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.
So will they or won’t they? One worry making the rounds is that on the economic front the government will overreact to the weather crisis in the same way it did during and after the SARS crisis, when it expanded monetary and credit growth much too quickly to make up for a supposed slack in employment growth.Given the level of unhappiness caused by the storms – not altogether the fault of the government although they have been criticized for being unprepared and for sugarcoating accounts of the crisis (no big surprise on the latter charge) – the government may be biased towards over-stimulating rather than under-stimulating employment growth in the near term. When in doubt, step on the gas.
Not everyone agrees.At a conference in Beijing today former Central Bank Deputy Governor Wu Xiaoling said that China would continue tightening economic conditions in order to moderate economic growth and rein in inflation.She also suggested that the government would allow more flexibility in the currency regime, especially since “the U.S. rate cuts have limited the room for the central bank to use interest rate as a leverage tool to adjust domestic demand.”I guess there are some rather tantalizing ways to interpret that comment, but I guess I shouldn’t read too much into it.
On the other hand, according to today’s Financial Times, “China has ordered financial institutions to provide emergency loans to businesses and individuals hit by the snow storms and power cuts that have paralyzed swathes of central and southern China.” They then go on to say that the directive, issued by the PBoC late Thursday night, “could bring a speedier than expected end to the credit squeeze instituted in recent months to fight inflation and cool a number of sectors of the economy, especially the property market.”Already, as I have mentioned several times before on this blog, there seems to be evidence that the weather crisis has tilted the balance of policy activity away from the monetary alarmists, who only seemed to gain the upper hand just a few months ago, back to the growth camp. As a card-carrying monetary alarmist I find that worrisome. How long the growth camp remains in control depends partly, I guess, on the duration of the weather crisis and the evolving evaluation of its economic, social and political impact.
Meanwhile weather conditions are not getting a lot better. Tthe China Daily today gives us the slightly awkward but soothing headline “Power could resume shortly in worst-hit area by snow”, but the story itself is not particularly optimistic. Conditions are grim.Other accounts of what China still has in store are even more alarming.Yesterday apparently Premier Wen speaking at a State council meeting warned the country that things were going to get worse, and today’s South China Morning Post has the headline “Another 10 days of misery forecast for a city living in fear,” which quotes Yu Jianhua, an operator for China Telecom’s information service in the city of Chenzhou, the subject of the headline, as saying "We know external help has been largely cut off. We know we must rely on ourselves and help each other. We cannot depend on the government.”
Most commentators see the weather crisis as an unambiguous political negative for the government, with the effect perhaps of increasing discontent and reducing credibility, unless the government succeeds in convincing people living in the affected areas that it has been sympathetic and effective in assisting them. The may well succeed in doing so since the leadership, perhaps a little belatedly, has nonetheless been firing all pistons to bring relief. Still, there is another, perhaps more positive, interpretation of the impact of the crisis making the rounds, at least among elite university students. Two different students (one from Tsinghua and one from Peking University) assured me yesterday that the weather crisis has provided a great excuse for the government to adjust CPI numbers that should have been adjusted earlier (I am trying to be polite here). I don’t know where they heard this and I have absolutely no idea if these statements have any basis or are completely groundless – and I am not trying to imply anything by repeating them – but I present them as, at the very least, evidence that there is a lot of cynicism out there.
In 16 and 17 days we will get PPI and CPI numbers for January.I think the consensus is moving towards 7% very quickly.
I’ve just seen one piece of good news and one favorable prediction about January inflation. The good news is that the State Administration of Grain said in a statement posted on Xinhua News Agency's Web Site today that in spite of the recent disastrous weather, China still expects to meet its grain harvest target this year.I did not realize that China is the world’s biggest wheat grower, but last year it harvested 501.5 million metric tons and this year it is on target to harvest around 500 million metric tons.
I hope this is true. The favorable prediction comes from Chen Xiwen, director of the Office of the Central Leading Group on Rural Work, according to today’s China Daily.“Given that prices of grain, pork and edible oil have seen no apparent rises, January CPI will remain stable,” Chen told the briefing held by the State Council Information Office.He predicted that January CPI inflation would be 6.5%.
