By Yiping Huang, Professor of Economics at the China Center for Economic Research, Peking University. Cross-posted from VoxEU.
On 19 October, the People’s Bank of China announced a series of rate hikes. This column argues that the moves were aimed at combating domestic inflation and avoiding the mistakes of Japan in the 1980s.
On 19 October, the People’s Bank of China announced a series of rate hikes. Although economists have been arguing for monetary tightening for months, this move was a surprise to many in the market.
This policy adjustment tells us several things:
- China’s monetary policymakers see greater inflation risks than the headline CPI inflation data;
- the government is probably trying to avoid the Japan mistake: loosening domestic monetary policy in order to reduce pressure for currency appreciation;
- therefore currency appreciation is likely to continue, if not accelerate; and
- the authorities might adopt certain measures to control the capital account temporarily in order to discourage “hot money” inflows.
China’s headline CPI rose to 3.5% year-on-year in August, up two-tenths of a percentage point from the previous month. A look at the disaggregated data reveals that inflation is mainly driven by food prices.
This is the reason why some officials argue that monetary tightening was neither needed nor effective. Nevertheless, during the thirty years’ reform period, almost every major inflation problem, that in 1988, 1993 and 2007, was initially caused by food inflation. Monetary policymakers have learnt not to treat food inflation lightly.
The current momentum of inflation is already pretty serious. CPI rose by 0.6% month-on-month in August, which can be translated into an annualised rate of 7.2%. This certainly is way above the central bank’s target. More importantly, the headline number is probably grossly underestimated due to under-represented service prices in the basket.
Some economists suggest CPI is currently closer to 5%-6%, compared with the official number of 3.5%. The Ministry of Commerce collects market prices for agricultural food every week. These numbers confirm that food prices already rose during the past three month at annualised rate of above 30%.
But that’s not all. Two more factors shadow outlook of China’s inflation picture.
- One, loan growth is slowing; this year’s new loans will likely surpass the central bank’s target of 7.5 trillion.
This is about 50% more than in a normal year. With negative real deposit rates, liquidity holders desperately look for opportunities to invest. They first pushed up stock prices and then housing prices. When these prices stabilised, they shifted their focus on certain types of commodities, such as beans, cotton, garlic, and sugar. As long as liquidity is abundant, some prices will rise dramatically.
- Two, wages are rising by 20%.
Economists and government officials still dispute the notion that China is rapidly approaching the Lewis turning point. But every business person in China agrees that it is happening. It is increasingly difficult to find additional workers and labour costs are skyrocketing.
Increases in wages are actually a positive development for China today. It has already led to improvement in consumption and therefore should be good for rebalancing the economy. But inevitably, it will be inflationary.
Not the Japanese tactic on currency values
The rate hike on 19 October is not only an effort to combat potential inflation, it is also an important departure from the typical Japanese approach of fighting currency appreciation. In the months following implementation of the Plaza Accord in 1985, Japan lowered interest rates and increased money supply. The reason? To reduce pressure for appreciation and mitigate its impacts. That approach, however, caused even more devastating consequence – a bubble, which eventually collapsed in 1989 (see Corbett and Ito 2010 and Ito 2010 on this site for more discussion).
Some Chinese policymakers had a similar mindset in the early days, believing China could not raise rates because to do so would exacerbate currency pressures. But since the beginning of this year, the asset bubble has been a persistent source of worry. Indeed, the government has already implemented a number of tightening measures aimed towards the housing markets. Yet these measures, unfortunately, have not had much impact since they have not addressed the root cause of the bubble risk: liquidity.
The rate hike on 19 October is unlikely to lead to a collapse of the housing prices, which have potential to go up further in the coming years given the healthy balance sheets of households and banks. But the latest change in the mindset of government officials may be able to help China avoid major asset bubbles like those experienced by Japan in the late 1980s and by the US during the early years of this century.
There is a worry that rate hike might lead to more inflows of “hot money”. This is probably true, given that all major central banks and those in Asia are in a “pause” mood, if not a “loosening” mood. But if the rate hike adds downward pressure on asset prices, it may also discourage hot money inflows. The net impact is not clear, but hot money is not something the government can completely eliminate.
In the near term, China’ government is probably safe to allow the currency to continue to appreciate. With risks of a double-dip receding, China’s policymakers are probably more confident about the growth outlook. There is also a possibility that China may be tightening controls over certain types of capital inflows in order to reduce “hot money” flows. These, however, should be viewed as temporarily responses to volatile market conditions. The long-term trend of capital account liberalisation remains on the track.
Corbett, Jenny and Takatoshi Ito (2010), “What should the US and China learn from the past US-Japan conflict?”, VoxEU.org, 30 April.
Ito, Takatoshi (2010), “China’s property bubble”, VoxEU.org, 15 April.
So what kind of currency appreciation are we talking here? And does it take into account contributions from potential QE2?
Huang: “[Chinese] wages are rising by 20%.” The best chance for rebalancing trade between China and the US is exactly this, to raise the wages of China’s labor. Principally, that puts money in their hands to buy, and some of that buying will be from increased imports. Rising wages there won’t bring incomes in China anywhere near those in mature economies, but will erode the margins on the most predacious low-value exports, exactly the production which is putatively most necessary to ‘protect’ from a rising renminbi. Once could raise the renminbi to squeeze out this production, or raise the wage base to make it unprofitable. Either way,inefficient low-margin production moves out of China, with the potential to bring China’s im/ex balances with major partners—i.e. the US—nearer to par. . . . None of that will help the _US_ trade deficit which is Made in America, but the narrative balances will realign in a needed way.
To me it hints that the pressures are building in China from actions in the US. When considering this we should not just think about this is terms of China and the US but a triangle between China, Europe and the US. Let us not forget that China’s biggest trading partner may not be the US but Europe and recent gyrations in the Euro have played a big part in what is happening in China.
These pressures make a trade war more likely in my opinion, one which the US will most likely lose because of its dependency on oil. With the Duzishan oil reserve base near completion and ready to be filled with oil, China has the ability to greatly affect the price of oil over short time periods. That it holds back on any such policy might well reflect the impacts on Europe rather than its impacts on the US.
Back to the main theme of this post and it appears that China may have fallen into a trap similar to a one which could affect the US. Interest rates have been so low for so long that certain parts of the economy have become unable to function without low rates. Michael Pettis points it out when he says:
One of the problems is that the economy – especially local and provincial governments and SOEs, not to mention the central bank itself – is so dependent on artificially low interest rates to remain profitable or viable, that even a small increase in interest rates can raise put pressure on cash flow and financial distress costs.
Final words go to Michael on the eventual consequences.
a sharp slowdown in growth – even more so if the trade surplus is forced down, as I expect it will be.
News for Mr. Huang. China is already in a Japanese style bubble.
By building up FX reserves of such a size (relative to world GDP) China has destabilized the world economy and set it self up for a “crash” at some point. Since it has been unwilling to take the quicker option of currency adjustment, it will suffer the longer but more serious pain of rapid inflation (which takes a while to build, but can really take off when it gets rolling … as it has started to do).
2 pundits frequently cited here approve this move:
2)Andy Xie was advocating this move months ago: