Stephen Roach: China Needs to Get Tough About Inflation

Morgan Stanley economist and Asia chief Stephen Roach’s current offering at the Financial Times, “Beijing’s Olympian task is to curb inflation,” says that the Chinese officialdom is focusing overmuch on growth in its policy mix. And Roach most assuredly believes that a serious slowdown is just starting.

The article oddly underplays its bottom line. China will face a slowdown due to faltering export demand, and its leaders are determined to keep growth going at a good clip. The policy bias has shifted towards expansion. That means giving short shrift to inflation-fighting. Roach points out that the Chinese officialdom has rationalized inflation, seeing it as structural, a notion Roach dismisses. He says, in effect, that even though the cost of tackling inflation now is unacceptably now, the cost of dealing it with it later will be even larger.

But that may happen on another leadership’s watch. And although Roach draws on the US’s experience in the 1970s, he misses an important lesson. We did not embark on inflation-strangulation until we perceived that inflation had become too costly. China simply isn’t there yet.

From the Financial Times:

China was slowing before the onset of the XXIX Olympiad and is likely to continue to slow in the year ahead. Elsewhere in Asia, a similar outcome appears to be in the offing.

Significantly, most of the Olympics-related construction activity in Beijing – some $42bn (€29bn, £23.6bn), according to the official Chinese tally – was completed more than a year ago…..Yes, there were plant closings in Beijing and the neighbouring city of Tianjin for a few weeks before and during the Olympics. But these two metropolitan areas collect ively account for less than 6 per cent of total Chinese output – hardly enough to make much of a dent in the Chinese production juggernaut.

At work, instead, are powerful repercussions of an external shock that has nothing to do with the Olympics: post-bubble adjustments bearing down on the US consumer, along with collateral damage now starting to show up in Europe and Japan. Developing Asia is the most export-intensive region of the world, with a record of more than 45 per cent of its pan-regional output now going to foreign markets. China’s export share is close to 40 per cent. As the industrial world slows, China and the rest of export-dependent developing Asia will feel the effects of a shortfall in external demand with a lag. Any gyrations traceable to the Olympics are likely to be overwhelmed by these much broader, more powerful macro forces bearing down on the region.

Policymakers in China are very much aware of the mounting downside risks to economic growth. Bank lending quotas, which have been the centrepiece of recent tightening initiatives, have now been relaxed. The pace of currency appreciation has also slowed – a sharp departure from the accelerated rate of revaluation that had been evident in late 2007 and early 2008. And policy interest rates have been left unchanged in a rising inflationary climate – keeping real short-term interest rates close to zero, a highly stimulative position….China’s pro-growth policy bias is once again coming though loud and clear…

In this context, inflation remains the biggest riddle for China. The recent pro-growth policy initiatives suggest that Chinese authorities are attempting to put a floor on the gross domestic product growth shortfall of somewhere in the 8 to 9 per cent range. Perhaps the biggest macro question for China over the next year is whether such a slowing – from the torrid growth pace of nearly 12 per cent in 2006-07 – is sufficient to stem the recent build-up of inflationary pressures.

There is good reason to believe that inflation risks will remain China’s most daunting macro challenge over the next few years. Particularly worrying is a growing inclination of Chinese officialdom to dismiss the build-up of inflationary pressures as “structural” – traceable to special forces that are argued to be beyond the control of domestic monetary policy. Three such developments are cited most frequently: recent labour reforms that have boosted minimum wages, an outbreak of “imported” commodity inflation, and international price equalisation that is presumed to bring the quotes of Chinese products up to world standards.

This structural excuse for China’s inflation problem is painfully reminiscent of an equally erroneous dismissal of US inflation risks in the 1970s. Back then, three structural forces were also cited as being beyond the purview of the US Federal Reserve, namely wage indexation to CPI shocks that created a wage-price spiral, imported inflation due to the worldwide commodity boom of the early 1970s, and mandated increases in production expenses traceable to regulatory initiatives in pollution abatement and worker safety.

The most important lesson of the 1970s is that the Fed proved to be dead wrong in dismissing inflation risks as structural. While inflation eased off in the middle of the decade as the US went through a deep recession, it roared back…. in the latter half of the 1970s, hitting a high of 13 per cent by the end of 1979. It took a new, courageous Fed chairman, Paul Volcker, to put the structuralist inflation argument to rest by driving up the federal funds rate to extraordinary levels and putting the economy through a wrenching hard landing.

That is an outcome that China – and an increasingly China-centric developing Asia, long fixated on social stability and poverty reduction – simply cannot risk. A hard landing could prove devastating to regional development imperatives. Yet to the extent that China and other Asian countries dismiss mounting inflation risks as structural and fail to heed the most salient lesson of the 1970s, the risk of an eventual hard landing will only grow.

That poses a serious question for the rest of Asia as well as for the broader global economy: can a build-up of inflationary pressures be contained to China? In the near term the downside of the global business cycle may limit the spread of inflation. But over the medium term that could change. The cross-border linkages of globalisation may make containment of Chinese inflation exceedingly difficult.

Temporary growth risks should not be the dominant concern in post-Olympics China. Stagflation may well be the greatest risk: an externally induced growth shortfall coupled with a significant deterioration of underlying inflation risks. Chinese officials are fixated on the growth side of the stagflationary equation, but they ignore the inflation piece of the outcome. That remains the greatest worry in the aftermath of an otherwise spectacular Olympics.

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  1. Dean

    Lester Thurow, ex-dean of MIT’s Sloan had some exceptional insights on China circa 2004; here is the video (worth watching):

    P.S. Do not forget China’s substantial room to improve its undeveloped rural areas vs. the controlled enterprise coastal zones(which we mostly consider the modern face of China).

  2. S

    international heralt tribune artilce on China central bank discussing how to recomncile its low earnings on treasuries without tanking the dollar. low returns starting to stress financing.

  3. Lune

    While Chinese officials may wish to continue to grow at 8-9%, the question will be how? The Chinese have not focused so much on developing internal consumption as on exports. In order to maintain 8-9% growth rates while exports decline would mean increasing domestic consumption likely by 10-15% a year. That is a tall order.

    One bad scenario would be if China chooses to meet those consumption goals with increased state spending rather than private consumption. After all, it’s much easier to direct state agencies to spend on “infrastructure” projects and force banks to lend to state enterprises in a command economy than it is to force private industry to re-tool and focus on domestic markets.

    In the end, that would leave China with large deficits and poorly invested capital, a-la Japan’s massive public works projects in the 90s. Not a good situation to be in. And if a Volcker-style intervention is required at that point, China could be facing a social revolution…

  4. Matt Dubuque

    Although I am a big fan of Roach, I think he fails to take any account of the uncertain wealth effects from the Shanghai bourse losing over 50% of its value in less than a year. For some reason he omits it completely from his text.

    This bourse was central in Chinese popular culture last year and stock market “investing” had developed into a real mania of sorts.

    I think we may well be seeing traces of that stock market collapse beginning to creep into the admittedly very noisy Chinese data.

    Matt Dubuque

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