Inflation is rearing its head in China, though it may not be that obvious.

The situation reveals a need for the authorities to take defensive action before the economy incurs more serious damage.

A most important economic barometer, inflation always triggers prompt reaction from the central banks of various nations.

The US Federal Reserve has made two consecutive interest rate hikes in recent months, after the international oil prices rallied and inflationary pressure mounted.

The same rule also applies to many other economies, like the United Kingdom, the European Union, Canada, Australia and New Zealand, whose central banks often move quickly to increase interest rates when inflation appears to be looming.

But the situation is different in China, partly because of the characteristics of the Chinese economy.

Since the start of the year, the consumer price index (CPI), the major index to judge inflation in China, has been surging steadily.

In June and July, the CPI growth even exceeded the 5 percent red-line set by the central bank. In July, the index surged by 5.31 percent, the highest monthly growth since February 1997.

Meanwhile, the soaring oil price in international markets fuelled a price hike of oil products in China late in August, the third time within a year.

Similar price rallies mean increased charges for water, electricity and foodstuffs.

Even the prices of steel and construction products, which eased earlier this year, also quickly rebounded as market demand rose recently.

For an economy that has been haunted by years of deflation, rising prices is a positive matter.

But if the rally is too strong, it will exert a negative impact on people's life and the economic competitiveness of the country.

For example, if the CPI growth is too high, it will turn the actual interest rates into negative, which will affect people's consumption power and force diversion of savings from banks to other uses.

In banks of Wenzhou, East China's Zhejiang Province, the "negative'' interest rates have already led to a sharp decline of bank deposits. Similar phenomena also exist in many other cities.

If the situation continues, banks will face higher risks.

Fortunately, inflationary pressure in China is not equal to the "stagflation'' that countries experienced in the 1970s, when two oil crises triggered an international financial crisis, accompanied by high-flying prices and rising unemployment, which rendered the global economy stagnant.

The international oil price rally has also aroused economists' concerns over the possibility of the reappearance of stagflation, in which inflation occurs when the economy is weak.

Researchers say that if the international oil price remains at US$45 per barrel, it would slice off 0.5 percentage point off the growth rate of the world economy in 2005.

And if the price holds on to 2006, it would reduce another 1 percentage point in economic growth.

However, unlike the 1970s crises, this time the oil price hike comes about not entirely from political reasons, but also because of increasing global demand for energy and manipulation in the futures market. The prices are expected to move down if such elements are better controlled.

Therefore the stagflation is unlikely to occur, especially in China, which, despite increasing oil demand, consumes only a small proportion of oil in the international markets (at around 7 percent). And oil still only accounts for less than 20 percent in all energy resources used domestically, so the impact of the oil price fluctuation on the Chinese economy is not as serious as some reports have predicted.

For the overall economic climate in China, though the CPI growth has been too strong, it has been mainly attributed to price hikes in foodstuffs, which is recovering from years of low prices. It does mean that farmers are getting higher income and consumption power.

On the other hand, after years of deflation, the price rally can bring more business opportunities for enterprises and trigger investment and consumption growth.

The authorities have already taken macroeconomic adjustment via measures such as tighter credit supply to slow down economic growth since the second half of last year.

But the efforts have not worked well so far, since the growth is still high, based on the economic indicators released in the year's first half, and it seems unlikely to ease down in the second half of the year.

The impact of the price rally of industrial products related to energy and raw materials has already been transmitted to the consumption sector.

Taking housing loans, for example. They increased by nearly 600 billion yuan (US$72.5 billion) in the first six months of the year. And commercial housing prices witnessed double-digit growth.

If housing prices are taken into consideration, then the CPI growth might be more shocking.

Moreover, authorities should have amended CPI constituents long ago, since the variety of consumer products has increased considerably over the past two decades and many influential sectors, such as auto, tourism, construction decoration and telecommunications, are still not included in the index.

The efficiency of using an outdated index to assess inflation is therefore questionable.

In my opinion, inflation has already landed on China. And it will erode people's income and affect their lives.

If the interest rate level remains unadjusted or even lower than price growth, it will lure more funding to enter the stock market and real estate sector, which would produce more bubbles that have already hit the real estate market.

Therefore, if the authorities still hold on to the low interest rate policy to stimulate the economy and decline to take more concrete measures to fight against inflation or make it a top priority in policy-making, the Chinese economy would be in great danger when inflation becomes out of control.

(China Business Weekly September 13, 2004)