Is Inflation About to Burst the Chinese Bubble?

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.

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  1. josephBarcelona

    Inflation fears are worse for us in the west than for them
    They are a saving culture, most of it outside the official banking net
    They can bare with it, we cannot

    1. Ignacio

      Oh God, why on earth do we have to read the same, unfunded, unthinked, intolerable mantras all the time, even after reading a pondered, illustrated and illuminating piece of article.

    2. Alex

      Most Western nations at this point could use some inflation: the Fed has repeatedly noted that US inflation is actually running below ideal levels. Chovanec’s incredible blog also has a table comparing food prices in Boston and Hangzhou: how is it that, in a country (China) in which the average person makes 1/12th of what she would make in the US, she ends up paying more than her Western counterpart for even basic food items? And observers wonder why the Chinese Consumer has not fully taken off yet…

      Southern Weekly has also noted that, for every $1 increase in China’s forex stash, it has to release the same amount of yuan back into the domestic market. China’s gigantic forex stash is often cited as a sign of immutable power by naive Western investors, but does the policy I just described seem sound in a country whose most visible economic ill is inflation caused by monetary oversupply?

      Also, I wish that the “China = saving culture” school would cite actual evidence for its claim. In all likelihood, Chinese save to excess not because of cultural puritanism, but because the economy is so distorted that it provides only limited investment vehicles to a populace that takes home a disproportionately small share of the overall national income. Said vehicles include luxuries like gold and jade, which have surged in price worldwide, and, most prominently, real estate, the speculation of which drives all but the richest Chinese out of the market. What do you do when you cannot invest and spend a huge share of your income on food? You save.

  2. craazyman

    I’m no expert on Japan or China, but I wonder how complete any analysis can be that does not account for social structures and institutions.

    The story in links yesterday — “Grisly Road Death Leaves Village in Disbelief” — seems to sum up, in a single metaphor, the Demonic Shadow that dances and weaves with every move of China’s Money, like Li Po’s shadow that tangles and breaks with his every step as he drinks wine alone by moonlight.

    That shadow is a hideous barbarian, and it seems destined to overwhelm their fractured culture in some final conflagration, or frozen in an anarchic Police State. Somehow Japan’s Shadow was restrained by its tribal uniformity and, maybe, by the utter destruction of its culture in WWII.

    I wonder how China can survive its Demon without another radical restructuring of its Property-Money-Spirit. Maybe it can. But I think they are drunk, and they will go their separate ways.

    1. craazyman


      It’s quite a challenge to find a good English translation of Li Po’s “Drinking Alone by Moonlight”. There are dozens and most are clumsy songless stumbles of multi-syllabic misery. The Wikipedia one isn’t bad, but not very good either.

      1. MyLessThanPrimeBeef

        It is said that Li Po was part Persian or some other Central Asian blood.

        Perhaps you will have better luck with the poem in its Persian version.

        1. craazyman

          interesting. i think his portrait on wikipedia is a masterful drawing and, yes, it suggests something other than pure Chinese — or at least what I would imagine as pure Chinese.

          the 2nd linked translation is, I think, quite good indeed — I can see why the American poet Charles Bukowski was such a Li Po fan.

          I’d have no luck in Persian. Wouldn’t know their squiggle from their comma. :)

          1. MyLessThanPrimeBeef

            The Wiki Li Bai painting, I am not familar with that one…but the second one in the same article, by Liang Kai, with Li Bai spelled Li Po, as the name was supposedly pronounced in China at that time, that painting is in all the books about Zen painting.

  3. godfree roberts

    China’s governance system–and its citizens’ personal financial habits–are radically different from ours. It is even more difficult to make useful projections about their future than it is to predict our own. Quiet boggling is probably the best approach…

    1. fajensen

      I sometimes have to work work with Chinese project managers. In my experience, they generally cannot manage anything, not even themselves.

      *Every* Chinese project I see is a massive brute-force effort with hundreds of people sitting idle on-site for months waiting for orders, then everyone jumps up like frogs in a lake full of dynamite when *all* the instructions (and counter orders and counter-counter-orders) all arrive at once after months of nothing!

      The Chinese project teams *literally* behave like screaming lunatics *every, single, time* that their Gods (a.k.a. Management, Sales) demand something. While skilled, they don’t dare do anything themselves so they jump up and down in front of the lone gweiloo: “You fix naou”, “You fix naou” totally apoplectic. Then they phone and email *everyone* they know off to complain, “make faster!”.

      It almost like those stupid American “we build something under random but stupid constraints, usually a deadline”-shows on “Discovery” just with a lot more shouting morons thrown in (and the morons being skinny blokes on crystal meth instead of bloated guys on ‘roids).

