SPEAKING
FREELY China's new-old inflation
paradigm By Mark A DeWeaver
Speaking Freely is an Asia Times
Online feature that allows guest writers to have
their say. Please click hereif you are interested in
contributing.
The latest Chinese
economic statistics might make one wonder if the
economy is on the verge of overheating. In the
past 12 months, Consumer Price Index (CPI)
inflation has risen from 0.8% to 3.3%, while
first-quarter GDP (gross domestic product) growth
came in at 11.1%, the fifth consecutive quarter
above 10%. The
last
time the economy grew at a double-digit rate for
five quarters in a row, from the second quarter of
1994 to the second quarter of 1995, inflation was
running at more than 20%. Could the country be
about to enter another high-inflation period
similar to those experienced in the late 1980s and
early 1990s?
In fact, the dramatic
structural changes that have occurred in the
Chinese economy over the past two decades make
such a scenario very unlikely. While past high
inflation rates were the result of excess demand,
infrastructure bottlenecks and trade deficits,
today's inflation has more to do with money-supply
growth generated by balance-of-payments surpluses.
China today is more like Japan, South Korea, and
Taiwan in the late 1980s, which had inflation in
the 5-10% range as a result of large
foreign-exchange inflows, than the China of 20
years ago.
Too much of a good
thing While it might be argued that, as
Milton Friedman famously said, "inflation is
always and everywhere a monetary phenomenon", the
underlying cause is not always the same. Inflation
may originate with an import-price shock, as
appears to have been the case in the United States
during the energy crises of the 1970s. But it can
also result from rising export prices, as occurred
in oil exporters such as Indonesia and Nigeria
during that same period. And there have been many
cases where the culprit was the creation of money
to cover government deficits - the hyperinflations
of Weimar Germany in 1920s, Republican China in
the 1940s, and Argentina and Brazil in the 1980s
being well-known examples.
The driver for
the high Chinese inflation of the late 1980s and
early '90s was excess demand for both consumption
and investment goods resulting from the economic
liberalization of the post-1978 "opening and
reform" period. As there had been little
investment in basic infrastructure and production
capacity for many raw materials, demand growth led
to shortages that could neither be alleviated
locally nor, given insufficient export earnings,
with imports. The resulting increases in producer
prices were quickly passed on to finished
products, and the general price level rose.
Fast-forwarding to today's China, we find
a very different situation. Overinvestment has led
to excess capacity in a number of sectors, while
massive foreign-exchange inflows, both from
exports and investment, are now available to
finance the import of resources that are in short
supply domestically.
Nowadays, the problem
is not one of too little foreign currency but of
too much. To maintain exchange-rate stability, the
monetary authorities must buy as much foreign
exchange as anyone wants to sell at their target
exchange rate. Since these purchases result in the
issuance of additional local currency, the result
is an inflationary money-supply increase.
It is interesting that inflation could
result both from the trade deficits of 20 years
ago and today's trade surpluses. What these two
cases have in common, as Friedman's dictum would
suggest, is excess money-supply growth. Formerly,
the new money resulted from local credit creation
in response to excess demand. Today, the new money
is flowing in from abroad as excess supply is
exported, while the credit creation is occurring
overseas.
There is an important difference
between these two cases that suggests why today's
inflation is so much more benign. Under the former
conditions of insufficient aggregate supply, local
credit creation tended to spiral out of control as
enterprises with soft budget constraints used
loans from the state-owned banks to compete for
scarce resources. Today's money-supply growth is,
to a large extent, limited by what foreign
consumers with hard budget constraints can borrow
to purchase Chinese exports.
Global
resource constraints Over the long term,
however, it is hard to see how a country as large
as China can replicate the high-
growth/low-inflation stories of Japan, South Korea
and Taiwan in the 1980s. Eventually China's
economy must once again face resource constraints,
this time those of the planet as a whole. And
judging from the global commodities boom of the
past few years, this point may be fast
approaching. Chinese demand growth is now an
important driver of price increases for everything
from metals to agricultural products. When
excess demand from China pushes up world prices,
its own domestic price level will naturally go up
as well. This is evident in the March inflation
report, which showed local food inflation in line
with international levels. The food index rose
6.2% in the first quarter, mirroring a 7.3% rise
in the corresponding US statistic for the same
period and big year-on-year moves (as of April 20)
in the Goldman Sachs commodity indices for corn
(up 33%), live cattle ( up 22%), soybeans (up
20%), cocoa (up 19%), and lean hogs (up 16%).
Many are now expecting the People's Bank
of China to raise interest rates in an attempt to
bring inflation back below 3%. But given that
food-price increases accounted for 64%, or 2.1
percentage points, of last month's 3.3% inflation
rate, this may not be the right policy. If the
problem is a global one, a more useful remedy in
the short run would be to allow faster currency
appreciation to lower yuan prices for imported
food.
The government's long-term strategy
is to engineer a change in the character of
Chinese economic growth by promoting greater
efficiency in the use of resources, particularly
energy. But as the country's main area of
comparative advantage continues to be low-cost
manufacturing, it will take years if not decades
for significant progress to be made. In the
meantime, China's old excess demand-driven
inflation paradigm will increasingly become the
new paradigm for the world economy.
Mark A DeWeaver, PhD, worked as
a research analyst in Shenzhen from 1991-95, first
for W I Carr and later for Peregrine Brokerage. He
manages Quantrarian Asia Hedge, a fund that
invests primarily in Hong Kong-listed Chinese
equities (on the Web at www.quantrarian.com), and
can be reached at deweaver@quantrarian.com.
(Copyright 2007 Mark A DeWeaver. Used by
permission.)
Speaking Freely is an
Asia Times Online feature that allows guest
writers to have their say. Please click hereif you are interested in
contributing.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
