Rising inflation in an overheating economy will set off alarm bells in the heads of most investors. When it comes to investing in China, however, the alarm bells would probably sound louder as official economic statistics are often deemed unreliable, making it difficult for investors to gauge the potential impact of inflation on their investments.

The truth is that there is no consensus on this issue, leaving investors to make judgment calls on which side of the debate they would prefer to be on when deciding to invest in China.

“Chinese statistics are not always reliable and you have to take everything with a pinch of salt,” says Charles Bastyr, chief investment officer and portfolio manager with Meadowbank Asset Management Inc. in Toronto. “This doesn’t mean inflation statistics are way off, but it’s tough to get a real picture.”

In its May 2007 research report on China, Hong Kong-based brokerage, banking and private equity group, CLSA Asia-Pacific Markets says inflation statistics are considered more reliable than most statistics on the domestic economy. However, the report adds: “That said, they are far from perfect.”

The report goes on to say that inflation data is problematic as China publishes a cost of living and a retail price index, but both are presented as year-over-year changes. Index levels are unavailable, making it impossible to assess monthly trends, and weights are not published for either index, although they can be statistically estimated.

On the other hand, U.S.-born 1980 economics Nobel laureate Lawrence Klein claims that after extensive research on China, he found official economic statistics were credible.

In his online autobiography, he says research conducted in 2004 found that China’s inflation rate was actually overstated by more than 1%. Incidentally, Klein’s position, which has been leveraged by Chinese officials, has positively influenced the way in which China’s official statistics are interpreted.

Credible or not, Bastyr cautions that the overall trend in China is toward higher inflation fuelled by excess liquidity in the domestic market and “too much foreign money flowing into the country.” This is the result of the country’s massive trade surplus and also of the certainty that its currency will be revalued — albeit at a measured pace, he says. The currency has been kept low by rigid currency controls.

In fact, according to official statistics, in July inflation in China reached a 10-year high of 5.6% over the same period the previous year, almost double the official 3% target. This follows a 4.4% surge in the previous month and an average 3.5% increase in the first seven months of the year.

Whether or not these statistics are reliable is irrelevant when assessing the cause of higher inflation in China. Erik Nilsson, senior international economist with the Bank of Nova Scotia’s International Research Group in Toronto argues that the rise in inflation “is narrowly based” and is fuelled primarily by a significant increase in food prices, mainly pork, chicken and eggs. He believes the risk of a spillover into other sectors of economy is limited.

Incidentally, food accounts for more than one-third the weight of China’s Consumer Price Index, which statistically estimates the change in prices of a defined basket of goods and services over different time periods relative to a base year.

According to China’s National Bureau of Statistics, food prices rose by 15.4% year-over-year in July, while non-food prices grew by only 0.9%. Within the food group, meat prices saw the largest increase at 45.2% (pork prices were up 74%), followed by eggs at 30.6%, cooking oil at 30.1% and vegetables at 18.7%. For selected non-food goods and services, the price of clothing; transportation and communication; and recreational, educational and cultural articles declined by 0.6%, 1.3% and 1.2%, respectively. On the other hand, the price of household facilities, articles and maintenance services, and health-care and personal articles rose by 1.2% and 2.2%, respectively.

Patricia Perez-Coutts, vice president and portfolio manager with AGF Funds Inc. in Toronto contends that barring the rise in food prices, China’s “inflation remains in a healthy range.” She adds that while property prices and wages have increased moderately, their impact on inflation is insignificant. Although wages in manufacturing have risen, labour productivity has risen even faster, resulting in falling unit labour costs.

@page_break@An August 2007 CLSA report on manufacturing in China states: “Inflation is minimal especially when agricultural prices are excluded.” The report claims durable goods prices are falling but that in recent months the deflation rate has slowed, meaning the rate of decline in prices is lower. Although manufacturers paid more for oil, coal and chemicals in July, the overall rate of input price inflation was the weakest since April.

Arguably, although inflation in China is rising, it does not appear that the risk is significant — at least not yet. The government has relied largely on administrative and tax measures to keep asset and property prices in check. Tighter monetary policy, resulting in three interest rate increases in 2007, is viewed as being inadequate to reduce liquidity in the economy and stem inflation. The government also cut the tax on interest income to 5% from 20% to promote saving.

Nilsson says interest rates being offered on savings accounts are below the inflation rate, which discourages saving and promotes spending. The benchmark one-year deposit rate is now 3.33%, while the lending rate is 6.84%. As a result, the growing middle class has become big spenders, fuelling inflation. Those who are seeking higher returns are flocking to the stock market. According to a Morningstar Canada report in August, investment funds that focus on China or have significant exposure to that country were among the best-performing mutual funds in Canada.

One of the problems about questioning the accuracy of China’s official statistics is that it is always one of the first countries to release its numbers, especially GDP figures, says Bastyr. The provinces of China also release their own statistics at a later date. These do not add up to the official numbers, which end up lower than the sum of the provincial numbers. In order to eliminate inconsistencies in the official statistics, many economists, including Nilsson, use alternative methods to come up with their own proxies on economic statistics.

From a comparative standpoint, it is not prudent to compare Chinese inflation statistics with those of, say, the U.S. For example, it is estimated that food accounts for 34% of the CPI in China and only 15% in the U.S. On the other hand, housing has a 42% weight in the U.S. and only 13% in China.

Given the differences in the composition of the indices, the drivers of inflation are different. Also, in the case of high food prices in China, the most significant contributor is higher pork prices, which is not because of demand but rather supply-side shocks resulting from pig disease.

As far as individual investors are concerned, inflation often makes companies look as if they are growing faster than they actually are. Revenue is growing as a result of higher prices, but profits may not necessarily be growing because of higher input costs. A growing company can therefore appear to be a tempting investment, but if growth is a result of inflation, the stock price may not eventually reflect investor expectations.

Inflation in China is evidently not currently a serious problem, in spite of perceived inconsistencies in data, although Nilsson believes “it will get worse before it gets better.”

Bastyr does not expect the Chinese government to take significant measures before the 2008 Olympics. IE