My Blog

April 22, 2008

TUE 22 APR

Stagflation revisited By Michael Pettis

In my January 17 posting I wondered whether China might experience stagflation in the near future.  In my piece I defined the stagnation part of stagflation a little differently than its normal definition.  Specifically:

 

In China a “stagnant” economy is not one in 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%.  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

 

I agree that the idea of stagflation in China seemed at the time a little farfetched given the country’s rocketing economic growth, and I received quite a few comments saying exactly that.  Still, it seemed to me that there was a real possibility that frantic efforts to cool the domestic economy, if they didn’t involve serious measures to constrain monetary growth (which, for me, is another way of saying adjusting the currency regime to cut net inflows sharply), could very easily lead to a sharp slowdown with absolutely no slowdown in money growth and so no slowdown in inflation. 

 

I noted in particular a comment by John Tamny, at Investors.com, in which he claims that in the US “empirical evidence suggests that economic slowdowns correlate far more with rising, rather than falling, prices.”  This is because, he argues, inflation is monetary, and not necessarily affected by changes in aggregate demand. 

 

Since much of the tightening focus here in China is in the form of loan caps, administrative measures, and a more rapid appreciation of the currency, and the last of these simply means more hot money inflows and so more monetary expansion, one could make a very plausible case that the tightening can cause an economic contraction while having no impact on inflation, which would continue to rise.  Stagflation is not only possible, but in certain fairly plausible scenarios it is very likely.

 

Given my musings I found it very interesting that, according to today’s China Daily, a prominent Chinese economist is now making a similar warning.  According to China Daily:

 

While combating inflation and excess liquidity, the nation's financial regulator should also be wary of possible stagflation, the Shanghai Securities News quoted a noted economist as saying on April 20.

 

Speaking at a financial expert forum in Beijing, Tang Shuangning, chairman of the China Everbright Group and also a well-known economist, said the nation faces the threat of both inflation and stagflation. It is justifiable and necessary to adopt a tightening monetary policy in order to prevent the economy from going too fast, but monetary policy alone or improper use of it could cause a dilemma.

 

In order to address the problem, he suggests the government increase agricultural investment to secure food supply and stable prices. Therefore, it is necessary to combine monetary tools with other means such as credit and fiscal policies to support rural production.

 

I am not sure we have the same outlook.  It seems to me that what he is saying is a variation on an argument I hear a great deal.  China can sharply curtail monetary growth and make up for the resulting drop in demand by rapid fiscal expansion – and I think he suggests fiscal expansion directed at the agriculture sector.

 

I don’t completely agree.  I would argue that China actually needs to be a little careful about assuming that it has unconstrained use of fiscally expansion measures.  Why?  After all since Chinese government debt is low (around 20% of GDP, I think) and the fiscal deficit is also low (below 1% of GDP), isn’t there plenty of room for fiscal expansion?

 

I am not sure there is.  I think the ability to play the fiscal card is a likely to lot more constrained than we might think, for at least three reasons.

 

1.        I think government debt is a lot higher than the headline numbers.  There is almost certainly a lot of government-guaranteed municipal and provincial debt that is not recorded.  A few years ago a Chinese economist estimated that this kind of debt might add up to 10% of GDP.  I have no idea how much there really is and if his estimate would change today, but as someone with a lot of experience in developing countries I can only suggest that during a contraction these numbers always turn out to be much higher than originally expected.  In addition there are a lot of bonds on the balance sheet of the large banks issued by the AMCs.  This debt is guaranteed by the MoF but the non-performing loans the AMCs purchased in exchange for the bonds are almost certainly worth no more than a quarter of the value of the bonds.  That means that the AMC’s are bankrupt and their obligations should also be included as government debt. 

 

2.        In a contraction these numbers are likely to rise as contingent liabilities suddenly surge.  Specifically I expect that non-performing loans in the banking system are much higher than the official numbers (no big surprise here – nearly everybody pretty much thinks the same) and in case of a contraction they are likely to rise significantly.  I was told by a friend of mine who worked on the Japanese banking crisis that in 1990 the Japanese government had almost no debt.  By 2000, after ten years of cleaning up the banking system, its debt significantly exceeded 100% of GDP.  I haven’t verified these numbers but my only aim is to make the non-controversial point that in a serious contraction we might see an explosion of contingent liabilities.  In fact we almost certainly will.

 

3.        Finally, I am skeptical about the stability of the current fiscal deficit.  Aside from the fact that there may be a lot fiscal spending occurring indirectly and off-balance-sheet (a former student of mine from Tsinghua University who works for an SOE in another province assures me that this is the case, although he gave me no specific examples, so I am not sure), I believe that both fiscal expenditures and fiscal revenues have grown very quickly in recent years.  I need to check the numbers (and I will at some point) but I have been told by another professor here that the biggest reason for rapidly rising fiscal revenues has been corporate taxes (because the recent surge in corporate profits).  If this is true, a sharp contraction might automatically cause the fiscal deficit to surge even without additional spending, since corporate profits would almost certainly drop sharply and, with them, corporate taxes.

 

At any rate the China Daily article is headlined “Preventing Stagflation is also important.”  It certainly is. I am delighted that this debate is occurring, and I suspect that it is very much in the minds of the folks at the PBoC and the more-monetarist-oriented think tanks. 

 

I noted two other interesting pieces today.  Xinhua reports that the authorities are announcing new measures to crack down on “profiteers.”  They say:

 

China’s oil regulators are ready to launch a nationwide crackdown on wholesalers who sell to illegal filling stations and dealers in the wake of supply shortages…

 

…Illegal dealers and filling stations are believed to have aggravated the situation by hoarding oil and jacking up prices to drivers wanting to avoid the long queues at licensed stations.

 

Aside from the obvious point that shortages are a common consequence of price controls, it is clear that an inflation purist would insist that the long queues, from which people are willing to pay money to escape, are a form of reduction in the quality of good or service that is as much a component of inflation as higher prices, and so headline inflation is being disguised as waiting time.  Real inflation is higher than the official numbers, and Chinese motorists are paying this higher cost, but it is not showing up correctly in CPI.

 

The second additional interesting piece today is also from Xinhua.  It notes that according to Zhang Wei, a “senior official” from the China Council for the Promotion of Foreign Trade, China’s combined direct investments abroad amounted to $92.05 billion by the end of 2007.  Not a big number, but I think it is growing fast, and I suspect that the PBoC would like to see it grow much faster.