October 16, 2007
China: Inflation is not the big threat to stability
For China’s rulers through the ages, stability has been the chief objective.
The same is true for the Communist party today. For the current government, however, economic stability matters most of all. Yet observers of the Chinese economy, both at home and abroad, now worry that what looms ever closer is instability in its most dangerous guise - that of inflation. Are they right to do so? Probably not, is the answer.
Consumer price inflation did hit 6.5 per cent year-on-year in August, the highest rate in 11 years, largely because of a 49 per cent surge in meat and poultry prices. One much-respected Chinese economist remarked last month that "we have entered a very delicate stage of our development". He is convinced, moreover, that true inflation is far higher than what he regards as the government’s over-optimistic figures.
Albert Keidel of the Carnegie Endowment for International Peace takes a similarly alarmist view. He writes that "China’s economy today looks much as it did before the inflationary catastrophes of 1988-1989 and 1993-96". The first of these episodes contributed hugely to the protests that culminated in Tiananmen Square in Beijing in 1989. The second ended up with inflation at more than 20 per cent, the sacking of the governor of the central bank and a big jump in interest rates.
Mr Keidel makes three points: first, while the price increases have indeed been limited to food, these remain of large importance to Chinese consumers, particularly to the urban Chinese; second, inflation is already visible in the data on nominal gross domestic product, which is growing at between 6 and 7 per cent a year faster than the government’s estimates of real GDP; and, finally, real interest rates on deposits are negative, which is likely to encourage the Chinese to spend at least a part of their huge holdings.
The remainder of the article can be read here . Comment from our expert panellists appears below.
Yu Yongding: It is fair to say that inflation is not immediate threat to China’s economic stability. However, there are many reasons for the Chinese government to worry about inflation.
First, China’s growth rate will be more than 11 percent in 2007. According to consensus until very recently, China’s potential growth rate was 8-9 percent. In China’s 11th five-year program, the growth target was set below 8 percent. In the past, China has never been able to maintain a growth rate above 10 percent for more than two consecutive years without causing serious inflation 4-5 quarters later. In the current cycle, the Chinese economy has maintained a growth rate above 10 percent for four consecutive years, while having kept inflation below 3 percent. This is already a miracle. Perhaps, China’s productivity gain in recent years is great. However, with a growth rate of fixed asset investment around 45%, local governments-led city-construction movement rampant all over the country, and an infamous wasteful use of energy and raw materials, it is hard to believe that China’s productivity (measured by total factor productivity and/or capital-output ratio) has improved so dramatically that China’s potential growth rate has risen from 8 percent to 11 percent and will be able to maintain the current growth momentum without causing serious inflation. Yes, China’s domestic demand is less than its potential supply. But when we are discussing excess demand and inflation, the relevant concept should be total demand. My guess is that there is excess demand in China and the excess demand is increasing. As a result, there is material inflation pressure on the economy.
Second, the recent food price hike cannot be entirely attributed to one-off external shocks. Virtually, prices of all inputs for food production, from feeding-stuff to fertilizer, have increased, which in turn may partially be attributed to demand-pull factors of the economy. For example, thanks to real estate development, the size of China’s arable lands has been shrinking rapidly and has almost reached the lower boundary of preservation set by the government. Though the government will be able to contain the rise of food prices at a time via administrative methods, these factors are not one-off and will not go away automatically.
Third, inflation expectations have been established among the public. According to a recent survey by the PBoC, the public believed that inflation will deteriorate further. People have started to adjust their behavior correspondingly by withdrawing their deposits to buy shares and real estates, and pushing for more increases in wages and salaries. Therefore, at this stage, even if inflation is not a big threat to stability, worsening inflation expectations are.
Fourth, growth rate of wages and salaries has reached double digits in recent years and continued to accelerate. This trend fails to be reflected in statistics, due to the fact that in China “gray income” perhaps is very important, if not more important than formal income. I do not know how productivity can rise fast enough to offset the rapid increase in labor cost without pushing up prices of products.
Fifth, price distortion is still wide spread. China’s energy price is among the lowest in the world; taxes on mining and extraction activities are excessively generous; pollution is almost free; rents on lands in many places used for FDI are very cheap. The low inflation to a certain degree is achieved at the expense of low efficiency and misallocation of resources. Unless the government gives up the plan for further price reforms, price increases for many important products are inevitable, which in turn may worsen inflation and inflation expectations.
Sixth, China’s money supply has been growing at a much faster speed than that of GDP for long time. Currently, despite PBoC’s policy intention of tightening, the growth rate of M2 was more than 18 percent in August. The growth rate of banks loans is also very high. In other words, China’s financial conditions are still quite loose and conducive to inflation.
Seventh, since later 2006, China’s equity price has more than doubled and stock market capitalization over GDP ratio has increased from less than a half of GDP in 2005 to more 100 percent of GDP currently. The wealth effect is bond to show up. The signs of the effect are already ubiquitous.
In short, all necessary conditions for a worsening of inflation are present in China. The surprising thing is not China’s inflation has worsened but that the inflation rate is still so low. Therefore, the government must be vigilant on inflation and take it as a big threat to stability.
