My Blog

February 27, 2008

Andy Xie has an interesting Op-Ed in today’s South China Morning Post in which he argues that the US, with Europe not far behind, is entering into a period of low growth and rising inflation.

It feels like the 1970s: economies weakening, inflation accelerating, the US dollar tumbling and oil prices surging. Most prominent economists abhor the comparison. The arguments against it are that, first, oil is a smaller part of the economy today and, second, that central banks have learned not to accommodate inflation. I hope so, but I am not convinced. Central banks are putting growth above inflation in their policy priorities. They hope they will have the time to deal with inflation when economies recover. Down this slippery path, central banks may get trapped; economies may take time to recover, which forces them to tolerate inflation for longer and longer. The end could be similar to that in the 1970s, when only a severe recession could cure inflation. Even though central banks know more now than three decades ago, they may still be heading down the same path.

As I’ve said many times before I am not as pessimistic as many about the depth and duration of a US slowdown for mainly two reasons:  First, I think the flexibility of the US financial system has weakened the transmission mechanism from financial crisis to economic contraction (they are not necessarily linked except though a change in the financing of investment and consumption).  Second, high commodity prices and high trade surpluses in Asia means that we are still in a cycle in which trade deficits (the US and, increasingly, Europe) are being recycled.  This is likely to keep risk appetite high, and once the markets bottom out, perhaps in the next two or three months, investment flows into risky assets will re-ignite.

Nonetheless I do agree with Xie that we are increasingly likely to see a combination of stalling growth and rising inflation.  What he says next is intriguing:

China is in a tight spot. The US is in a much better position to tolerate inflation. Foreigners hold over US$14 trillion of America's financial assets, about 100 per cent of its gross domestic product. Inflating away paper assets is a net positive for the US economy. Moreover, America's low-income group is more indebted, and inflating away debt benefits most Americans. China is a net creditor, as reflected in its US$1.5 trillion foreign exchange reserves. Low-income earners in China are net savers. Inflation decreases the purchasing power of low-income earners and decreases the value of their savings.

Inflation may be politically popular in the US but is certainly destabilizing in China.  China and the US both face inflation this year, but they will take different approaches to deal with it. China will maintain a tight monetary policy to contain inflation, while the US will loosen monetary policy to stimulate demand. The yuan is obviously an appreciating asset in such a macro scenario. To stop the currency from overshooting, China has to tightly control capital inflows.

I hadn’t really thought of the differing impacts of inflation on the various major economies, and I need a little more time to think about this, but if Xie is right, and certainly his argument seems plausible, we may see very different policies implemented in different economies to deal with rising inflation.  These different approaches to dealing with inflation may create more strains in the world economy.  I suspect that in the short term China may be hurt more by rising inflation, but if this forces it to deal strongly with inflation while the US dithers, in the medium term the Chinese economy may emerge in healthier shape – as long as the fight against inflation does not undermine the banking system.  

Of course my model of the Chinese economy implies that the only way China can deal seriously with inflation is by adjusting the currency regime.  I had a conversation earlier today with an economist at a major Australian bank (I haven’t asked his permission to identify him, so I won’t), but he believes, as I do, that the key issue is to adjust the currency very rapidly (via a large, one-off revaluation), although he thinks it may be several months before the authorities have the courage and incentive to do so.  In his opinion, it will take significantly higher inflation to force anxiety levels to the point where the authorities will finally agree to a one-off revaluation, but he does think it is inevitable. 

We both think that this will happen late this year or perhaps early next year.  His conversations with various Chinese analysts led him to expect inflation in February and March to be much higher than consensus forecasts (which already have risen dramatically recently).  He has also heard that pork production is not as high as it will need to be to bring pork prices down.  If I remember correctly I think he even implied 10% for February would not be a surprise.

