Is Inflation a Threat to China's Stability?

In the comments at Martin Wolf's Forum, there is a very nice analysis of China's inflation problem from Yu Yongding:

Comment on "China: Inflation is not the big threat to stability" by Yu Yongding: It is fair to say that inflation is not immediate threat to China’s economic stability. However, there are many reasons for the Chinese government to worry about inflation.

First, China’s growth rate will be more than 11 percent in 2007. According to consensus until very recently, China’s potential growth rate was 8-9 percent. ... Perhaps, China’s productivity gain in recent years is great. However, ... it is hard to believe that China’s productivity ... has improved so dramatically that China’s potential growth rate has risen from 8 percent to 11 percent and will be able to maintain the current growth momentum without causing serious inflation. ... My guess is that there is excess demand in China and the excess demand is increasing. As a result, there is material inflation pressure on the economy.

Second, the recent food price hike cannot be entirely attributed to one-off external shocks. Virtually, prices of all inputs for food production, from feeding-stuff to fertilizer, have increased, which in turn may partially be attributed to demand-pull factors of the economy. ... Though the government will be able to contain the rise of food prices at a time via administrative methods, these factors are not one-off and will not go away automatically.

Third, inflation expectations have been established among the public. According to a recent survey by the PBoC, the public believed that inflation will deteriorate further. People have started to adjust their behavior correspondingly by withdrawing their deposits to buy shares and real estate, and pushing for more increases in wages and salaries. Therefore, at this stage, even if inflation is not a big threat to stability, worsening inflation expectations are.

Fourth, growth rate of wages and salaries has reached double digits in recent years and continued to accelerate. ... I do not know how productivity can rise fast enough to offset the rapid increase in labor cost without pushing up prices of products.

Fifth, price distortion is still wide spread. China’s energy price is among the lowest in the world; taxes on mining and extraction activities are excessively generous; pollution is almost free; rents on lands in many places used for FDI are very cheap. The low inflation to a certain degree is achieved at the expense of low efficiency and misallocation of resources. Unless the government gives up the plan for further price reforms, price increases for many important products are inevitable, which in turn may worsen inflation and inflation expectations.

Sixth, China’s money supply has been growing at a much faster speed than that of GDP for long time. Currently, despite PBoC’s policy intention of tightening, the growth rate of M2 was more than 18 percent in August. The growth rate of banks loans is also very high. In other words, China’s financial conditions are still quite loose and conducive to inflation.

Seventh, since later 2006, China’s equity price has more than doubled and stock market capitalization over GDP ratio has increased from less than a half of GDP in 2005 to more 100 percent of GDP currently. The wealth effect is bond to show up. The signs of the effect are already ubiquitous.

In short, all necessary conditions for a worsening of inflation are present in China. The surprising thing is not China’s inflation has worsened but that the inflation rate is still so low. Therefore, the government must be vigilant on inflation and take it as a big threat to stability. ...

Inflation is a big threat to stability in two senses. First, it creates inflation expectations, which in turn will sustain inflation by creating a vicious cycle of interaction between cost-push and demand-pull factors. Second, inflation and assets bubble will reinforce each other and cause serious financial instability. In my view, at this moment, the most dangerous characteristic of China’s economic situation is the symbiotic relationship between inflation and the asset bubble.

In his article, Martin did not mention China’s asset bubble. ... The average P-E ratio of China’s share price has hit 60 on 14th October. The capitalization of China’s two stock exchanges has more than doubled in less than two years and the capitalization/GDP ratio has already surpassed 100 percent. There is no doubt whatsoever that China’s equity bubble is very serious. However, stock markets are still inundated with endless inflows of liquidity.

Over the past several years, the main source of liquidity came from the PBoC’s intervention in the foreign exchange market aimed at controlling the pace of the RMB revaluation... To maintain the price stability and contain asset bubbles, the PBOC has carried out large-scale sterilization operation to mop-up the excessive liquidity.

