Thomas Palley: Inflation, Chinese Style

Thomas Palley sends along his latest on China's battle against inflation, and the broader consequences of its anti-inflation strategy. William Polley says that Palley "gets it right":

Inflation, Chinese Style, by Thomas Palley: China’s government recently announced inflation hit a ten-year high of 6.5 percent in August. This increase in inflation is directly related to global trade imbalances, yet China is trying to control inflation without addressing that problem. That carries two consequences. First, it is doubtful this strategy can work, which likely augurs rising Chinese inflation. Second, the strategy aims to shift the onus of global trade adjustment on the U.S., which may come back to haunt China and the global economy.

China’s current inflation is a textbook case of prolonged under-valuation of a fixed exchange rate in tandem with export-led growth. As such, significant exchange rate revaluation should be a central element of its anti-inflation policy. However, instead of making such an adjustment China’s authorities are hoping to control inflation by exclusive reliance on tighter domestic monetary policy. It is doubtful this strategy can succeed because it leaves intact the inflationary impulse from China’s trade surplus and under-valued exchange rate.

One important contributing factor in China’s inflation is the rise in global commodity prices, including oil and base metals, which are now feeding through into prices. Food prices are also on the rise owing to increased global prices for wheat and corn. Furthermore, China has been hit by a virulent outbreak of swine flu that has decimated its hog population, driving up the price of pork, which is China’s favored meat.

In coastal areas, which have been the hub of China’s export-led growth, wages have started rising in response to rising living costs and in response to the gradual elimination of extreme surplus labor conditions.

Most importantly, China is beset by significant asset price inflation that borders on an asset price bubble. This asset price inflation is the product of massive expansion of the money supply caused by China’s trade surplus. Dollars earned by Chinese exporters have flowed back to China and been converted into local money by the central bank, which has bought dollars at the fixed exchange rate to prevent appreciation. Holders of these money balances have then bought stocks and real estate to gain higher returns and to protect against potential inflation. This has driven up real estate prices, triggering a massive construction boom that has in turn caused inflation.

The implication is clear. China is suffering from imported inflation caused by higher global commodity prices, domestic demand inflation caused by excess demand in export industries, and asset price inflation due to an increased money supply caused by China’s trade surplus.

The under-valued exchange rate is a key culprit since it contributes to excess demand in export sectors and it also drives the money supply increase via the trade surplus – which has hit new record highs in 2007. That suggests significant exchange rate revaluation should be a central component of China’s anti-inflation strategy. Moreover, revaluation would also diminish the impact of global commodity price inflation because commodities are priced in dollars so that a revaluation lowers their domestic price in renminbi.

Instead, China has chosen to rely exclusively on monetary tightening, raising interest rates and reserve requirements on bank deposits. This strategy is unlikely to work. First, there is already significant asset inflation and extensive debt-financed speculative investment, which means the monetary authorities are constrained from sufficiently meaningful tightening for fear of triggering a financial collapse.

Second, raising reserve requirements on bank deposits lowers the return on deposits and makes them less attractive. That provides an incentive for depositors to spend their money or invest elsewhere, which spurs more inflation.

Third, and most importantly, continuation of China’s under-valued exchange rate means continuing trade surpluses and large foreign direct investment inflows, which means further monetary expansion in China.

Putting the pieces together, the picture is one of rising Chinese inflation, and with that comes the risk of inflation-triggered social and political problems. In this regard it is worth recalling that the Tiananmen Square disturbances of May 1989 were in part caused by industrial worker unrest over erosion of living standards by inflation.

As for the global economy, China’s anti-inflation policy and continued refusal to adjust its exchange rate places the burden of trade imbalance adjustment squarely on the U.S. This adjustment will likely happen via recession and there are signs that process may already be underway. This is a sub-optimal approach, which is bad for all.

Comments

[PeterRabid]

Hurrah ! Palley thoughtfully analyzes the problem from the other side, after his spot-on post of September 12.
http://economistsview.typepad.com/economistsview/2007/09/thomas-palley-t.html#more

What's bad for the goose is bad for the gander.

Which one is the goose?

[Meh]

I don't know, every time I read Palley I get this sense of "retrofitting." Which is to say, there's a domestic US problem and he seems out to find all the reasons why China should solve that problem.

Now, admittedly, it's a long time since I did "Histories of developing economies" but one important factor is that they tend to run much higher inflation than old economies, it's part of running much higher growth levels. There's a lot of theoretical work about "it doesn't have to be that way" but most of the historical examples show that it's a tightrope that has to be walked, because the medicine for controlling inflation tends to be a lot more harmful than the disease for a developing country for whom the growth and creation of infrastructure, relatively basic living standards and an industrial base is the first priority.

[kharris]

Palley mentions, but does not emphasize, the expectations aspect of the problem. To the extent that China's population expects continued large current account surpluses and the resulting growth in demand and money supply, they will continue to expect inflation. The typical remedy offered from the US is that China ought to boost domestic consumption. That seems likely to keep consumer price inflation bubbly, though for a different reason.

If we take Meh's point as a given, and at China's average per capita consumption level, I think we probably should, China still has an interest in the best monetary policy it can manage. At the same time, the argument that the Chinese need to live better, rather than become more powerful as a nation, supports the gradual shift toward higher levels of consumption facilitated by more balanced trade. The shift would be from one source of inflationary pressure to another. Monetary policy would need to adapt to the change, but still needs to be anti-inflationary to a reasonable extent. Those most likely to suffer from inflation in China right now are the poor, after all.

[Blissex]

«This asset price inflation is the product of massive expansion of the money supply caused by China’s trade surplus. [ ... ] The implication is clear. China is suffering from imported inflation caused by higher global commodity prices, domestic demand inflation caused by excess demand in export industries, and asset price inflation due to an increased money supply caused by China’s trade surplus.» This analysis is woefully incomplete, as it stops at China. What has happened is that the inflation has been imported largely from the USA, the UK and Japan, all countries that have had zero or negative real interest rates or a long, long time. A long period of zero or negative real interest rates by all expectations should have led to a hugely inflationary wages and prices boom, and many have been baffled that only assets have enjoyed that. Sure, in the west: but the hugely inflationary boom has happened, even if in India and China, as western and (to a lesser extent) Japanese companies have used essentially free capital provided by their own governments to industrialise China. One of the aspects of the China and India boom is that a significant part of their exports are in capital intensive sectors, instead of the traditional labour intensive sector which take advantage of a developing economy's unskilled labour pool. Well, the era of low low low interest rates has resulted in western government subsidising gleefully the export of capital intensive jobs from their countries to China and India, and the purchase by the wealthy of capital assets in the west, driving high end wage inflation in Asia and high end asset inflation in the west. Amazingly bizarre policy! It mostly benefits only one section of society in the west. Curious indeed.