Andy Xie: Psyching Out Inflation

Plenty can be done to stabilize prices, from raising interest rates and privatizing state companies to dumping the dollar.

Article originally from Caixin Magazine. Andy Xie (谢国忠) is an independent economist based in Shanghai, and the former Morgan Stanley star chief Asia-Pacific economist.

A cost-price spiral psychology has become a powerful multiplier influencing China’s inflation dynamic. Will it spiral out of control?

Businesses and consumers alike expect high inflation rates to persist. Businesses are hiking prices to deal with their own rising costs, and they have no incentive to change. Working-class consumers are responding to inflation by pursuing higher wages.

This cost-price spiral could be broken with an interest rate overshoot. But since policymakers are currently reluctant to raise rates, inflation psychology is strengthening its grip on the economy.

Some analysts and government officials point to price trends for one or two consumer items, and then use these patterns to reach conclusions about inflation. This is erroneous and dangerous.

Technical factors can change price trends temporarily. For example, cutting import duties and highway tolls can decrease the inflation rate for a time. But these moves change price levels only once. It would be wrong to extrapolate from such one-time changes that inflation is trending down, and that the country can thus afford looser monetary policy. It cannot.

That’s because China’s economy is slowing, albeit from a high base. An export slowdown is the main reason, followed by slowing investment in coastal provinces.

And inflation remains poses a serious threat to China’s economic stability. The current monetary growth rate, while significantly below the levels in previous years, is not restrictive relative to China’s potential growth.

The private lending sector’s high interest rates are mainly due to strong demand from the property development sector. When property prices decline, demand and interest rates will come down, too.

To bring down interest rates in the private sector, what’s needed are a level playing field for credit access between the private and government sector, and less demand for money instead of a bigger money supply.

The current growth rate isn’t low by historical standards. Key factors of production such as manual labor and energy are still in short supply. Pushing growth, then, would only exacerbate inflation.

Here are some signs that the economy is slowing: Total exports rose 24 percent in the first half and 17.9 percent in June alone. It is possible that export volume may have declined sequentially since May.

Many export companies, especially in traditional industries such as shoes and furniture, have reported sales declines over the past two months. This isn’t surprising since the global economy is double-dipping on the European debt crisis, and U.S. property prices are falling again.

China’s auto sales rose 3.3 percent in the first half to 9.3 million units. The market has normalized after seeing skyrocketing growth over the past five years. Market penetration rose rapidly from a low base. It appears the auto penetration rate has reached an interim saturation level.

Fixed asset investment in June contracted slightly from levels seen in the first half of the year. For the first half, though, it still rose 22.6 percent nominally, led by a 31 percent jump in western provinces and 29 percent increase in central provinces.

Weakening signs aside, electricity consumption continues to show strength. It rose 12.2 percent in the first half from last year, with industrial consumption jumping 11.9 percent. Total power consumption rose 13 percent in June.

The Chinese government would do well to target electricity demand to an 8 percent growth rate per annum, though. Until electricity consumption slows to below 8 percent, then, growth shouldn’t be a concern that overshadows the fight against inflation.

Destabilizing Force

Reportedly, nominal GDP rose 18.3 percent in the first half, higher than the nation’s money supply growth rate of 15.9 percent. The discrepancy could be explained by the spending of money borrowed in 2010 but idled since then, and credit expansion outside the banking system.

Compared to the real GDP growth rate of 9.6 percent, the GDP deflator – the broadest gauge of inflation – was 8.7 percent as of June.

China’s monetary policy has tightened somewhat relative to the past but remains loose relative to a potential growth rate of about 8 percent, a figure consistent with the vanishing labor surplus and non-accelerating inflation.

Yet inflation shows no signs of cooling. In fact, inflation permeates China’s economy. Price levels in China’s formal economy (such as supermarkets) are higher than in many developed countries, not only due to cost push but as a result of inflation expectations.

A shortage of blue-collar workers is pushing up manual labor costs at double-digit rates. Energy costs also remain high and are trending higher. High land costs are still working into production costs. And rents are climbing.

As capital intensity in the economy continues to increase, growth potential is declining. By 2020, the potential growth rate may reach 5 percent. If China accepts a 5 percent inflation rate by that year, the money growth rate should be guided down to 10 percent and the interest rate should hit 7 percent for six-month to one-year deposits.

