We’ve commented before on the near-impossibilty of teasing decent inflation estimates out of China. Despite that, we were early to comment that inflation was getting out of control. From a joint post with Marshall Auerback in February:
The government has engineered an enormous increase in money and credit in the past year. In fact, it seems to be as great as 5 years’ growth in credit in the previous Chinese bubble. The increase in money and credit is so great and so abrupt that you tend to get a high inflation quite quickly even if there are under utilised resources. Add to this the fact that China simultaneously is providing massive fiscal stimulus.
This combination is the making of a very messy situation. If China seeks to sustain demand via fiscal policy, the result is likely to be a big inflation problem. With many Chinese students steeped in Chicago School monetary theory coming home and assuming positions of authority, they could push for an aggressive, Paul Volcker-style effort to stop inflation.
But, what if the they don’t? Inflation can take off and thereby begin to ERODE the competitiveness of Chinese exports. Nouriel Roubini pointed out this issue in 2007: if China didn’t revalue, inflation would do the trick regardless. A continued high rate of inflation relative to its trade partners would push up the price of goods in home currency terms, which in turn translates into higher export prices. This might be the real reason why China is so reticent to revalue its currency. The Americans might go crazy if the Chinese devalued, but if the inflation is high enough, they might have to do it, as it will severely erode their terms of trade and cause their tradeables sector to collapse.
Or the hard-line monetarists triumphing by fighting inflation and the result is riots as unemployment increases.
Note that we pointed out that China was becoming less dependent on exports, but by increasing investment, which we also saw as unsustainable:
Exports are the only area where China makes any kind of money because they can sell these products for about 10 times what they obtain for a comparable product in the domestic economy (where profits are virtually nil). The export sector is a big contributor to overall super excessive fixed investment in China. Dollar appreaciation means foreign direct investment will go to zero net.
There will be strong forces for a reduction in fixed investment in this large sector. Hence, there is a good chance that even without monetary tightening by the Chinese authorities, the overall fixed investment boom in China will turn down….Nobody is thinking about this scenario but it is a real possibility. And with fixed investment now at fifty per cent of GDP (which is unprecedented in any economy) and exports at more than thirty, we’re looking at ratios that have never been reached before on a combined basis.
And the story in recent months from China has been of evidence of inflation. Consider this recap from Patrick Chovanec:
I’ve consistently argued that pent-up inflation poses a serious threat to China in 2011, I’ve also been predicting that we would almost certainly see the CPI rate dip in December, given the government’s high-profile crackdown on food prices. My reasoning was based on politics, not economics: it was politically imperative for China’s leaders to show they were taking action to rein in the skyrocketing cost of living, and they had the tools at their disposal to enforce a short-term, targeted result.
Price controls, and related crackdowns on speculation and hoarding, make bold headlines but do nothing to solve the economic pressures causing inflation. In China, those pressures arise from the fact that, due to China’s stimulus policies, its money supply has expanded more than 50% over the past two years. There’s just more money out there chasing the same amount of goods. Capping prices can’t change the fact that money buys less; it only changes how people are forced to deal with that fact – usually in a way that creates even bigger problems, like shortages or black market corruption.
Peter Tasker, in a Financial Times comment, argues that rising wages pose a fundamental challenge to China’s strategy:
The China story that has been sold so skilfully all over the world is simply another version of the “new era” thinking that has characterised every investment mania from the South Sea bubble to the dotcom frenzy….
There are good grounds for concern about the future. A significant increase in the profit share of national income, as we have seen in China this century, implies a significant decrease in the labour share – meaning that wages fail to keep up with economic growth. The other side of this is apparent in the gross domestic product numbers – a decline in the contribution of consumption and a ballooning dependence on investment. The longer these trends continue, the greater the ultimate reversal.
We’ve seen this movie before – 40 years ago, to be exact. In the 1960s Japan was achieving year upon year of double-digit GDP growth, fuelled by government-directed investment into infrastructure projects….
In the mid-1950s, Japanese labour had taken 60 per cent of total value added. In the miracle years this ratio fell to 50 per cent, then started a V-shaped recovery in 1970 as the labour market tightened. Ten years later it had soared to a plateau of 68 per cent. These gains had to be fought for. In the 1970s, Japan’s now dormant union movement was in its heyday. Profit margins were squeezed, and in real terms the stock market went nowhere for a decade.
Can workers grab a bigger share of the economic pie before the urbanisation process is complete? In Japan they did. In 1970 Japan’s urbanisation ratio (the proportion of urban population to total population) was still just 53 per cent. Currently the Chinese urbanisation ratio is 45 per cent, roughly where Japan was in 1964. However, Chinese statistics are notoriously unreliable. The floating population of unregistered urban migrants is estimated at between 50m and 140m people. So China’s true urbanisation ratio may already be close to Japan’s in 1970.
If China were to follow Japan, the next stage would be labour strife and inflation. The best way to avoid that outcome would be a radical tightening of the current super-easy monetary policy. But that would risk a serious slowdown and probably necessitate a large revaluation of the renminbi – both anathema to Beijing. Meanwhile, China’s reliance on a cheap currency is helping to fuel a trade war, in the words of the Brazilian finance minister.
There is no good way out of the corner into which China has painted itself. Rebalancing the economy is absolutely necessary. It is also a long-term project fraught with risks for China’s rulers – and for investors who have bought the story of inevitable western decline and unstoppable Chinese ascent.
The tendency of businesses and economies is to push successful models to their breaking point. We’ve over-relied on consumer debt and a cancerous growth of the financial sector; China has become unduly dependent on exports and investment. And each nation is fighting tooth and nail to stick with its old habits, precisely because the elites who’ve benefited from these strategies still wield considerable clout. So change is likely to come about only via disruption.