Although the sterilization policy has created serious problems for commercial banks, which have to buy an ever large amount of low yield central bank bills and deposit an increasingly higher proportion of their cash with the central bank, sterilization operations are largely successful in mopping-up excessive liquidity. ...

However, despite the relative success of sterilization, China’s financial system is still flooded with excess liquidity. Otherwise, asset prices would have failed to soar; inflation should be tamed; the growth rate of investment should have fallen. Then where [does] the excess liquidity comes from? The answer lies in the fact that excess liquidity is not only a money supply issue, but also a money demand problem. ... Even [if] money supply remains constant, excess liquidity can be created by decrease in demand for money.

There are two fundamental reasons behind the drastic decline in the demand for money. First... Developments in capital markets have given normal savers the opportunity to diversify their assets. Stocks, bonds and fixed assets are now within the reach of many... [This] encourages households to shift their deposit away from banks into stock exchanges. ... Second, even if citizens’ preference for savings deposits has not changed, interest rate gains are being outpaced by price increases, hurting intentions to save in the form of savings deposits. ...

The ... main culprit of the excess liquidity present in 2007 is sharply weaker demand for money. Under these circumstances, even if the PBoC manages to totally sterilize inflows arising from China’s twin surpluses and adjust the growth of M0 and M2 to rates comparable with history, money supply will still outpace demand by far and create excess liquidity.

Historically speaking China’s money supply growth has been far greater than GDP growth and the pool of savings deposits are immense. China’s M2/GDP ratio is more 160 percent, perhaps, the highest in the world. With 38 trillions Yuan deposits vis-à-vis capitalization of 8 trillions Yuan of floating shares, potential for deposits shifting away from banks and entering the stock exchange market to drive up share prices is tremendous. ... On the one hand, the feast can last for years, until the biggest fool of all buys the most expansive shares and stock exchanges crash eventually. On the other hand, the current rise of share prices is ... highly unstable and hence the market can crash anytime. Speedy government intervention is required to cool down the assets markets, the sooner the better. However, the government is reluctant or unable to do so due to constraints.

Equity bubble, inflation, run-away housing price, overinvestment and massive trade surplus all are big threat to stability. China’s balance is on knife-edge. If the equity bubble bursts, housing market collapses, labor costs continue to rise rapidly, and global demand for Chinese products falls due to whatever reasons, what will happen to the Chinese economy? To sort out all possible scenarios and design policy mixes in response to different scenarios are great challenges to economists. ...

Comments

[Patricia Shannon]

http://www.ajc.com/search/content/news/stories/2007/10/16/china1016.html

China searches for harmony in its society
Troubled land: Financial woes, economic inequality and rising amount of violence plague Communist country.

By Audra Ang
Associated Press

Published on: 10/16/07

Xiamen, China —- As Communist Party leaders gathering in Beijing this week call for creating a "harmonious society," signs abound that the country is far from it.

In China's wrenching transformation from a poor, largely agricultural society to a prosperous industrial one, the party is wrestling with changes that have angered many Chinese.

"Farmers have lost their land, workers of state-owned companies have gotten laid off, people living at the bottom of society struggle in their daily lives, there is a huge difference in incomes of the rich and the poor, and a large amount of violence exists," said Ai Xiaoming, a professor at Sun Yat-sen University and an advocate for human rights and legal reform.

"These are signs of a disharmonious society," she said from Guangzhou, capital of prosperous Guangdong province, where rising land prices have touched off disputes between farmers and developers.

The tensions pose a challenge for the authoritarian communist government, which often tries to suppress dissent, and especially for President Hu Jintao. In power for five years, Hu has made a priority of distributing the benefits of recent decades of speedy economic growth more evenly.

According to the most recent figures from the Ministry of Public Security, 87,000 "mass incidents" were reported in 2005, including a deadly clash between police and villagers over the seizure of land for a power plant. And just last month, thousands of demobilized soldiers sent to railway training centers rioted in at least three cities.