There’s been an outcry in business and government circles over a money shortage. This largely reflects excessive demands for property development and other fixed asset investments. If monetary policy is to accommodate such demand, inflation will worsen. Hence, the solution to this “money shortage” is to reduce these activities.

One obvious way is to lower property prices. If prices fall 25 percent nationwide, the total value will fall by about 1 trillion yuan, equivalent to a 10 percent increase in bank lending. Monetary conditions would ease sharply with such an adjustment, which is likely in the second half of the year.

Balancing Act

Rising wages are essential to China’s rebalancing. The stagnant global economy will dent China’s export growth for years to come. Investment-led growth isn’t sustainable without export support.

Rebalancing means shifting some money from investment to consumption, and the vehicle for this change is a wage hike. But it only works if wages rise faster than per capita nominal GDP. But fiscal revenues have far outpaced the per capital nominal GDP growth. Wages have not risen as fast as nominal GDP. Hence, China’s rebalancing has not really started.

The market, through the labor shortage, is pushing the economy toward rebalancing by increasing wages. The current system is still against rebalancing. It tries to raise sufficient revenue to cover government spending needs. This force causes inflation to erode wage purchasing power, shifting it to the government.

Resistance to rebalancing is destabilizing and affecting China’s foreign trade relations. What can be done? State-owned enterprise (SOE) reform can help.

In the 1990s, China sold public housing to tenants to soak up money supply and cool inflation. The same tactic is possible today. The central government owns a vast number of companies that account for half of the nation’s GDP.

If run efficiently, they could be worth 100 percent GDP. Current profit ratios for SOEs is less than 5 percent, compared to 13 percent for S&P 500 companies. Privatization could more than double their profits.

The effects of past monetary growth, which is now turning into inflation, can be offset by selling SOE shares to savers. For example, if the central government wants to increase lending for infrastructure, it could sell enterprise shares of equal value to balance the inflation impact.

A similar tactic could be accomplished by launching the Shanghai Stock Exchange’s international board as soon as possible. The board would soak up excessive liquidity and recycle it into the global economy, thus cooling inflation at home and supporting global demand.

China’s urbanization process offers another way to balance.

City growth is spreading to central and western regions of the country. This is good, but it shouldn’t be viewed as a license to invest by every city governments.

Urbanization requires economies of scale to succeed. Only some cities can prosper. I have long argued that China should develop 30 cities with an average 30 million people each. These super-cities would yield prosperity through economies of scale by sharing infrastructure and decreasing market intermediation costs.

In a market economy, city selection can be accomplished through the bond market. Only cities with good prospects could raise money. But because China’s financial system is government-owned, capital allocation is a political process that leads to overdevelopment in too many places and massive waste.

The state-owned financial system has obviously created another wave of bad debt. It was bailed out by taxpayers a decade ago in what was then viewed as the last, free lunch. But the same movie is showing again, and the central government may be preparing for another bailout for the financial system.

For something different, China could develop a municipal bond market to finance urbanization. The market makes mistakes but at its own peril. U.S. urbanization relied on this mechanism, and it worked out reasonably well.

Currency control offers another option for rebalancing. The U.S. Federal Reserve’s monetary policy will remain loose for a long time to come. As a result, China may have to cut the yuan’s link to the dollar. Otherwise, the room to maneuver macroeconomic policy will only get smaller.

The yuan isn’t overvalued, in my view. The domestic price level is so high that it is hard to justify a higher currency value. As exports cool, the trade surplus will likely shrink.

Appreciation pressure is mainly from hot money. If China floats the currency, hot money will likely leave, exerting a powerful downward pressure on the exchange rate. If China floats the yuan today, it may be turbulent for a short period. But it will stabilize, probably around current levels.

This points to a good opportunity to float the currency. China failed to grasp similar opportunities in 2004 and 2008, with bad consequences. A float would give China flexibility over interest rate policy at a time when the United States, which faces high unemployment for years to come, is likely to keep interest rates low.

The Fed may begin to raise rates in the second half 2012, but it will not climb to the historical average close to 6 percent for many years. Hence, continuing to link the yuan to the dollar will enormously complicate China’s inflation problem – the problem that now has too many people psyched out.

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