Financial World, 1st June 2011
China’s rise in inflation shows that problems with its growth rate are becoming acute, says Andrew Smithers.
China causes a great deal of well justified worry. It is very large, growing very fast and pursues a disruptive policy of exchange rate intervention. Its fast growth poses a problem is if continues and another if it falters. Its exchange rate intervention also has the potential to cause trouble in two different ways. So long as it succeeds in keeping China’s real exchange rate below its equilibrium level, it inhibits the much needed rebalancing of the world economy, but if this starts to fail Chinese inflation threatens to shoot ahead.
The developed world currently runs massive fiscal deficits with those of the UK and US exceeding 10% of GDP. These must come down and, in the process, there will, as a matter of identity, be an equal fall in the cash flows of the private and foreign sectors. Unless foreigners bear a significant part of this adjustment it will simply not be possible to avoid either continued large fiscal deficits or a return to recession. This is because the household sectors in both the UK and US have low savings rates and very bad balance sheets. They cannot therefore save much less or investment much more, which means that the sector’s cash flow is unlikely to get worse than it is today. This means that the full adjustment will have to fall on foreigners or business. The scale of the required change in huge as the budget deficits need to fall by at least 7% of GDP if not more. This cannot all fall on the business sector, because its cash flow can only fall through higher investment or lower profits and the two are connected. If profits fall too much business will not invest and we will fall back into recession. What is almost certainly needed is a combination of rising investment and falling profits and this will clearly be a difficult balance to achieve in practice even if helped by an improvement in the current account balances of the UK and US, which is how foreign cash flow falls, and almost certainly impossible without such help. Improving current account balances for the deficit countries, notably the UK and US, thus seems a necessary condition for a sustained recovery. This in turn requires decent growth in China. Slow growth, let alone an actual recession, unless it was accompanied by a world wide recession, would lead to a rise in the Chinese trade external balance. Given China’s size, this means that below trend growth in that country is incompatible with a sustained recovery for the UK or the US.
It is unfortunately the case that not only a slow down but even continued growth poses a problem for the developed world. The one aspect of this is the impact of continued Chinese growth on the prices of food and raw materials. In the developed world, the demand for food and goods does not rise very much with rising living standards as the bulk of the extra demand is for services. In the developing world the demand for food and raw materials rises strongly with improved living standards. This is partly because the extra demand for food is not so much for more calories as for more protein, which takes four of five times as much resources to produce as wheat and rice.
China’s policy of pegging its exchange rate, so that the renmimbi rises only slowly in nominal terms compared with the dollar, adds to the difficulties of getting a smooth adjustment. Having an undervalued exchange rate means that the China’s foreign exchange reserves are rising rapidly, as dollars have to bought to keep the rate pegged. The government have to issue currency to buy the dollars, so China’s domestic liquidity rises naturally with the intervention. To prevent increased liquidity from causing inflation it has to be “immunised”. This can be done by issuing government bonds to mop up the liquidity, or by increasing the banks’ reserve requirements with the central bank. Lacking a large bond market, increased reserve requirements has had to be the method used. Until recently this has been successful in keeping inflation at bay, though the world recession which followed financial crisis was probably a great help. The recent and worrying pickup in inflation would probably have hit the economy three years ago it inflationary pressures had not be halted by the drop in world demand.
There are problems with any form of immunisation and the use of increased bank reserve requirements seems to be increasingly failing as a way to prevent inflation. Despite the rising in reserve ratios liquidity appears to be leaking into the economy. One problem is that banks are neither allowed nor able to pay much interest on deposits when they have such large reserve ratios. This means that deposits give poor returns at times when investment in assets, particularly houses, has been giving high ones. Depositors have therefore a strong encouragement to use their money to buy assets. The liquidity produced by the foreign exchange intervention then leaks out going around rather than through the banks and with asset price inflation leading the way. Consumer price inflation follows, as the wealth induced by rising asset prices seeks an outlet.
Rising inflation in China is one way of adjusting the real exchange rate, but it is a very risky one. In March consumer price inflation hit 5.4%. As this is rather greater than US inflation, which was 2.7% in March, the difference means that China’s real exchange rate will rise against the dollar even if the nominal exchange rate is unchanged. The renmimbi has rise by 4.4% against the dollar over the past year and, from the view point of world stability, the best policy would be for China to allow its nominal exchange rate to rise even faster. A steady rise in the nominal exchange rate and a manageable difference between the inflation rates of the two countries is the ideal way to adjust. But once inflation starts to pickup in the way China’s has in recent months it is difficult to bring back down again. Beyond a certain level inflation becomes unmanageable. Expectations of inflation rise as prices accelerate and make their own contribution to a further rise in inflation through workers wanting increased wages and producers higher prices. China is busy tightening its monetary policy but as the rate is now over 5%, it is likely to have difficulty in bringing down inflation and expectations for it without cutting back growth to below trend. As I have already pointed out this will probably cause its trade surplus rises again and render sustained recovery in the UK and US even more difficult.