Martin is right to say that China’s the growth of domestic demand remains subdued, rather than overheated, relative to the rapid growth of potential and actual output. In 2006, the contribution of net exports to China’s growth should be about 3-4 percent. Taking away the contribution, China’s domestic demand perhaps would not be able to support a growth rate of 9 percent. In 2007, China’s net exports will amount to more than 300 billion US dollars. If China fails to maintain the export momentum, its growth rate may fall significantly due to overcapacity. This implies that though at this moment, China is suffering overheating, but the overheating can turn into deflation very quickly. This is because of China’s growth is characterized by high investment rate and high growth rate of fixed asset investment, and hence overheating caused by over-investment at the current period could be followed by deflation caused by overcapacity at the ensuing period.
China experienced a period of investment fever from 2002 to 2004. As a result, in the early 2005, the economy showed sign of overcapacity. However, the expected slowdown of the economy failed to materialize because of the surge of a second round of investment fever. In a sense, China absorbed the overcapacity by creating more capacity. The problem is that this practice is not sustainable. The surge of China’s net exports since 2005 is also partially a response to overcapacity.
My point is that China is facing both overheating and overcapacity, with overheating at the current period and overcapacity at the next. Inflation is a big threat to stability in two senses. First, it creates inflation expectations, which in turn will sustain inflation by creating a vicious cycle of interaction between cost-push and demand-pull factors. Second, inflation and assets bubble will reinforce each other and cause serious financial instability. In my view, at this moment, the most dangerous characteristic of China’s economic situation is the symbiotic relationship between inflation and the asset bubble.
In his article, Martin did not mention China’s asset bubble. Martin may deliberately avoid discussing this issue. The average P-E ratio of China’s share price has hit 60 on 14th October. The capitalization of China’s two stock exchanges has more than doubled in less than two years and the capitalization/GDP ratio has already surpassed 100 percent. There is no doubt whatsoever that China’s equity bubble is very serious. However, stock markets are still inundated with endless inflows of liquidity.
Over the past several years, the main source of liquidity came from the PBoC’s intervention in the foreign exchange market aimed at controlling the pace of the RMB revaluation in the face of increasingly large current account and capital account surpluses. To maintain the price stability and contain asset bubbles, the PBOC has carried out large-scale sterilization operation to mop-up the excessive liquidity.
Although the sterilization policy has created serious problems for commercial banks, which have to buy an ever large amount of low yield central bank bills and deposit an increasingly higher proportion of their cash with the central bank, sterilization operations are largely successful in mopping-up excessive liquidity. As a result, the growth rates of monetary base and M2 are broadly in line with the target of the PBoC.
However, despite the relative success of sterilization, China’s financial system is still flooded with excess liquidity. Otherwise, asset prices would have failed to soar; inflation should be tamed; the growth rate of investment should have fallen. Then where the excess liquidity comes from? The answer lies in the fact that excess liquidity is not only a money supply issue, but also a money demand problem. Under special circumstances, demand for money can be the driving force behind excess liquidity. Even money supply remains constant, excess liquidity can be created by decrease in demand for money.
There are two fundamental reasons behind the drastic decline in the demand for money. First, predilection to hold household savings deposits has been weakening. Developments in capital markets have given normal savers the opportunity to diversify their assets. Stocks, bonds and fixed assets are now within the reach of many. Reforms in the stock market in the period of 2004-2006 along with foreign inflows played an important role in igniting the rise of stock price. Regardless of its provenance, the realization that higher returns can be obtained through the stock market encourages households to shift their deposit away from banks into stock exchanges. The increase in share prices in turn encourages further flight and asset price inflation, ultimately creating a vicious cycle. Second, even if citizens’ preference for savings deposits has not changed, interest rate gains are being outpaced by price increases, hurting intentions to save in the form of savings deposits. The worsening of inflation since Q4 of 2006 is adding oil on the fire. The rise in share price and inflation accelerated the flight from household savings deposits, which in turn make the share prices even higher.
The rise in asset prices and inflation in the past was certainly attributable to excess liquidity created by the twin surpluses and capital inflows due to CNY appreciation expectations, and the central bank’s inability to sufficiently sterilize inflows. However, the main culprit of the excess liquidity present in 2007 is sharply weaker demand for money. Under these circumstances, even if the PBoC manages to totally sterilize inflows arising from China’s twin surpluses and adjust the growth of M0 and M2 to rates comparable with history, money supply will still outpace demand by far and create excess liquidity.
Historically speaking China’s money supply growth has been far greater than GDP growth and the pool of savings deposits are immense. China’s M2/GDP ratio is more 160 percent, perhaps, the highest in the world. With 38 trillions Yuan deposits vis-à-vis capitalization of 8 trillions Yuan of floating shares, potential for deposits shifting away from banks and entering the stock exchange market to drive up share prices is tremendous. Constant investment into equity and real estate markets prevents rational valuation of assets. The pressure on share prices to rise is far from being exhausted. On the one hand, the feast can last for years, until the biggest fool of all buys the most expansive shares and stock exchanges crash eventually. On the other hand, the current rise of share prices is a positive feed-back process and is highly unstable and hence the market can crash anytime. Speedy government intervention is required to cool down the assets markets, the sooner the better. However, the government is reluctant or unable to do so due to constraints.
