VZCZCXRO9921
OO RUEHCN RUEHGH RUEHVC
DE RUEHBJ #0855/01 0700602
ZNR UUUUU ZZH
O 100602Z MAR 08
FM AMEMBASSY BEIJING
TO RUEHC/SECSTATE WASHDC IMMEDIATE 5580
RUEATRS/DEPT OF TREASURY WASHDC IMMEDIATE
INFO RUEHOO/CHINA POSTS COLLECTIVE
RUCPDOC/DEPT OF COMMERCE WASHDC

UNCLAS SECTION 01 OF 02 BEIJING 000855 
 
SIPDIS 
 
SIPDIS 
SENSITIVE 
 
STATE FOR EAP/CM AND EEB/OMA 
TREASURY FOR OASIA/DOHNER 
USDOC FOR 4420 
STATE PLEASE PASS USTR FOR STRATFORD 
 
E.O. 12958: N/A 
TAGS: ECON EFIN PREL EINV CH
SUBJECT: PROMINENT ECONOMIST SEES CHALLENGE IN RESPONDING TO 
DOMESTIC HEAT VS. OVERSEAS COOL 
 
REF: BEIJING 800 
 
SUMMARY 
------- 
 
¶1. (SBU) On March 6, the Vice President of the National Development 
and Reform Commission's Academy of Macroeconomic Research, Ma 
Xiaohe, characterized elevated inflation as a challenge that will 
outlast recent food supply shocks.  Five consecutive years of 
double-digit GDP growth has boosted demand for labor, agricultural 
inputs, energy, and other raw materials (both domestic and 
imported), underpinning current price increases.  This trend, 
coupled with rapid expansion of the money supply due to continued 
large balance of payments surpluses, will make inflation "hard to 
control."  However, the headline CPI should moderate over the coming 
months as production increases in some of the food items that 
experienced supply shocks.  Government tightening to contain 
inflation and excessive investment growth may take hold just as 
external demand for China's exports slows, mandating a need to be 
"cautious."  On fiscal matters, Ma said the government's number one 
challenge is ensuring the proper targeting of funds as they pass 
through multiple levels of government.  His recent travel to the 
U.S. to study comparative public finance left him impressed with the 
transparency of budget formulation and debate, a quality that might 
prove helpful in reducing waste in China's own system.  END SUMMARY 
 
INFLATION: IT'S NOT JUST ABOUT FOOD 
----------------------------------- 
 
¶2. (U)  On March 6, the Vice President of the National Development 
and Reform Commission's Academy of Macroeconomic Research, Ma 
Xiaohe, discussed inflation, monetary policy, and fiscal reform with 
Fin MinCouns and Econoff. 
 
¶3. (SBU) Ma agrees with analysts who forecast a rise in the consumer 
price index (CPI) over the coming months, followed by a decline as 
food price increases, which account for 85% of the rise in the 
headline inflation rate, play themselves out.  This pattern will 
result from "base effects" (there won't be additional supply shocks) 
as well as increased production in response to higher prices. 
However, Ma characterized elevated inflation as a longer-term 
challenge that will be "hard to control," with roots in five years 
of double-digit growth coupled with rapid expansion of the money 
supply resulting from a large and growing balance of payments 
surplus. 
 
¶4. (SBU) Ma said that a sustained economic expansion has increased 
price pressure for domestic inputs to agriculture, industry, and 
services.  Wages are rising rapidly, a wealthier population is 
consuming more food, and expanding industries are using more energy. 
  Meanwhile, China is also importing inflation through its growing 
demand for raw materials, petroleum, and foodstuffs sourced abroad. 
Ma cited white goods as an example, telling the story of a friend 
who was warned that, as a result of higher steel prices, he would 
pay more for a refrigerator if he took delivery a month later. 
 
CPI WILL MODERATE 
----------------- 
 
¶5. (SBU) Ma named three reasons that the rise in the headline CPI 
will moderate six to eight months from now.  First, farmers are 
increasing pork and agricultural production in response to higher 
prices.  Second, monetary tightening now in process will slow the 
growth of domestic demand.  Finally, a downturn in trade partner 
economies will reduce external demand.  (Comment: Although China has 
declared a "tightening" posture, real interest rates have fallen 
over the last year, the RMB is hardly appreciating on a 
trade-weighted basis, and money supply growth in January was at a 
20-month high, so there is far to go if a change in monetary 
conditions is to slow domestic demand, as Ma suggests.  End 
Comment.) 
 