This is not stable, by any means, but a lot of other analysts, including me, are predicting that CPI’s rise will be closer to 7%. Is 6.5% achievable?Perhaps, but not without some fudging.The government has been aggressively selling and/or delivering food reserves.Given the weather-related chaos in the food markets, this is not at all an unreasonable policy, but it does tend to put temporary downward pressure on prices, and that pressure will be reversed when the government replenishes its stocks. According to other reports farmers are complaining that food price freezes – another way of containing headline CPI inflation – are hurting them because they are being squeezed by higher fertilizer and energy prices.Finally according to the China Daily article, “To help keep prices down, the government has ordered all highway and expressway operators to exempt trucks carrying vegetables from toll fees.”Both price freezes and toll-road-fee exemptions reduce nominal food-related inflation, but they do so simply by a sort of accounting trick – what should have been called “higher food prices” will now be called something like “extraordinary loss” on the farmers’ and toll road companies’ income statements (I don’t mean that literally – the inflationary cost will simply show up as lower revenues or higher taxes).
I would have thought that it would have been smarter to let the full rise in food costs pass through into CPI numbers in January, because then inflation could be blamed on extraordinary circumstances.They can continue to subsidize the food costs to the worst-affected consumers, since this is politically and humanitarianly necessary, but the subsidies should be segregated and made explicit, although perhaps this would be administratively too complicated. Still, as it is, the net effect is to reduce upward pressure on prices in January and postpone that pressure into the next few months.This is surely more likely to cause inflationary expectations to rise than are price increases concentrated in January.
The government has spoken, I guess. At any rate the stock market certainly thinks it has. As a side project I run a small investment club, with money supplied by me and some friends, that is invested in a diversified portfolio of Shanghai-Stock-Exchange-listed B-shares (which foreigners are permitted to own, unlike shares in the much larger A-share market), so I can’t say I was disappointed when I clicked onto the SSE website and found that the B-share index was up 7.94% today (A-shares are up 8.13%). Although I am a little surprised at the extent of my gains, I am not at all surprised that my shares, and the market more generally, is up significantly today.
In fact I knew all weekend that my shares would be up today. How did I know?Easy.Everybody knew the market would be up today because the government very cleared signaled over the weekend that it wanted the market to go up. It was as simple as that.An article in today’s China Daily explains: “Monday's rally came after the China Securities Regulatory Commission (CSRC) gave the green light to CCB Principal Asset Management Co. and China Southern Fund Management Co to launch two funds expected to raise 14 billion yuan for equity investment.”
About four months ago, as a sign that it was very unhappy with the excess rise in the stock market and wanted it to come down, the government embarked on a series of measures to bring prices down.One of these measures was to prevent the launch of new mutual funds – always an important sign here of the government’s intentions.The market duly collapsed. At its peak in mid-October the Shanghai CSI hit 5885, before dropping to 4318 on Friday (a decline of nearly 27%).But now, by approving the application of two of these funds, the government made it clear that it believed the decline in the markets of the last three months has been excessive and may begin to have adverse effects on public sentiment. It was time for the market to go up.
While I yield to no one in the gratitude I feel towards anyone who can increase my wealth by several tens of thousands of dollars in a single day, I have to say that this is not as good for the development of stock markets in China.This kind of behavior will only delay by several more years the time when Chinese markets begin to fulfill their role as an efficient allocator of capital, taking money away from the least efficient and passing it on to those with the best growth prospects.I wrote about why in a January 2 posting (“The government condemns Chinese financial markets to speculation”).
A purely speculative market does not allocate capital efficiently based on reasonable estimates of future earnings prospects. Speculative investors simply try to exploit short-term price changes, usually based on changes in short-term demand or supply factors.In China the only important piece of information is about short-term changes in government and regulatory actions caused by changes in the government’s current intentions (and these change dramatically month-by-month and even day-by-day sometimes).Bloomberg quotes a grateful fund manager today as saying: “It is encouraging to investors that the government has done something to intervene in the market decline. We are probably already at a level where the regulators don't want to see a further decline.” Recent activity simply reinforces the message that in the Chinese markets the only thing that matters is the government’s intention, and the only people allowed to play are the speculators.
I am currently in Spain for a business meeting and will send the next week or so in New York, so some of my entries are going to be posted late.In China the debate about policy continues to rage, it seems, and although those of us outside the State Council can only guess at what is happening, the back-and-forth in the press gives us some hints of what the issues are likely to be.For example in China Daily Fu Jing wrote yesterday that economic policy needs a “rethink”.
The country needs to rethink its economic policy with snowstorms hitting regions and an economic slowdown in the United States, economists have said.“The economic situation has become complicated with the new factors cropping up," Wu Jinglian, one of China's top economists, told China Daily yesterday.It is imperative that the new developments are considered with measures to combat high inflation and the overheating of the economy, said Wu, from the State Council Development Research Centre, the central government's think tank.