      China will cook off pretty nicely once their super-bubble pops; all these crazy super-aggressive, driven, people singularily focused on clawing their way to The Top suddenly losing both all their money and their only opportunity in life.

      *That* pile-up will be something to see! And something “the authorities” completely did not see coming!!

      1. MyLessThanPrimeBeef

        The jumping frogs you encountered in China, were they as scary as the Vampire Flying Frogs they recently discovered in Vietnam?

        1. fajensen

          Nope. Delivering projects to crazy Chinese in Iran is just a job that I have chosen to do because it pays for what I am really interested in doing ;-)

          I am also interested in discontinuities. Like cheap LEAP PUT’s on businesses that happens to depend on functioning 12000 km long JIT supply lines to volatile, me-me-me-oriented people like, f.ex., the Chinese.

  4. small business owner

    I have a small business in flooring and just received my inflation notice. From Shaw Industries.
    The global economy has begun to show signs of recovery in many industries.As this has occurred petrochemical supply chains are experiencing shortages and higher prices.While housing and related industries continue to fight for recovery,carpet and rug raw material supply and costs are being impacted by global demand for these same raw materials.
    As a result of across the board higher raw material costs in all fiber types, backing and chemicals, Shaw Industries will raise all residential and commercial carpet and rug prices effective February 5,2011. The increase by style will range from 5-8%. This is going to make it tough for my business to pass this on to my customers, may margins are so squeezed, but the customers are shopping for lower prices shopping for the best deal putting pressure on us that our margins are at the lowest I’ve seen. It’s a race to the bottom on both labor and materials, example 2 years ago on a commercial job to supply and install standard Vinyl Composition tile (what you see for flooring in grocery stores) I was getting $3.50 per square foot I am currently at $1.75 per square foot and still losing business to competitors.

  5. Jim Haygood

    Maintaining its US dollar currency peg has led China to buy huge quantities of dollar assets, which are expanding its money supply at double-digit rates. Theoretically, this expansion could be sterilized by selling domestic yuan-denominated bonds.

    But it isn’t happening, and the underdeveloped Chinese domestic market probably isn’t even capable of absorbing such an outsized flood of issues. Among other things, large domestic bond sales might cause disintermediation of the banks, which offer below-market, negative real rates to captive savers.

    So, in classic fashion, China has pumped up a huge credit bubble via incompetent central planning (a case of the pot calling the kettle black, for denizens of post-Bubble Bernankeville). When it pops, it’s gonna hurt! And it’s likely to take Australia’s absurd housing bubble down with it.

  6. Joseppi

    China is big and has big problems – But hey, who doesn’t have problems.
    What China does have that the West no longer has is capital. Yes, capital that central element to Capitalism. This capital is in the form of FOREX reserves, which gives them leverage and control in world trade. And more important is the means of production to produce a profit that creates capital.
    The West shipped it’s means of production infrastructure to Asia and then resorted to financial innovation to create the illusion of prosperity. This financial gimmickry was really a fiat ponzi con game collaborated by the government and multi-national corporations and was based on debt.
    The question is who would suffer more when the unsustainable world economic system realigns? Do you think that countries with state capitalism, that possesses the means of production and has a homogeneous population, or a country suffering from Corporate Capitalism that has no allegiance to a any sovereign country and a large population of unassimilated immigrants might fare better?

  7. Cochise On Rye

    China is definitely going to have some major problems in the near future. How it plays out is anyones guess.

    After 10 years of China sourcing, we are voting with our feet and returning to Mexico. Anecdotally, the business development officer at the Los Angeles Mexican Consulate says that inquiries by businesses with similar concerns has increased three-fold.

    Will not miss the 15 hour plane rides and the business environment so aptly described above by fajensen.

  8. Bi Ming Tan

    Generally a good article with many valid points. However, I have to take issue with the following statement:

    “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).”

    I’ve worked in China for the past 15 years. Not so sure that this is true. Some businesses prefer only to do domestic business as they can keep prices/profits higher by the virtue of their relationship with the purchasing party(particularly if that party is a government entity) and/or the offering of “incentives” to those parties to ensure that the highest price(rather than the true market price) is paid for their goods/services.

  9. az native

    to alex:
    we already have inflation if you include food and energy. Look at gas prices, groceries. It’s convenient for bernanke to exclude these important parts of our economy.
    What a bunch of criminals!!!! END THE FED

  10. Top Fund Manager

    There is a myth that China is dependent on exports. In fact, it’s a small part of their economy. I think that exports are about 9% of their economy. China is not overly dependent on the U.S.

    As Jim Chanos has pointed out the real bubble is in fixed investment. As inflation starts to spiral upwards the Chinese will be forced to raise rates which could have disastrous consequences for the property market.

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