Then there's the emerging middle class, whose investments in homes, cars and their children's education gives them a growing stake in society and an awareness of their rights.

"The amount of demonstrations is growing as social issues of instability are increasing. People's sense of safeguarding their rights is awakening," wrote Wen Yunchao, a columnist for the Southern Metropolis Daily newspaper. "I will slap anyone who says today's China is harmonious."

Maybe some of the rich who are holding back contributions from the Republicans realize that such things will happen here if people get desparate enough.

[Farrar Richardson]

The world needs more intelligent economists like Yo Yongding and Mark Thoma

[Meh]

I wouldn't be at all surprised to see the asset bubble in China burst at some point, both in real estate and equities.

However, I'm not sure that comparing numbers with developed economies gives a good sense of when. If we look at the development of South Korea or Thailand, inflation ran higher than people thought sustainable for quite a while. As such, it seems that some elements of inflation are linked to rapid urbanisation and rapid industrial growth and the calculations involved are not the same as looking at a more static economy.

For instance, productivity increases... Whilst existing Chinese factories may be unlikely to make the leap to German productivity levels (and thus take the sting out of inflation) the productivity increase associated with opening new factories (and moving labour from subsistence farming to global corporation backed industrial production) could be quite large (although hard to measure.)

As such, this state of affairs might be "meta-stable" for longer than we expect.

says...

On the positive side, inflation has the effect of offsetting the RMB's nominal devaluation in the forex market and stabilizing trade flows. While Chinese liquidity growth has been partially sterilized, this is a costly practice which cannot be extended indefinitely.

[Patricia Shannon]

Please define "sterilize" in this context. When I first saw it mentioned here, I thought it had something to do with China's one-child policy! Not all readers of this blog are economists :)

[paine]

"The world needs more intelligent economists like Yo Yongding ..."
what ???

at its heart
this is at the most generous
well meaning gibberish

based on no comprehensive view
full of two handed
auto-nullifications
and
woven with pseudo data nonsense

if you don't see my point
read it again

its like a ming tatoo parlor view
of the present han boom economy

[Mark Thoma]

I don't think paine was very impressed with the analysis.

[Tom Geraghty]

I don't understand the whole "China is exporting inflation" due to a "labor cost explosion" argument. Here's Brad Setser from last week:

China, with a rising current account surplus, is still a net drain on global demand. . . . China . . . is now exporting a big net contraction, not expansion, in demand to the rest of its world, because its supply is growing far faster than its domestic demand. . . . consumption is too low, particularly in education, medical care and other areas, like financial services . . . Government-financed public services are too small, especially compared with the growth rate. . . . the fall in consumption as a share of GDP [is tied] to the fall in labor income as a share of GDP . . .

Does this sound like an economy where labor costs are rising rapidly?

[Tom Geraghty]

Sorry, the last line of the previous post (Does this sound . . . ) is mine, not Setser's.

[wjd123]

...the fall in consumption as a share of GDP [is tied] to the fall in labor income as a share of GDP . . .Tom Geraghty

Tom Geraghty,

What's a person to believe? I thought the problem with demand was that the Chinese save too much. If this is true and the equity bubble bursts, they may have saved their way into a recession.

[calmo]

Didn't Tim just use this expression "knife edge", from Yu:

China’s balance is on knife-edge.

but that doesn't mean that Yongding has bridged the communication gap, I sense here.
For me (sucker for anything disorienting) the piece comes across in strange chunks (not as Mark describes "a very nice analysis" nor as paine rebels with "a ming tatoo parlor view of the present han boom economy").
Remember those days when we used to talk about an Eastern and a Western orientation? Ok, it was way beyond "inscrutable" then and this, too, comes across as canned (ie not "live") economics.
No offense (not even now that paine has cleared the floor for absolutely any remark) but I wish Yu was less Western?...something.
It's as if Yu obtained an MBA, making all communication thereafter problematic.

says...

