China is wrestling with inflation and the central government has marked it out as a top priority this year. But I believe the problem is far from over and the third quarter will emerge as a critical period.

Among emerging economies, China has continued to maintain relatively robust economic growth. Given the extremely accommodative monetary policy employed over the past couple of years, the nation's inflationary pressure emerged relatively early. With the CPI soaring beyond expectations in October 2010, domestic inflation and inflation projections have mounted and became the main target of the central government's macro-controls. The huge liquidity accumulated in the past two years, rapid expansion of the real economy as well as labor supply and social security system changes have largely pushed up land, labor and resource costs. The latter elements have also become the driving forces of inflation this year.

Though the government has adopted relatively tighter policies and unveiled a new round of property controls, continuous capital inflow and huge accumulated liquidity have pushed up both commodity prices and inflation expectations. China's economy is expected to report relatively steady growth in the first half of the year, while global commodity prices (especially energy prices) have remained high and volatile.

Inflation has extended well beyond agricultural products and has manifested itself largely in energy, raw materials, key capital goods and labor costs. In the first quarter, grain production prices rose by 12.1 percent year-on-year (YoY), cotton prices by 55.1 percent, pork prices by 18.6 percent and fruit prices by 29 percent. Most raw material purchase prices increased by more than 10 percent while the average wage of rural residents even increased by 20 percent.

These all suggest that this round of inflation will not retreat any time soon, possibly lingering for a year or so. If the tighter monetary policy (the new property controls, in particular) lasts, it will help to curb demand expansion as well as rising costs and will substantially alleviate inflationary pressure after the fourth quarter of this year.

Rising commodity prices directly impact industrial products. In fact, coal, oil and steel-related products account for about 20 percent of the Chinese Ex-factory Price Index (EFPI). These products are also important input items for chemicals and machinery equipment and tend to show the greatest volatility. Therefore, the movement of energy and steel prices largely determines the EFPI trend. Meanwhile, as the oil price is subject to international market movements, it swings the most and has the greatest impact on EFPI. I estimate that for every 10 percent rise in the crude oil price, this would cause the EFPI to increase by 0.55 percent. Indirect impacts, on the other hand, are harder to quantify. What is certain is that surging oil prices will take its toll on downstream chemicals and closely-related coal, steel and other downstream product prices. The indirect impact should be more significant than the direct impact. I expect international commodity prices to stay high and fluctuate considerably in the second quarter, while industrial product prices in the third quarter are expected to rise by 0.3 percent or more month-on-month (MoM). Considering the tail-raising effect, the EFPI may well record a year-to-date (YTD) high of 7 percent or more in terms of YoY growth in the third quarter.

As for the CPI, rising commodity prices should have an influence in four main ways: (1) energy prices are closely correlated to agricultural product prices, as international grain prices tend to rise along with commodity prices, thus impacting domestic grain prices and CPI; (2) energy prices affect agriculture input costs, such as machinery expenses, fertilizers, pesticides, and are passed on to CPI; (3) higher energy prices push up related industrial products and translate to end-user prices; and (4) some service prices, such as transportation costs, will head north and then be passed on to the CPI. However, as domestic end-market oil prices are not solely determined by the market and a fair number of service prices are still under government control, the real effect of the pass-through mechanism and its time lag is subject to government policy. Technically speaking, considering the tail-raising effect of last October's CPI surge (should last until this September), the ongoing drought in several provinces, and the strong seasonal demand from most industries around August, we may see some MoM price hikes in the third quarter. While the latest property price controls and interest rate cycle can help curb inflation in the medium to long term, rents and mortgage rates should be pushed up, increasing the prices in some of the residential categories in the CPI. As such, the third quarter will see some renewed upward pressure, and the CPI could climb to more than 6 percent and create a new YTD high.

The author is Executive Director of BOCI Research Limited (www.bocigroup.com). The opinions expressed here are entirely his own and do not represent BOCI or any other affiliated companies within the group. Nothing in this article constitutes an investment recommendation.

(HK Edition 06/16/2011 page2)