It’s pretty obvious how China can achieve its top economic priority of price stability
Premier Wen Jiabao made stabilizing prices China’s top economic priority for 2011. Amid the surge in world energy costs, this story didn’t make the front page. However, Chinese policymakers did take their time spent out of the limelight to allow the Chinese yuan to appreciate roughly 0.3% against the US dollar.
Chinese inflation is elevated and near 5% (4.9% is the official rate as of January 2011). I understand that China’s growth adjustment will take time; but if you’ve got unwanted inflation, then domestic policy is too loose (fiscal or monetary). And in this case, it’s the monetary policy that’s too loose – that goes for both currency and rates policies.
On the rates front: there’s a very frothy feel in domestic asset markets, specifically the property market. Low rates and easy money have sparked a(nother) property boom in China, one that policymakers are trying to tamp down. The Economist published a recent article to the point.
But it’s going to take much, much more than raising down payments and reserve requirements to shore up demand for risk assets. I mean, it really doesn’t take a genius to see that real rates are entirely too low. What’s the investment strategy here: nominal GDP is expected to grow at a 11% in 2011 (according to Economic Intelligence Unit, no link), while the lending rate is just 6.06%. There’s no rocket science here: money’s entirely too easy and inflationary pressures are there.
Furthermore, deposit rates are too low and capping domestic consumer demand. Rates need to rise.
On the currency front. Although there’s been some appreciation in the nominal currency, the yuan, Chinese policymakers only recently allowed their currency to fluctuate at all (again) on an annual basis (see chart below). Notice how the annual appreciation was near 0% spanning Q3 2009 to Q4 2010 (October). Since the central bank doesn’t fully sterilize the inflows of foreign currency from export sales, the depressed nominal rate on the yuan feeds through to the economy via inflation.
Inflation is rising, which is perking up the Chinese real exchange rate. In January 2011, the trade-weighted real effective exchange rate appreciated at a 4% annual rate (according to the JP Morgan Index). The real exchange rate takes into account the nominal rate plus shifts in the purchasing power of the domestic currency, as measured by relative price fluctuations.
The chart illustrates that the nominal exchange rate is now gaining traction on an annual basis, since the Chinese government halted its movement against the USD in 2009. I suspect that the nominal momentum will continue to grind upward throughout this year in order to temper some of the inflationary impetus coming from outside its borders (like Fed policy). But as I said before, it’s Chinese policy that’s too loose at home.
The problem is, that Chinese policymakers want to rein in accommodative policy without raising rates too much because they don’t want the currency to appreciate markedly and are unable to fully sterilize all the flows. Inflation results.
If Chinese policymakers question how to achieve their top economic priority, price stability, then the answer to this self-induced problem is pretty obvious: significantly raise rates and the value of the currency.
Rebecca Wilder
Interesting discussion on Mr. Soros’s article:
http://www.project-syndicate.org/commentary/soros52/English
I sometimes wonder, is the renminbi the flip side of the euro?
Mark:
Isn’t the question: “when will Germamy leave the EU and be independent?”
The real question is when Europe will leave Germany and be independent.
Rebecca,
You have written the best article explaining China’s economic situation that I have read in a long time. Hopefully, your efforts will draw a stronger and more well rounded level of reader participation to Angry Bear. Your reference articles are spot on.
A few questions:
1. I assume that you’re concerned that China will not raise interest rates fast enough to head off further inflation. If that is generally true, what do you believe will happen?
2. China appears to have engaged a measured ramp up approach to raising interest rates in order to avoid an economic shock. It strikes me that most western nations have used the same approach in the past. So, what’s the problem with continued measured growth of interest rates as opposed to hitting the Chinese economy with a shock? Had China induced an economic shock with a sudden surge in interest rates, such a move would have had economic consequences.
3. It appears that China needs to put its planned low income subsidies in place before it goes for the kill with interest rates. I see that move as being essential. What’s your opinion?
4. How does current U.S. Federal Reserve policy have any major impact on China’s inflationary pressures? I am not clear on that point and haven’t been since the Fed started buying up U.S. Treasuries, the goal of which is to absorb 70% of such flows this year. Won’t the end of the Fed’s Treasury buy cycle, perhaps in June 2011, have more of an effect than anything underway now?
5. You stated that China’s “central bank doesn’t fully sterilize the inflows of foreign currency from export sales, the depressed nominal rate on the yuan feeds through to the economy via inflation.” Can you explain that in more detail? I read quite a bit about that but I still don’t understand why China can’t sterilize almost all of the foreign currency flows. Secondly, why would the lack of total sterilization be a source of domestic inflation? Who is holding the foreign currencies that haven’t been sterilized?
