Higher-than-expected inflation, particularly soaring food prices, is clouding the mainland's bright economic outlook. In response, the State Council has drafted a raft of measures to control rising consumer good prices.

According to a statement issued by the State Council on its official website, supplies of food and other necessities will be augmented, subsidies for low-income families will rise, and policies aimed at maintaining market order will be put into place.

While certain components of the mainland CPI, including clothing, transportation, and recreation/education remain at reasonable levels, the same can not be said for food and home prices, which are rising rapidly.

Food prices have soared and are expected to remain high. Assuming prices remain stable throughout the rest of the year and in the first half of 2011, inflation will still be substantially higher than the current level in the first half of 2011 on a year-on-year basis.

Demand driven inflation is a natural outcome of urbanization and modernization. Rising household income normally gives a significant boost to purchasing power. While the growth rate of income per capita in urban household is rising steadily, growth in consumption expenditure is moderating. Thus, the general standard of living is rising.

Demand-driven price hikes are a result of a higher standard of living and rising wages. However, the magnitude of recent food inflation is in danger of becoming unacceptable to mainland consumers, as it is rising much faster than income levels.

While expenditure growth among rural households remains lower than the growth rate of its income, with a higher portion of their income spent on basic needs, soaring food prices are bringing social tensions to rural areas. This is probably the major trigger of the tightening policies that are focused on trimming excess liquidity.

On the other hand, prices of materials used in food production are also on the rise. Cost-push inflation, supported by the rising prices of fertilizers, therefore, is also in place.

Housing prices are expected to stabilize. While rising incomes can drive up housing demand, restrictive government policies focusing on the housing market are likely to put a damper on investment demand within the real estate market.

Given the prominence of housing to the mainland economy, policymakers have been closely monitoring rising prices within that sector. On the back of a higher comparable base in 2010 versus 2009, growth in rental costs will moderate in 2011.

As the baseline negative interest rate spirals lower, the People's Bank of China and the Central Government are expected to implement another rate hike of 25 basis points before the end of the year with a view to managing inflation expectations. The rate-hike will not derail the strong economic growth trend on the mainland, but will instead serve to encourage depositors to save rather than engage in further investment activities.

During inflationary periods, retailers with higher pricing power and well-managed cost structures tend to benefit more, while companies with thin margins and high sensitivity to costs will be hurt.

While the market awaits policy changes, the resultant near-term policy overhang may cause certain food manufacturing companies to underperform.

The author is an associate director and economist at CCB International Securities Ltd. The opinions expressed here are entirely his own.

(HK Edition 11/23/2010 page2)