Equity bubble, inflation, run-away housing price, overinvestment and massive trade surplus all are big threat to stability. China’s balance is on knife-edge. If the equity bubble bursts, housing market collapses, labor costs continue to rise rapidly, and global demand for Chinese products falls due to whatever reasons, what will happen to the Chinese economy? To sort out all possible scenarios and design policy mixes in response to different scenarios are great challenges to economists. Unfortunately, these are issues too complicated to discuss in this comment on Martin’s instructive article.
Posted by: Yu Yongding | October 17th, 2007 at 2:00 pm | Report this commentMartin Wolf: Should the Chinese government worry about inflation? My piece for this year’s special report on China argued No. Yu Yongding disagrees. The debate is important. Since my thoughts were partly stimulated by his, I would like to respond to his important contribution.
Let me first consider some of his detailed points, before turning to what I consider to be the big issue.
First, overall demand is growing faster than potential supply, he argues. This is possible, though the evidence for most goods does not support this proposition. But we agree that if there is excess demand it is because the growth of net exports has been so strong. Domestic demand is growing more slowly than potential output.
Second, it is essential to distinguish relative price shocks from overall inflationary pressure. I agree with Yu Yongding that there are reasons to expect a rise in the relative price of foodstuffs, particularly those produced in China for which foreign substitutes are not readily available. But a rise in these prices does not necessarily mean overall inflation. I do recognise, however, that if the People’s Bank of China had an inflation target (which would be sensible) it should be trying to lower the rate of inflation of other goods if it agrees that there is a long-term trend for higher relative food prices and not just a short-term price shock.
Third, I agree that inflation expectations are likely to rise in a country without a credible domestic nominal anchor. Such an anchor is no longer provided by the exchange rate, since few can believe it will remain stable in the medium run even against a basket of major currencies. (It is no longer stable against the dollar, of course.) Again, this strengthens the case for moving to a domestic anchor, via inflation targeting.
Fourth, I am much less worried than Yu Yongding about rising nominal wages. Real wages ought to be rising in China and the relative prices of services (where productivity growth is relatively low) should be rising particularly fast. This is the classic Balassa-Samuelson effect in a fast-growing developing economy. Overall inflation in China ought, for these reasons, to be substantially higher than in the countries against which it has pegged its exchange rate. Until recently, however, it has not been. Indeed, the puzzle is not that inflation is now rising, but that it was so low for so long. In a recent paper Barry Bosworth and Susan Collins of the Brookings Institution estimate the rise of China’s output per hour at 8.5 per cent a year between 1993 and 2004 (”Accounting for Growth: Comparing China and India”, National Bureau of Economic Research Working Paper 12943, February 2007). This productivity growth (if true) would support very rapid rise in nominal wages.
Fifth, I accept the point on suppression of prices of various goods, particularly energy. So inflation has indeed been repressed.
Sixth, I am not so sure about the excess growth of money supply. In an economy whose nominal gross domestic product is rising at somewhere between 12 per cent and 16 per cent a year, money supply growth of 18 per cent does not seem so dramatic, particularly since the assets available to Chinese people are so limited. But I do agree with Yu Yongding that the rapid rises of asset prices may reflect excess monetary growth and loose monetary conditions. I did, in fact, remark on this link in my original piece: “Recently, this stock of deposits appears to have spilled over into asset markets, including the stock market.”
Now turn to the bigger picture.
I do agree with Yu Yongding that the role of investment in driving demand tends to create strong demand in the first period and excess capacity in the next. I agree on risks in asset markets. I agree, too, that the household sector may finally decide to reduce its monetary holdings, partly because of growing anxiety about inflation. This would certainly prove destabilising.
Yet my big point is that it is quite clearly the external sector, not domestic demand, that is now destabilising the economy. Domestic demand is growing considerably more slowly than potential output. Consumption growth is particularly weak and savings enormous. The increase in net exports is generating a current account surplus forecast at 12 per cent of GDP this year ($400bn). This is ludicrous for China and, in my view, globally destabilising, as well. Why should China be investing so much money abroad at what are certainly going to be negative real returns? Moreover, it is the increase in the external surplus that is generating the huge reserve accumulations and consequent monetary distortions and asset bubbles.
It is in the external sector then that the origin of the growing disequilibrium lies. The real exchange rate is now massively undervalued. It will have to appreciate one way or another, to restore equilibrium. That can happen either through domestic inflation (and higher nominal wages) or faster appreciation of the currency. The second seems to me to be preferable. Yu Yongding evidently agrees. As the real exchange rate appreciates, China will have to spend more on its own products. The best way to do this is via lower savings and higher consumption. The country certainly does not need even higher investment.
In short, I believe that rebalancing the economy is the overriding issue. Inflation is merely an inevitable symptom of the failure to do so.
Posted by: Martin Wolf | October 25th, 2007 at 12:53 pm | Report this comment