I don't understand the whole "China is exporting inflation" due to a "labor cost explosion" argument. Here's Brad Setser from last week: ... Does this sound like an economy where labor costs are rising rapidly?

And your point is? The Chinese labor pool is not infinite (especially since food prices are rising and migration from rural areas is slowing) so at some point GDP growth is going to be constrained by labor costs. This is not destabilizing per se, but it does mean that inflation will increase for China's trade partners.

[Bruce Wilder]

Chinese policymakers kindled Chinese growth with a ruthless and extreme policy of subsidizing FDI, to overcome the hinderances of the under-developed Chinese economy. There's clearly a fear that upward fx valuation and/or domestic inflation could upset that virtuous cycle. But, I suspect that the Chinese policymakers fear something that is only in the past. China's infrastructure and human capital resources are much greater; China's manufacturing will be reaping substantial gains from deepening vertical integration and improving infrastructure as well as a much better trained workforce. On the commodity import side, Chinese upward valuation is all good for China; on the export side, China can make substantial gains in terms of trade. Both effects of upward valuation will sweeten with real gains any lubricating domestic inflation.

It would seem to me that inflation would be a stablizing force for China's economy, a source of much needed lubrication as the price structure of the Chinese economy adjusts. Inflation, plus upward valuation of the RMB in the foreign exchange markets, need not necessarily be all that painful for the Chinese.

The pace of change in China would seem to be the destabilizing element. The necessary adjustments are large, and difficult to coordinate. So difficult, that a sharp recession is almost inevitable. Any shock to the system could overwhelm the ability of Chinese policymakers to keep their very large balls in the air.

But, the domestic Chinese price structure will have to adjust to the reality of a high-productivity, manufacturing economy, which will mean a rise in wages, an increase in money transactions, and an increase in the numbers and varieties of products and services consumed -- a lubricating inflation can aid these adjustments. Also, the Chinese are not adequately banked; that legendary Chinese saving has included a lot of stuffing-in-the-mattress savings. A lubricating inflation could be a great aid to developing the banking system, pushing savings into interest-bearing accounts and minimizing the problems of debtors in paying back loans.

[johnchx]

Patricia Shannon asked:

Please define "sterilize" in this context.

Sure! When the People's Bank of China (PBoC) "intervenes" in the foreign exchange market, it buys dollars for renmimbi. It can do this without limit because -- as the Chinese central bank -- it can create renmimbi out of thin air (just as the Federal Reserve can "print" dollars).

The problem is that all of those newly "printed" renmimbi go into circulation, increasing the money supply and -- possibly -- sparking inflation.

To prevent this, the PBoC borrows those renmimbi back, issuing a sort of low-interest bond in return. This is called "sterilizing" the intervention, and the end result is that there is no net increase in the Chinese money supply. (There is, of course, an accumulation of sterilization bonds on the balance sheet of banks, which can eventually lead to other kinds of trouble).

[Patricia shannon]

Thank you, johnchx.

[dissent]

Oh I think there's a problem with the lack of democracy and political accountability, and how that impacts the development of the real economy.

A recent issue of the Economist reported that
1 Chinese savings have gone DOWN significantly over the last decade.
2. The share of Chinese GDP going to consumption has also gone DOWN signif in the same period, and is now the lowest among the major economies at 38%.

How is this possible?

Because wages have gone DOWN as a share of GDP.

This, folks, is the 'real economy' of a dictatorship.

It may seem like by fiat the leaders could increase the wage share, but actually, absent real political power of wage earners, it is very difficult. Too many intervening/ countervailing forces.

says...

Because wages have gone DOWN as a share of GDP. ... It may seem like by fiat the leaders could increase the wage share, but actually, absent real political power of wage earners, it is very difficult.

Have wages also gone down in absolute terms? Given that China's labor pool is still remarkably underemployed, an increase in labor costs would seem to be plainly unwarranted. Once the economy reaches full capacity, the situation will be very different.