TIGHTENING MEETS SLOWING EXTERNAL DEMAND 
---------------------------------------- 
 
¶6. (SBU) Ma said that Chinese financial institutions have little 
direct exposure to U.S. subprime issues, but there is risk to China 
of declining external demand -- and this could occur at the same 
time as China tightens its domestic policies.  Ma said that China 
will need to be "cautious" and attentive to international conditions 
as i makes economic policy decisions over the coming months. 
Despite the widening spreading between Chinese and U.S. interest 
rates due to cuts by the U.S. Federal Reserve, China still has some 
"space" to raise its own, asserted Ma (ecoing a point made tat day 
 
BEIJING 00000855  002 OF 002 
 
 
by PBOC Governor Zhou).  Raising interest rates, however, risks 
attracting even greater capital inflows, adding to a "vicious 
circle" of money supply expansion leading to further investment in 
productive capacity (particularly in the tradable sector), leading 
to an increase in the current account surplus that would then draw 
in another round of capital inflows. 
 
UTILITY IN SOME INFLATION 
------------------------- 
 
¶7. (SBU) In response to a question from Finatt, Ma acknowledged 
there is utility in China tolerating moderate inflation somewhat 
above that in advanced economies. (Note: Many developing economies 
with protracted high rates of economic and productivity growth in 
the manufacturing sector tend to have higher inflation rates, 
particularly in  services.  This can help rebalance growth by 
providing an appreciation of the real exchange rate and inducing 
investment in services).  Ma suggested that from a macroeconomic 
perspective, inflation that remains below double-digits is not 
problematic.  However, Ma noted that even moderate rates of 
inflation present political challenges as it hurts poorer households 
the most; it is common in China for poorer families to spend more 
than half their income on food.  Ma stressed that the government 
must be prepared to help low income households cope.  (Comment: 
Senior officials from the National Bureau of Statistics have also 
noted that China's limited social safety net contributes to its low 
tolerance for inflation.) 
 
2008 BUDGET AND REFORM 
---------------------- 
 
¶8. (SBU) The 2008 budget released at this week's National People's 
Congress projects an overall expenditure increase of 23% and is 
notable for its even larger increases in social services: 45% for 
education, 25% for health, and 24% for social security.  Ma said 
China's greatest fiscal challenge is ensuring that funding is not 
mismanaged as it passes through multiple layers before reaching 
intended beneficiaries.  To address this, the government is 
resorting when possible to direct payments to county governments 
(bypassing provinces) and specific earmarks for items such as 
teacher salaries.  However, most expenditures cannot be controlled 
in this manner.  With regard to the education increases, Ma shrugged 
off criticism in the media that the funds would not go where most 
needed, stating that the target will be to finance compulsory 
education in Central and Western provinces, including teacher 
salaries and school facilities. 
 
¶9. (SBU) Ma traveled to the U.S. and Canada last fall to conduct a 
study on comparative public finance.  He spoke highly of his 
Washington meetings, singling out the Office of Management and 
Budget.  During the U.S. visit, he was struck by the public manner 
in which the federal budget is formulated.  In his view, China might 
draw value from studying this process as it may promote cost control 
and limit waste. 
 
COMMENT 
-------- 
 
¶10. (SBU) China's economic policy makers have been debating whether 
to tighten monetary policy to fight inflation or keep it more 
relaxed in the face of slowing external demand -- and so far, 
tightening has won the battle of words (but not necessarily deeds, 
as we noted above).  Ma's comments to us, along with those of with 
Dr. Jiao Jinpu, Acting Director General of the People's Bank of 
China (PBOC) Research Bureau (reftel), demonstrate that 
government-affiliated economists are carrying the central 
government's tune about inflation being the top economic priority 
yet are mindful that once the impact of one-time supply shocks plays 
out over the coming months, concern may shift to the consequences of 
slowing export growth.  There is on one hand a case to be made that 
inflation will prove persistent given high rates of money supply 
growth, but on the other, solid ground for concern that lower 
productive capacity utilization due to the continued high growth of 
investment and weakening external demand will prove deflationary. 
The Fed's easing further constrains the PBOC's ability to raise 
interest rates.  As Premier Wen highlighted in his recent speech, 
2008 is shaping up as a "most difficult year" for macroeconomic 
policy formulation and implementation. 
 
RANDT