A smooth landing for China is possible, but it a hard one is at least equally likely and could come in one of two ways. First the current tightening could produce a sharp fall in domestic demand. Secondly a further rise in inflation could occur, which would delay matters but make the solution even more difficult as an even more stringent cut back to credit would be needed. This would mean an even sharper slow down in the economy, an even greater rise in the foreign trade surplus and thus an even more disruptive impact on the world’s current account imbalances.
Economies usually adjust well to mild changes but find sharp ones disruptive. China needs a much higher real exchange rate than it has today. This can only be achieved by some combination of relatively high inflation in China, compared with the developed economies, and a higher nominal exchange rate. As either a rapid inflation in China or a rapid rise in the nominal exchange rate would be risky, the ideal is a sustained period over which the nominal exchange rate rises at around 5% to 10% p.a. and Chinese inflation is stable at around 4% p.a. The real exchange rate between the dollar and renmimbi is influenced by the gap between Chinese and US inflation rather than just the level of Chinese inflation. A very low level of US inflation is thus desirable, with zero being better than 2%. This is particularly the case because China rapid growth means that it has a naturally rising real exchange rate – the so called Balassa-Samuelson effect. The need to adjust the real renmimbi dollar exchange rate is not therefore simply a one-off problem needed to cope with the current undervaluation of Chinese currency, but a requirement that will need to continue so long as China continues to catch up the developed world.
In addition to these difficult issues of adjustment the scale China’s investment raises problems. Rapidly growing economies must have high ratios of investment to GDP and as investment is more volatile that consumption this points towards rapidly growth being naturally less stable than a slower rate. Investment is more volatile than consumption because decisions to cut back on capital spending do not have the same direct and negative impact on living standards as decisions to cut back on consumption. They can, however, have an even greater indirect impact on living standards because of their knock-on impact on wages and employment. This factor on its own would render the growth of developing economies more volatile than those of mature economies. Experience, however, suggests that there can be, but need not be, an important offsetting factor.
In 1950 the US GDP per head was five times that of Japan, but there was rapid convergence. Over the next two decades until the oil crisis Japan grew at 9.3% p.a. in real terms and invested 30% of its GDP, while the US grew at 4% p.a. so that by 1973 US living standards were only 1.4 higher than US ones. Thereafter, until the crash of 1989, Japan continued to grow more rapidly than the US but the difference narrowed substantially. It was, however, only from around 1978 that China has been on a rapid growth path. It started, however, with living standards only half those of Japan in 1950. China’s long term growth rate can thus remain very high for many years to come before convergence of livings standards will be any where near those that Japan reached in 1973. As the table above shows, Japan and China have been similar in their growth rates during these catch up periods and have had similar investment ratios. The table shows, however, while Japan’s GDP growth from 1950 to 1973 was no more volatile than that of the US, China’s from 1978 to 2009 has been twice as great. (This relatively high volatility also applies if all three countries are compared from 1978 to 2009.)
The relative lack of volatility shown by Japan’s from 1959 to 1973 suggests as I have mentioned that there has been some compensating factor to offset the natural volatility of investment. Investment is planned on the basis of expectations of demand. These will regularly prove wrong, but in rapidly growing economies the rapid rise in domestic demand means that such errors will produce only very short periods of excess capacity. But while this could reasonably account for Japan’s experience from 1950 to 1973, the same dampening process does not seem to have applied to China. One reason is probably that China is three times more dependent on exports than Japan and mistakes made in investing for exports are not bailed out as quickly by rising demand as those dependent on the domestic market. Another possibility is that China’s policy of pegging its nominal exchange rate has created large imbalances in domestic investment because of the way, described above, that housing in particular is encouraged by the way that the authorities try to immunise excess liquidity.
China therefore faces difficult problems in terms of its rate of growth and with imbalances in the constituents of that growth. The rise in inflation shows that these problems are moving from the chronic to the acute stage. There is therefore a sizeable risk that China will not have a soft landing and this will increase the difficulty of achieving a sustained recovery in the UK and US.