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Cablegate: Prominent Economist Sees Challenge in Responding To

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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

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