On a very different note, Martin Wolf has an article in today’s Financial Times which includes a graph prepared by the World Bank that lists the fiscal costs, in GDP terms, of various bank bailouts since the Spanish banking crisis of 1977 (which cost around 17% of Spain’s GDP).  The worst two were the Argentine crisis of 1980-82 and the 1997 Indonesian crisis, which the World Bank estimates to have cost around 55% of GDP.  In comparison the1980’s S&L crisis in the US (the least “expensive” of the lot) cost just under 4% of GDP, and the Mexican crisis of 1994 weighed in at around 19% of GDP (I am reading these numbers off a bar chart, so I may be off by a point or so).

The World Bank estimates that the Chinese banking crisis of the 1990s cost the country around 46-47% of GDP.  That is a big number.  One of the wilder things I often hear from analysts who argue against any slowdown of the Chinese economy or of a crisis in the banking sector is that naysayers have been warning about crises in China for nearly three decades and yet have always been wrong.  Why should we believe that this time they will be right?

There are many reasons why this argument is nonsense, but the most obvious is that the naysayers were not wrong.  China has indeed suffered from at least two, possible three, crises during the reform period (as is natural – a fast-changing fast-growing economy nearly always has a rough path to follow).  Just because a non-marketized economy with a rudimentary financial system experiences financial or economic crisis differently than countries with very different financial systems doesn’t mean that things in China have progressed smoothly – although I guess if Wall Street bankers don’t lose their jobs it hardly seems like a real crisis, does it?  

I haven’t been able to get the figures for the 1985-87 inflation period, whose most obvious manifestation may have been a political showdown in 1989 but which also has an economic counterpart, but the World Bank estimates of the fiscal cost of the Chinese banking crisis in the 1990s suggests that it was pretty ugly – indeed it was the third most expensive crisis among the 15 listed..  Among other things the World Bank figures show why we need to be skeptical about reports that China’s total government indebtedness is less than 20% of GDP.  Much of its debt still exists in the form of unrecorded contingent liabilities.

Finally, one last think that struck me while I was reading a Bloomberg article about China Railway Construction Corp’s upcoming RMB 22.3 billion IPO.  There are rumors that it has already drawn RMB 3 trillion in bids (oversubscribed 135 times).  I have already written why this process is fraught with risk for eager investors, but I was struck by the following comment:

“Investors are moving their money to the primary market to hedge against the decline on the secondary market, as the returns are quite secure,'' said Wu Kan, who manages the equivalent of $41 million at Dazhong Insurance Co. in Shanghai. ``The first-day gain of China Railway Construction won't be amazing, but at least investors won't be running the risk of losing money.”

I know from personal experience how easy it is to be misquoted or to have one’s quotes taken out of context, so I really hope that Mr. Wu didn’t mean what he sounds like he said, but if so, it is very scary when a professional money manager believes that bidding in these IPOs does not involve the risk of losing money.  Just because IPOs shot up in the past is no guarantee that they will shoot up in the future, and the size of the first-day IPO surge has declined dramatically in the last few months.  What is more, because of the subscription mechanics even a small decline will be very costly to the poor retail investor, who because of the expected oversubscription needs to leverage up the amount of risk he wants to take by an astronomical amount.  If the deal is successful the investor on average may profit on 1/135th of the money he puts up, but if it is unsuccessful, he may find himself with a large part of his order, or perhaps even all of it, filled.  That is not a reassuring thought.

Comments (5) for "Will inflation affect China ...