6. I see no basis for assuming that China’s global exports will slow absent another global downturn. Similarly, I see no basis for believing that China’s domestic economy can continue its current growth rate once interest rates jump up. If both of these considerations are valid (and they may not be valid), what is your projection for China’s overall economy? Will China not have to rely even moreso on its global exports once it slows the growth in the domestic economy?
Thanks for a great article.
Rebecca,
Brad Setser would be very proud of your article. Well done!
The very fact that China runs a trade surplus leads to inflationary pressures. The Chinese government policy of buying up the foreign currencies earned by its exports and exchanging them for renmimbi results in a continuous increase in the money supply.
See also:
http://anamecon.blogspot.com/2010/04/effects-of-unbalanced-trade.html
Running a trade surplus creates a chronic reduction in domestic Aggregate Supply, ie the AS curve shifts to the left, leading to ever rising prices. This could be remedied by its spending its foreign reserves, but this would compromise its growth rate.
Interesting. You conclude that China’s interest rates are too low. They have 11% growth and only 6% interest. So interest rates are 5% below growth and this is causing the domestic inflation.
But the US is growing at 3.5% and interest rates are negative (the impact of QE). The fed says that 200b of QE is equal to .25% cut in interest rates. Given we have 2.3T of QE this puts US rates well negative. We are not any different than China. Our interest rates are functionally 6% below growth. And this is causing domestic inflation. Just as in China.
MG,
Thank you! I will hit on your points (although perhaps a discussion off line is also warranted).
Point 1. The answer is not clear-cut in the traditional sense. In the index, much of China’s inflation is being driven by food prices. If that comes off, then you will see the official numbers peak (I say official bc it’s widely known that China manipulates the official numbers and the actual rate of inflatio may be seriously biased upward, like twice as high, to the measured numbers). But as for the underlying dynamic, inflation should pick up over the longer term, which is consistent with achieving higher per-capita income, i.e., wages rise which puts upward pressure on final goods prices.
2. Yes, China (and other non-Japan Asian countries) have been driving much of the global rebound. I imagine that a dollar price of oil at $150 is ‘cheap’ compared to what it would be if china tightened up and the domestic consumers had access to cheap global goods and a higher rate of return on savings (the low deposit rate). The shorter the transition, the more painful will be the economic impact on all economies. But the transition would nevertheless occur.
3. It’s already started with the subsidies – but yes, much more fiscal support is needed. The fiscal support is already there by shoring up the banking system and other welfare measures already in the pipeline. If the country is going to run smaller current account surpluses, then for a given level of private saving (which is really high, both in the corporate and household sectors), the government’s gotta spend. And spend big in order to force down the domestic private desire to save. I suspect that big government deficits could offset a lot of the adverse effects on trade of a transition to a domestically-led growth model.
4. China pegs its currency (crawling or basket peg, whatever), which means that if Fed policy loosens up, so must chinese policy, all else equal, to maintain the peg. Therefore, domestically, you get looser money flows when the Fed’s policy is too accommodative for China.
5. Brookings wrote a nice publication a couple of years ago regarding Chines reserve policies and the costs of sterilization. I think that you’ll find it helpful: http://www.brookings.edu/articles/2009/0721_chinas_reserve_prasad.aspx
6. Between the two: inflation rising or interest rates rising, I find surprising inflation the more plausible scenario. Therefore, there’s still a risk of overtightening, like they did in 2007, only after inflation pushes them there. The base case is that China plugs along, soaking up export income and managing the domestic economy, but the tail risks have increased.
“Will China not have to rely even moreso on its global exports once it slows the growth in the domestic economy?”
China is experiencing an asset price bubble inflation problem. This can only be ‘fixed’ by faster real domestic growth. Thus, China will rely less on global exports if it’s importing more and producing more at home.
Rebecca
Thanks, Rebecca.
Won’t faster domestic growth lead to more inflation? And that should lead to a further rise in interest rates.
This morning it was clear that China is moving right along with automobile purchases.
Carmakers warn of China slowdown
By John Reed and Patti Waldmeir in Shanghai
Published: March 8 2011 18:28 | Last updated: March 8 2011 18:28
Foreign carmakers are warning of a slowdown in the world’s largest auto market, after February sales figures showed the first year-on-year decline in 16 months.
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China recently revised its economic growth target down to 7 per cent per year for the five-year plan running through 2015, from the previous 7.5 per cent.http://www.ft.com/cms/s/0/1d9fcb66-49ae-11e0-acf0-00144feab49a.html?ftcamp=rss#axzz1GfmCWtYt