81%. That may not sound like much, but it was the second such rise in three months. Beijing is keen to tackle consumer price inflation (CPI): it stands at a two-and-a-half-year high. That's the result of a property market that's still booming, loose lending conditions, and rapid food-price inflation (caused in part by poor weather). On a trip to Inner Mongolia, premier Wen Jibao said that Beijing had already taken a "slew of measures" to combat inflation. The central bank governor promised to place inflation control at the centre of economic policy-making. So it's little surprise the Shanghai market has slipped 12% since November. The fear outside China is that any over-tightening in monetary policy could slow the growth of the Chinese economy and derail the global recovery.

Why is inflation so important?

Rapid price inflation (whether in revolutionary France or Weimar Germany) has historically been associated with political instability and social upheaval. In China the hyperinflation of the 1940s was a significant factor in the success of the communists in overthrowing the Nationalist government. More recently, the near-20% inflation rates seen in the late 1980s are widely cited as a causal factor behind the growth of the protest movement that culminated in the Tiananmen Square massacre in 1989.

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Is a similar upheaval a possibility now?

Beijing appears to be worried so worried that last week Wen Jibao took the rare step of speaking on a radio phone-in to reassure the public. "I can tell everybody, the government has complete confidence in tiding over this difficult stage together with the masses," he said. Responding to a caller angry at high food prices, he said that, "indeed in recent times prices have risen across the nation and under these circumstances the lives of low- and middle-income earners are evidently more difficult".

Should Beijing worry?

Yes, for two main reasons. The first is that the poor are disproportionately affected by price inflation because they spend the bulk of their money on food and other necessities. As John Stepek put it in a MoneyMorning commentary this week, the poor don't see inflation as a handy way of eroding their mortgage debt, but as something that could push them to the brink. This is particularly true in today's China because it is the food sector that accounts for much of the inflationary pressure. Officially, food prices were up nearly 12% in the year to November, accounting for 75% of the official CPI rise (with a one-third weighting in the calculation). But unofficially, reports suggest that prices for basic foodstuffs (such as grain, pork, edible oil, eggs, and especially vegetables) have soared far more, putting huge pressure on the poorest households.

And the other reason?

Sound economic management is Beijing's trump card when it comes to asserting the supposed superiority of one-party rule. Without it, things might look very different. Over the past couple of years, China's continuing strong growth has looked particularly impressive when contrasted with the Great Recession suffered by the US and other Western economies. But an urban population growing rich relatively quickly may not put up with a lack of political freedom and respect for human rights if the situation changes. An angry, hungry working-class and a disillusioned middle-class would be a dangerous combination.

How does this affect the global economy?

That depends on whether Beijing's strategy (of rate rises and tighter restrictions on bank lending) works. Some China watchers are pretty relaxed. For example, Andy Rothman, a Shanghai-based strategist for CLSA Asia-Pacific Markets, argued in an FT Beyondbrics blog this week that Beijing is on top of the issue. Food-price inflation is already subsiding from its late-2010 peaks. Besides, Chinese consumers are better able to handle inflation than those in other, poorer, Asian economies, because their incomes have been rising steadily in recent years. According to this view, the impact on the global economy may be minimal.

So there's nothing to fret about then?

Not all analysts are as sanguine. Standard Chartered's Li Wei expects inflation to tick up to 7% or 8% in the next few months. Goldman Sachs' Yu Song predicts the same, or higher. Many analysts are warning that China's slowness to tackle its rising inflation means its economy risks a hard landing this year. Andy Xie, formerly of Morgan Stanley and a long-term prophet of doom when it comes to China and its (alleged) property bubble (see below), issued a warning last week. Unless China curbs its inflation rate, its economy is likely to crash and trigger the next major global crisis.

China's property bubble

Chinese housing prices jumped 7.7% in the year to November.However, that rate masks much bigger leaps in some cities. A recent report for the Chinese Academy of Social Sciences found that prices (in the 35 cities surveyed) rose 15% in the first nine months of 2010, making house purchasing unaffordable for 85% of urban Chinese. The report found that prices are running at nearly nine-times disposable income. That's far higher than the equivalent multiple before the bursting of the US property bubble. Moreover, that figure soars to a multiple of 18 in Shenzhen and 22 in Beijing.