Inflation is not China's biggest worry in 2011: Capital Economics

Inflation might not be China's biggest concern in 2011, as many experts believe, an economist at Capital Economics said in a note.

Inflation, which touched a 28-month high at 5.1 percent in November, has been identified as China's biggest hurdle to growth in 2011. The government has been increasing interest rates as well as reserve ratios in an attempt to contain the rise.

Much of the inflation is fueled by a rise in food prices, which hits the poor consumers harder because most of their incomes goes towards food.

But it is often forgotten that the poorest families are frequently also food producers. For many of them, rising prices translate into higher incomes, Mark Williams, an economist at Capital Economics, said in a note.

Inflation will be a problem if it spread beyond food prices but there is little sign of that happening, he added.

However, most of the market, including the Chinese government, believe that the rapid growth in bank lending, as well as rising wages over the past two years is driving the stronger demand for food.

The reality has more to do with the shortage of food, caused by the severe floods in China in 2010. Much of the crop was destroyed during the floods last summer, leading to a rise in food grain prices across the world.

This indicates that the farmers might not be benefitting much from the higher prices since they have lesser produce to sell, Williams said.

The price increases also will be temporary and will decrease once the harvest replenish supply, resulting in lower inflation in 2011 than what many are expecting, he added.

Williams argues that higher wages are not the reason behind inflation, because the wage increases had been occurring till 2008 at the same pace.

Additionally, in an ideal situation, higher food prices means that the farmer earns more, leading to lesser migration to cities, and eventually even the urban poor would benefit.

In fact, finding effective means to put a larger share of China's income into the pockets of average households, both in urban and rural areas, may present a bigger challenge than inflation this year, Williams said.

The vast imbalance in incomes is one of the factors the Chinese government is trying to fight in its 12^th Five year plan. The success of the plan would determine how fast Chinese domestic consumption can grow, leading to a stronger domestic economy and growth.

China's relationship with the rest of the world, particularly the U.S. would also benefit from the rebalancing as the rest of the world complains about the Asian country's massive trade surplus, which comes mostly because of higher investment into the region than the consumption rate.

Failure to achieve meaningful rebalancing in the form of a much smaller trade surplus would raise the risk that calls for a protectionist response become a rallying cry ahead of the US presidential election in 2012, Williams said.

Protectionism may ultimately prove to be a far greater threat to China than inflation, he added.