Price increases can indicate excess demand that can be met by increased productivity (the supply of goods) on the one hand, or by increased money supply or higher interest rates on the other. The more price increases (demand for a good) are met by increased productivity (supply of a good), the less impact the price increase has on money demand reflected in higher interest rates or increased money supply (possible inflation in terms of an excessive money-supply growth rate). Accordingly, companies have two ways to face cost increases raise prices to customers (and risk inflation) or increase efficiency and productivity.
The more companies can pass through cost increases by raising prices, the greater the risk of inflation. The more companies can offset cost increases by increasing the amount of output per unit of higher-cost input, the less likely inflation is. The United States has avoided the inflationary impact of energy price increases because consumers have been able to resist price increases thanks to the huge productivity gains of the Internet economy and price competition unleashed by deregulation.
China has huge still-untapped productivity improvement potential far more basic than the benefits of the Internet economy. These should enable China to experience non-inflationary domestic price increases, while rising income from the growing economy enables consumers to pay higher prices and still consume and save more.
China needs to allow non-inflationary domestic price increases in order to avoid an appreciation of the RMB, which would slow China's economy. Domestic price increases depreciate the RMB. They neutralize current upward pressure on the RMB's exchange value. Upward pressure on the RMB's exchange value makes its purchasing power stronger than other currencies' due to the comparatively low prices for goods in China. To maintain the policy of a fixed RMB exchange rate, prices inside China must be allowed to increase in a non-inflationary way to achieve "purchasing power parity" with other currencies.
If instead, the RMB appreciates because prices inside China have not been allowed to increase, three economic shocks will occur that will slow China's economy and harm innocent sectors of the economy not directly driven by those prices: (1) China's exports drop dramatically (especially where the profit margins are as slim as 3 per cent); (2) the cost of imported foreign capital equipment used to increase productivity increases dramatically; and (3) China experiences huge financial loss on the massive capital investment abroad that it has made to finance foreign demand for its exports.
By allowing domestic energy prices to rise closer to the global market level, China is moving in the correct direction (towards "marketization" of energy) and deserves support and recognition for its enlightened and informed policy-making.
(Source: China Daily/By Robert Blohm)