http://www.asiasentinel.com/index.php?option=com_content&task=view&id=2379&Itemid=422
China's Economy: The East is Red
Written by Sam Baker
Friday, 02 April 2010
...But so are the warning lights
A week before the 1929 market crash, which led to the deepest global
depression in modern history, Irving Fisher, one of the most famous American
economists at the time, said US stock markets were at a permanently elevated
plateau. In the 1980s, political elites, pundits and financial market
participants all thought Japan had figured out a new and superior "managed
market system." Both booms were illusory, fueled by easy money credit bubbles,
and both predictably ended in bust.
The China story is following the same pattern, with the seeds of economic
crisis being sown by an easy money credit-fueled investment boom facilitated by
the People's Bank of China, the central bank, which has set a target of a 17
percent year-on-year increase in broad money supply in 2010, according to a
March 7 story by the Xinhua news agency.
It is very difficult if not impossible to know when the China macro
bubble will burst, but we do know that a key trigger variable is inflation as
measured by the Consumer Price Index. Chinese policy makers are acutely
sensitive to inflation given the history of social upheaval in China caused by
inflationary episodes, including after WWII and preceding Tiananmen Square
protests of 1989.
As general price inflation pressures continue to build, China's policy
makers will eventually be forced into drastic action, which can't help but
trigger a macro crisis. Credit booms eventually end in bust. That is an iron
law of economics.
Although the CPI still remains relatively well behaved in China, that
doesn't mean that China's recent policy moves, including hiking reserve
requirements, are in any way pre-emptive and thus capable of neutralizing
rising inflation pressures before they beg an unavoidable catch-up response by
the People's Bank capable of derailing the economy. This is because consumer
price inflation is a result of easy money credit-fueled "monetary inflation".
As Milton Friedman observed, it takes roughly 24 months for easy money
conditions to manifest in a generalized rise in the price level as measured by
CPI.
With the epic credit boom last year in China coming on top of several
years already of aggressive growth in credit, the seeds have been sown already
for higher consumer price inflation in China as easy credit fueled monetary
inflation inevitably turns into a generalized inflation across the economy.
What this means is that China is already behind the curve fighting
inflation. Assertions that the tightening of reserve requirements are evidence
of China preemptively fighting inflation are erroneous in the context of the
above framework.
There has recently been an enormous amount of speculation whether China
will revalue the yuan in an effort to neutralize growing domestic inflation
pressures. Conventional wisdom has it that a stronger yuan would dampen
domestic inflation by reducing demand for Chinese exports and by making imports
less expensive. This is what the textbooks all say, but such textbook analysis
is contradicted by recent history. In China's case, we believe a modest
revaluation of the yuan is more likely to increase inflationary pressures
rather than reduce them - in a repeat of what happened from 2005 to 2008 when
CPI climbed virtually in a straight line from 1.8 percent in 2005 year on year
to a decade high of 8.7 percent year on year in February of 2008, all the while
the yuan gradually appreciated roughly 20 percent versus the US dollar.
During this same three year period, exports doubled and the China trade
surplus boomed. Such historical evidence suggests that there is unlikely to be
any dampening effect on domestic inflation pressures from the export side in
the wake of a stronger yuan. Chinese companies have proven they are keen to
grab market-share (and sacrifice margins) in the face a strengthening currency
and they are likely to continue to do so going forward.
Meantime, if we look on the import side of the equation, we see a
similarly weak argument for a stronger yuan leading to reduced domestic
inflation pressure in China. In the first six weeks of China's yuan
appreciation experiment in 2005, global commodity prices spiked 10 percent
while the currency appreciated less than 5 percent. Over the next 3 years,
commodity price inflation far outpaced the 20% gain in the yuan. In fact, the
Commodity Research Bureau's Continuous Commodity Index shot up by 20 percent in
2005 alone.
Meantime, as mentioned above, China's Consumer Price Index continued to
rise during the whole period from 2005-2008 in China when it peaked at 8.7
percent right before the global panic of 2008.
The bottom line is that anything short of a significant revaluation (in
the range of 20 percent or more) is unlikely to dampen inflationary pressure in
China. Modest appreciation is more likely to increase inflationary pressures as
evidenced in 2005 to 2008 period for three reasons: modest one-way appreciation
will tend to attract foreign capital inflows chasing further appreciation (and
the highest-growth economy in the world), exports are not dampened in any
material way, and global commodity prices rise faster than the yuan
appreciation.
Unfortunately for China, the kind of revaluation required to dampen
inflation (i.e. greater than 20 percent) is also likely to trigger a major
macro shock via the export sector. The same goes for interest rates. The kind
of interest rate hike China needs to slow growth enough to neutralize it is
also likely to trigger a macro crisis given the sensitivity of the corporate
and especially the highly leveraged real estate markets in China.
Thus Chinese policy makers are stuck between a rock and a hard place. No
matter what they do, inflation is headed higher because the credit
boom/monetary inflation horse is already out of the barn. CPI inflation follows
monetary inflation like the day follows night - unless a credit bust
intervenes. Thus, by deductive logic, we can see that the only solution to
China's inflation problem is a macro bust - painful now but even more painful
later
