Inflation with Chinese Characteristics

The former leader Deng Xiaoping famously stated that China's modernization drive as "Socialism with Chinese Characteristics." This has become the code word for Capitalism in China.

This week and next week the Chinese parliament is meeting in Beijing to discuss the future direction of the country with a particular focus on the economy.

The initial reports suggest that there is considerable debate going on within the sub-committees regarding the potential for rapid inflation based on the government's large stimulus program and its aggressive prodding of banks to rapidly lend capital to major state owned enterprises.

The stimulus package is not well understood but it is known that the focus is on stimulating job creation for infrastructure projects to employ migrant workers laid off from export industries in China's southern provinces.

In China when a directive comes from the central government to take action action is taken. banks will lend and state owned enterprises will expand.

The difficulty is knowing when enough is enough. How much is too much ? How much is too little ?

China is not one economy but rather several regional economies. The coastal cities and the south have been the fastest growing economic centers over the past few years. This is now shifting to more inland provinces (which is where much of the infrastructure spending is being allocated). If the growth and capital availability is excessive these provinces could experience a rapid spike in inflation by year end or early 2010. This is not the result the government is seeking.

A period of inflation seems inevitable however. One can not pump such a large amount of new capital into the economy without suffering from a certain level of inflation. The government's credibility will be decided by when it turns OFF the flow of capital rather than the actual GDP growth figure.

An additional problem problem is to what extent the rapid rise in lending will cause bad debts to accumulate again in the large national banks. China has largely solved the bad debt problem but could be faced with another round of balance sheet adjustments as a result of stimulating the economy to thwart a further reduction in GDP growth.

The perils are great but if manged appropriately or at least modestly reducing the risk China could emerge from this global recession as a beacon rather than a backward semi-public, semi-private economy.

Time will tell.