My Blog

February 1, 2008

I don’t know if I was the first one to use the word “stagflation” in discussing one of the potential scenarios for China in 2008, but I think it is a word that is going to come up again and again in the following months.  I first discussed the possibility in November in my class at Peking University and at various conferences, and I wrote about it recently in my blog (January 17, “Can stagflation hit China?”).  At the time a number of friends and associates thought I was being even more alarmist than usual – and one bank researcher was a little brusque in dismissing the idea – but I although I don’t think it is inevitable I do think more than ever it is worth pondering.

My basic worry is that inflation will persist because it is driven by three or more years of out-of-control monetary expansion, whereas the heavy-handed attempts to cool the economy could take effect just as a slowdown in the US dampens export growth, and if all the accompanying worry – not to mention the impact of the recent snow storm and its role in undermining faith in the government – causes consumption growth to slow, we could see a much sharper slowing down of the economy than expected.  One caveat, as I pointed out in the January 17 entry:

In China a “stagnant” economy is not necessarily one that is recession.  It is one in which employment growth fails to keep up with the growth of the labor population, which when I first came to China six years ago everyone assumed to be GDP growth below 7-8%.  Given the much higher growth we have seen in recent years and the still-upward pressure on unemployment, especially among university graduates, I suspect that the minimum level of GDP growth is probably much higher.

So why doesn’t the government quickly move to support the economy and prevent this slowing down?  The problem is that no one is really sure what is going on.  In the October Economic Conference the government made it very clear that it considers overheating to be one of its top two concerns (the other is inflation).  Now there are increasing rumors that the leaders are so worried about a potential slowing down that the government and the PBoC may move to a more accommodative stance.  

Last week Premier Wen worried publicly that 2008 was going to be a very difficult year for China, and just two days ago President Hu said “We should correctly realize the global economic situation and its influence on China, fully recognize the complexity and variableness of the external economic environment, scientifically manage the pace and intensity of macroeconomic controls, and make efforts to maintain stable and relatively fast economic growth as prolonged as possible.”  That’s a bit of a mouthful, but it sounds like he is saying “Forget those old-fashioned fears of overheating, we are not going to risk sacrificing growth”.  The always-interesting Xinxin Li of the Observatory Group has this to say in his report today:

This shift in the attitudes of top leaders is also good news for the PBoC, which is reluctant to tighten further.  Now, the central bank will feel more comfortable keeping interest rates on hold, and rely more on the RMB appreciation to curb inflation.  In addition, the government will likely utilize more fiscal measures to subsidize food and energy production, and fix the infrastructure damaged in the bad weather.  Overall, we expect China’s economic policies to be less hawkish in coming months; the risk of an over-tightening is dropping significantly.

But how aggressively can they move?  If they lighten up on tightening policies this could seriously backfire if domestic investment and industrial production continue to surge and the US slowdown turns out not to be as bad as expected, or if its impact on the Chinese economy is less than expected or (far more likely in my opinion) delayed.  So, to use a metaphor I have probably overused, China may be like the man in the old-fashioned shower who jerks the faucet back and forth between scalding and freezing several times before he can find the right level.  Growth may be paramount, but it isn’t clear how quick they should be to dismiss the concerns about overheating, and this lack of clarity is going to make it easy for them to what they have recently done best – do too little.  

If the Chinese economy slows down won’t that at least put paid to inflation?  Maybe.  It depends on what model you use to explain inflation in China.  If you think inflation is caused by food supply shortages relative to growing demand, a slowing economy might very well reduce demand sufficiently to cool inflation, especially if there is a lag between slowing consumption and production that allows inventory levels to build.  If you believe as I do, however, that inflation is caused by several years of excess monetary expansion, inflation is almost certainly going to persist, even with a slowdown in the economy.

I have already mentioned one economist John Tamny,, who claims that in the US “empirical evidence suggests that economic slowdowns correlate far more with rising, rather than falling, prices.”  I bring all this up because I see that the very wise Charles Goodhart, former Bank of England policy maker and now a professor at LSE, said in a speech yesterday that “We're going into a sort of a minor replay of the stagflation we had in the 1970s. Growth has been declining, productivity has been falling awkwardly, and there have been supply shocks on the inflationary side.”  He claims that we will need “a great deal of luck” to avoid it.

More alarmingly, given my contention that China’s economy is like the rest of the world’s but only more hopped-up on amphetamines, “Whether stagflation becomes entrenched is not at all certain. For us it may be a minor replay in the West, but in emerging economies it's a different story. If anyone's going to suffer, it's them.”  I hope he is dead wrong.

By the way, in totally unrelated news, China Coal Energy, whose $3.6 billion IPO drew $433 billion in bids, traded up 43% on its opening day before falling back about 10% from its high.  This was considered a hugely disappointing first day, but with such difficult markets (Shanghai was down nearly 1.5% today) maybe it wasn’t so bad.  Normally 30% may seem like a good one-day return, but remember that for every dollar of shares you got allocated, you had to put up bids for about $120, which according to Chinese regulations must be 100% cash-backed.  You risked $120 dollars (if the deal turned out to be a failure you would probably get all or nearly all your bid), but only made a profit of $0.30 – not so good.  I think we may start to see a decline in oversubscription.

Comments (3) for "Chinese stagflation?"

A major " NEGATIVE SUPPLY SHOCK " such as what we have in Southern half of China could amplify the stagflationary forces in economy CPI will go for 8% in Jan-Feb, while growth slipping fast on export, credit tigthening cooling housing and FAI. The massive energy, transport and passenger traficc distruption proabaly will take down another 0.5 ppt off 1Q GDP and push CPI up by 1-2 ppt to 7% in 1Q tricky, very tricky situation for government. But in this world, there is no free lunch, to contain inflation, growth have to be sacrified. It is now probabaly time to pay the price for the sustained monetary accmondation in 2005-1H2007. The bitter wine of asset reflation bust is probabaly inevitable By isaac - 2/1/2008 6:28 PM

It is hard to imagine that the government would be willing to sacrifice growth in the short term, but if inflation climbs towards 8% it would certainly set of alarm bells. By Michael Pettis - 2/1/2008 8:36 PM

sounds fiscal policy in the form of massive dose of tax cut for key supply bottleneck sector such as farming, food producing- distribution, transport, energy could be one the tricky issue in China is most Transport, energy are SOE, so instead of tax cut which not necessarily translate into better and more supply, in short term just forced statement investment might work By isaac - 2/2/2008 11:13 AM