I was getting my regular order at Starbucks in Shanghai the other day, a half-milk Earl Grey Tea with a raisin scone, when it occurred to me that I was paying 50 percent more than just a year ago. I remember this distinctly, because I used to pay 22 yuan (US$3.15) and now I’m paying 33 yuan (US$4.70). Did the price of oil of bergamot spike on world commodity markets? Was there a world-wide shortage of baking powder I didn’t know about?

The tea at Starbucks used to be a deal. You could get any size for the same price and, if I talked to the Chinese baristas nicely, I would even get two tea bags. But now, at 18 yuan for a Grande, 21 yuan for a Venti, or 12 yuan for a micro-sized Small cup, I’m suddenly arguing with them: Hey, aren’t these just tea bags and some hot water?

In fact, virtually everything sold at China’s Starbucks has increased in price since I arrived in Shanghai in 2004. The price of a Venti-sized Caffe Mocha is now 34 yuan which, at recent exchange rates*, is $4.85, as expensive as in Starbucks’ hometown of Seattle. Even my lowly little scone used to be only 8 yuan, now it’s 12. Why the Grande price increases, Starbucks?

The answer, you might suspect, is Starbucks trying to gouge its newly-affluent Chinese white-collar customers, but it’s not that simple of course, and inflation is definitely a contributing factor.

On May 12, China’s National Bureau of Statistics (NBS) announced national inflation, measured by the Consumer Price Index (CPI), had increased by 8.5 percent in April, following a 8.3 percent rise in March and 8 percent overall for the first quarter of 2008. This is, compared to last year’s 4.8 percent inflation (which thereafter became the 2008 target), a significant increase that is starting to look like a trend.

To be sure, Chinese inflation is not all to blame for your Frappuccino price woes: World-wide coffee commodity prices have increased more than 20 percent from a year ago and regularly change depending on agricultural output. Yet Starbucks’ global purchasing clout should be sufficient to insulate it from the yearly price fluctuations. There are also labor, supplies and operating costs to consider. For example, there are the effects of the new Labor Law enacted on January 1st, and producer prices for raw materials, fuel and power have increased about ten percent in the first quarter of 2008, according to the NBS, and the more general Producer Price Index (PPI) increased by 8.1 percent in April.

Are Starbucks’ price increases a sign of a broader pattern? A quick survey found KFC raised prices in March and McDonald’s did so in January and last October. The NBS announced that recent CPI growth is mostly attributed to increases in food prices, which went up 21 percent in the last first quarter. This last figure hit home for me with my monthly home food bills, which my domestic helper (also known as an ayi if you are living in China) aggressively bargains for, yet the amount I reimburse her each month has increased by about 100 percent compared to early 2007.

Some may wonder, what’s the big deal anyway? Isn’t a little inflation good for an economy? General economic principles say yes: In order to keep the economy running smoothly, a little inflation greases the wheels of commerce. This beneficial rate is generally thought to be one or two percent. China’s eight percent is more of an accelerant, but it is hardly hyperinflation, the savings-wrecking triple- or even quadruple-digit rates seen in South American economies such as Bolivia and Argentina in the ’80s. Eight percent is manageable but worrisome things may start to happen.

For example, people could start taking money out of savings, especially if the real interest rate, the bank interest rate minus the inflation rate, is negative, as it is right now in China: The current deposit savings rate mandated by the central bank is 4.14 percent, meaning with inflation at 8 percent, people are losing about 4 percent of their money’s value just by leaving it in the bank. Or, consumers may buy gold as an investment, an start hoarding commodities such as rice or cooking oil, expecting further price increases.

There’s little evidence of massive hoarding of commodities as yet, but in November 2007 three people were killled and 31 injured at a Carrefour Hypermart in Chongqing rushing in to get a 20 percent discount on cooking oil. And when it comes to buying inflation-proof investments, China has a natural love of gold and the China Gold Association said that in 2007 China was the world’s third largest consumer after the United States and India, and 2nd largest producer, in a dead-heat with South Africa. Apparently Olympic gold bars and bullion stamped to commemorate the year of clever (and rich) mouse sold out quickly. 81 percent of gold consumption in China goes into jewelry, which is also a big seller. So what, if anything, to do about increasing prices?

China has several options to combat inflation. Assuming that China’s inflationary dilemma is driven by money supply – that is, China’s huge US$1.68 trillion foreign reserves, hot money, real estate and other asset appreciation – rather than demand (consumption is still relatively low in China at less than 40 percent of the economy), the central bank could increase interest rates or otherwise reduce the supply of money in the economy by tightening bank lending through further increases to the reserve ratio.

The latter tool especially has been overused, increasing ten times in 2007 alone, with the increases each time being very conservative so as not to shock the system. Immediately following the release of the first quarter economic data on the April 16, the People’s Bank of China acted swiftly by raising the reserve requirement ratio, again by 0.5 percent, to a record-high 16 percent. In May, after the April inflation figures were released, they upped the ratio once more. to 16.5 percent. The collective shrug of the market could be seen almost immediately; it is already numb to this kind of pain. Some analysts were predicting a modest half-percent interest-rate increase following the April inflation numbers, but after the devastating earthquake in Sichuan on May 12 the government is likely to be more cautious with further tightening. Thus with only the reserve ratio to cool the economy, and even more fixed asset investment needed after the earthquake, inflation is unlikely to abate in the short-term as the government hopes.

The central bank needs to consider drastic measures and it is time for China to slaughter the sacred cow by allowing faster appreciation of the yuan. Otherwise, your Starbucks soy decaf triple Venti Caramel Macchiato will be getting even more expensive.

——–

* This article uses 7 yuan per US dollar

Categories: Consumption, Primary Growth Drivers