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Wednesday, October 17, 2007

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. ...

    Posted by on Wednesday, October 17, 2007 at 01:08 PM in China, Economics, Inflation | Permalink  TrackBack (0)  Comments (17)

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