Of course Xie is correct when he says that inflation is politically popular in the US. Once Nixon took the U.S. off the gold standard, economic dynamics in America began to change radically. They markedly shifted into high gear when Ronald Regan took office. Large trade deficits, manufacturing job loss, asset price inflation, rising debt-to-income ratios, and detachment of wages from productivity growth have since been the norm. The U.S. has become the mirror opposite of China (with the exception of asset price inflation). In marked contrast to China, a large part of U.S. current financial woes is the direct result of a shift in governmental policy away from emphasizing wage growth as a key objective. Another shift is a lack of concern about trade deficits. For quite some time now the American economy has been reliant on asset price inflation/financial booms and rising indebtedness/cheap imports in order to fuel growth. For a time, rising trade deficits kept inflation low while cheap imports distracted the poor and middle class consumers from grumbling about their stagnating wages, while the elite became fantastically wealthy. Clearly, U.S. policy has deliberately fuelled asset bubbles to keep the economy growing, while preventing asset price declines in order to avert recessions. Alarmingly, these bubbles inevitably create financial crises when they eventually implode. The current world crisis has been brought about by a tsunami of debt financed spending engineered by Greenspan. He not only allowed, but deliberately brought about, the most recent financial boom by systematically re-jigging inflation indices to under-report inflation, which allowed him to hide a policy of negative real interest rates in order to maintain the expansion and make it appear "healthy." At the same time the Greenspan Fed allowed an easing of credit standards, and new financial products that exponentially increased leveraged and widened the range of assets able to be borrowed against. In order to fool everyone with his Wizzard of Oz "magic", he allowed the breadth and extent of this mania (and credit risk) to be kept "off the books", bound up in $45 trillion of supposedly "safe" yet deliberately murky derivatives. Now that the curtain has been pulled back, the result is universal fear and a certain sense of desperation on the part of western central banks and bankers over the resultant ongoing devastation. To date, the world economy (and particularly China) has relied on the U.S. consumer's profligate spending habits for growth. If America's bubble economy is now tapped out, both China's growth and global growth will eventually slow sharply. I see no other country(ies) that have either the will or the capacity to develop alternative engines of growth of equivalent magnitude. By kevinfischer2002 - 2/27/2008 1:58 AM

Something I do wonder is how all of this is playing in the countryside. If you have huge increases in food prices, but very little increase in anything else, then presumably farmers ought to be quite happy. There is a difference between crisis and CRISIS. The Chinese political and economic system has gone through a number of crises without falling apart, which suggests to me that it is far more resilent and stable than people give it credit for. I don't see anything coming up that would overwhelm the political or economic system. Certainly nothing as bad as the banking mess of the 1990's. By Twofish - 2/27/2008 4:06 PM

Twofish, my understanding is that things aren't too bad in the countryside (excepting, of course, those areas that have been hit by climate disasters or pig disease). I have been told by a Peking University colleague that farmer incomes have improved, at least in the provinces he has examined. In general I think relative food inflation and wage inflation are not bad things in the medium term for China -- it is just that adjustments, even when they are good in the medium- or long-term, can still come with short-term costs. As you know I am less sanguine than you about the financial system. I worry that if we were to see a big jump in inflation or a sharp economic slowdown (or, heaven forbid, both) we would see serious problems emerge in the banking sector. I hope I am wrong. By Michael Pettis - 2/27/2008 4:23 PM

of course, inflation impact China very differently economically, but what andy forget to mention ( probabaly intentionally) is more important is the social-political dynamics. Greenspan view on China might be right, though the China economic system is very dynamic and resillient, however the social-political arrangement is quite rigid and the extremely wide income-wealth gap and ineffective government make any adjustment dangerous. Double digit inflation might be destabilizing for US economy, market. however it will hardly cause a dent on US flexible social-political structure. The reverse is also true, sustained deflation in Japan hardly caused a dent in JP social-political strcuture. Try this on China?? Price Stability is vital , how to achieve it and at what Cost, I dont know By isaac - 3/3/2008 7:00 PM

It is a mis-conception that peasants benefits from rising food prices 1. 200m peasants at prime(mostly male, 18-50) age work, live and consume in urban areas. Except for an ID card( HUKOU) and annual holiday trip back home, they are urban folks now. Rising food prices directly constrain their real disposable income just like every urban folks. They are workers in factory, not soft-commodity producer. 2. farmers urban wage income are 30% overall rural total income, the hit on overall rural income growth is big 3. Chinese farmers are small scale, mostly self-sufficient not big commodity producer in US-EU-LAAM. The surplus for sell is very limited. The rising input cost such diesal, fertilizer, seed, transport, even Labor (opportunity costs) are probabaly squeezing econmical return of farming The whole concept that rising food prices benefit Chinese farmer is illusion and mostly used to cover up the failing macro policies . The fact is simple, China is a big food importer so as most poor nations in world, globally US-EU-LATAM are only food suppliers By isaac - 3/5/2008 8:58 AM