China's economic riddle

The growing prosperity of a middle class of 100 million people has changed dietary habits. People eat more meat, and the main meat consumed in China is pork.

Demand for pork shot up last year at a time when supply was low. That fuelled price inflation which leapt from the usual 1-2 per cent to top 8 per cent this spring while urban wages jumped by 18 per cent in a year. Then the rising price of industrial inputs as commodity prices soared pushed the annual increase in factory gate prices to 10 per cent this summer, with raw materials, fuel and power prices in July 15 per cent up on the same month of 2007.

At the same time, the appreciation of the yuan and the positive interest differential with US after the Federal Reserve cut interest rates attracted a flood of hot money, estimated at $180 billion in four months this year.

That further increased Chinese inflation while state ceilings on bank loans proved ineffective in the face of informal lending of these incoming funds, or agreements by companies with bulging cash reserves to lend to those in need of working capital.

The government brought in price caps on food, and maintained controls of electricity rates. However, it had to grant subsidies to farmers to compensate them for demand-led increases in the prices of fertiliser, petrol and seeds.

With coal prices doubling in a year, electricity generators were squeezed and energy supplies dropped below demand.

A cap was put on coal prices that in turn discouraged supply. Thus the energy shortage got worse, and the government has been forced to reverse its previous policy of shutting down small mines, which are generally inefficient, polluting and unsafe.

The obvious tool of raising interest rates could not be used because the differential with the US meant that an increase would only attract more hot money.

In the spring and early summer, the currency, the yuan, was allowed to float upwards more strongly against the dollar as an anti-inflationary tool, but as the growth in exports slowed, the government took fright and slowed down the appreciation.

At the start of this year, "tightening" was accepted as the watchword for 2008 by a top-level economic conference.

By the summer, growth had taken precedence once more. There is a basic reason for this. Even if Mao's portrait still looks over Tiananmen Square, China has, in effect if not in theory, divested itself of communism. In its place, material improvement of its 1.3 billion people provides the regime with its legitimacy.

Some elderly people may recall the hyper-inflation that sapped the Nationalist regime and helped the communists come to power in 1949.

Others may kindle nostalgia for the more egalitarian, if poorer, era under the Great Helmsman. Some argue for slower growth, and Hu Jintao may propagate his doctrine of a "harmonious society" to less inequalities and care for society and the environment.

For most Chinese, growth - as epitomised by the Olympics - is what counts and the leadership dares not disappoint them, particularly against the backdrop of expectations built up in the last three decades, during which hundreds of millions have been lifted out of poverty and which has enabled the country to build gleaming modern cities and show the world its prowess with the great spectacle of the opening of the Beijing Olympics.