Although the article did mention that vigilance against inflation and overheating needed to be maintained, these seemed to be fairly perfunctory acknowledgements in an article warning that China’s economy may slow down much more sharply than expected, especially if tightening measures are enforced.
The fears of people who share Mr. Fu’s views were reinforced by the poor showing in the recently-released headline PMI for December, which dropped from 55.3 to 53.0, although this is still in “expansion” territory (anything above 50).Nonetheless it does suggest that both internal factors (the weather and the credit tightening) and external factors (a slowdown in export growth) are weighing on the economy, especially given the sharp drop in the new export orders index from 54.4 to 49.0.Today Goldman Sachs made a trade recommendation that investors short the renminbi against the rupee in part, it seems, because they think the weather crisis will slow the renminbi appreciation.
On the other hand the South China Morning Post had this to say:
Zhu Hongren , deputy head of the National Development and Reform Commission's economic operations department, the nation's top economic planning body, said overall economic fundamentals remained sound. He listed several positive elements supporting economic growth, such as the Beijing Olympics in August, efforts to restore agricultural and industrial output, and some "good news" yet to be delivered. "Let's wait and see what happens. I hope we can hear some good news."
Analysts believe he was alluding to a relaxation of economic controls by Beijing. They said policymakers were quietly loosening the monetary reins after the bad weather threatened to stunt first-quarter growth. The analysts pointed out that President Hu Jintao did not mention the government's resolve to prevent overheating - a common topic - when he spoke about the economy last week. Instead, he told policymakers to "fully realize the complicated and changing economic environment and preserve as long as possible China's stable and relatively fast economic growth".
In an article I had missed, about two weeks ago the Economic Observer weighed in against using price controls to combat inflation, arguing that as a monetary problem, the only way to address inflation was by adjusting (read: tightening) monetary policy and the currency.Similarly, a researcher at the very prestigious Chinese Academy of Social Sciences published an op-ed piece in the China Daily late last week warning that it was too early to claim that adverse global conditions meant it was time for China to relax its new-found monetary hawkishness:
Many say the Chinese authorities should reconsider the tight monetary policy currently in effect.Their concern is not baseless for the economic situation in and out of China does not allow for too much optimism. Capital markets around the world are stumbling. China and the US are also seeing a narrowed difference in their interest rates.
However, these facts are far from adequate for the Chinese authorities to change the tight monetary policy.
I have seen more articles supporting than opposing continued tightening and no relaxation of monetary policy, but interpreting what this means is not easy.As I see it, my sources are more likely to be biased to the monetary camp, who are still much more worried about the consequences of rising inflation and economic overheating, then to the pro-growth camp, who do not want to see economic and employment growth drop sharply.Until recently the monetary camp seemed to be dominating the debate after having been relegated (much too long, in my opinion) to the margins, so the fact that the so many economists are arguing strongly and urgently in favor of a continuation of monetary tightening and renminbi appreciation suggests to me that they are worried that they are being once again pushed away from the center of the policy debate.
Neither I nor any other outsider knows what is really happening, and I am probably doing little more than reading tea leaves, but I am worried that we may be seeing another shift in policy.If worry about a slowdown causes the authorities to back away from their recent acknowledgement about the serious monetary bind in which China has found itself, I can only imagine that things will get worse as we approach the Olympics.
Amid all this debate, the government continues to show the people that it cares about the consequences of the weather crisis.An article in yesterday’s China Daily tells us reassuringly that “Across China, the worst winter storm in five decades has prompted governments to fight profiteering and maintain market order.”Among other things the government has told affected mobile phone operators that they cannot discontinue service for lack of payment, and they have punished railway station managers for allocating impossibly-scarce train tickets to themselves and then scalping them at many times their stated value – a popular activity this year since, during the Spring Festival, millions of Chinese overcrowd the trains as they go home to see their families for this most-important of Chinese family holidays, and the recent weather disaster has closed down many of the trains and made this year’s homecoming impossible for hundreds of thousands of workers.
It is hard to argue with punishing railway managers who withdraw scarce train tickets and re-sell them at a profit, and of course when the main reason many customers cannot pay their phone service is because of weather-related breakdowns, they should not be penalized, but some of the other inflation-busting activities reported by the media are less helpful, even if they are crowd-pleasers.In their goal to eliminate “profiteering”, hotels inundated with travelers have been prevented from raising room fees, restaurants and grocery shops running out of food and other supplies have been punished for raising prices, and everyone is required to get approval from the appropriate authorities before raising any of their prices.It seems that passing on part of the cost of the crisis to small businesses (for some reason I suspect larger businesses have more recourse) is likely to make the economy less, not more, productive.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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September, 2007
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