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September 13, 2007

Albert Keidel (http://www.carnegieendowment.org/files/pb54) has a September 2007 Policy Brief for the Carnegie Endowment on the risks of inflation in China titled “China’s Looming crisis – Inflation Returns”.  He argues that

China’s economy today looks much as it did before the inflationary catastrophes of 1988-89 and 1993-96, and as in the past, China today faces more than inflation.  If inflation gets out of control, draconian steps to suppress it could cause hardship and social unrest.

He makes several interesting points. One point, which has not been sufficiently understood in the press or even by many research analysts, is that even though the 18% rise in food prices (which comprise one-third of the CPI basket) accounts for most of the CPI inflation, and this rise was driven largely by shortages on the supply side (especially pork), this doesn’t mean inflation isn't real.  

If prices for any particular good rise because of supply constraints the result is not inflation.  As spending shifts away from other goods to take into account the higher prices of the good in short supply, the shift will cause deflation in those other goods, and so the net effect on inflation will be zero or very low.  The rise in pork prices because of supply constraints, in other words, should be mitigated by the decline in other prices.  In China that did not happen.  Prices rose 6.5% in August.

This suggests that core inflation of just under 1% would have been higher if it had not been for the effect of rising food prices – without the mysterious pig disease, pork prices would have been lower but everything else would have been higher.  This is not to dismiss the distinction between core (or non-cyclical) prices and prices of goods that vary greatly as supply and demand adjust.  Food prices and farm production are certainly cyclical, but in this case I think it may be many quarters before the cyclicality works in our favor to bring prices down.  The point is to dismiss the idea that Chinese inflation was "only" food inflation, and that once food prices adjust we will be back to where we started..

A second point Keidel makes goes to the heart of an argument I have had many times.  I have been often told that in China bank runs are impossible because people have no alternative investments, and with nowhere else to put their money, why would they ever take their money out of the banks?  Aside from the fact that when you worry about the safety of your bank your first urge is to protect your liquidity, not to find an alternative investment, there are many things you can do with money.

Value-losing deposit rates early in both the 1988-89 and 1993-96 inflation bouts sparked heavy bank withdrawals and accelerated consumer spending – pushing inflation pressures to the crisis point.  In 1988, as inflation rose far above deposit rates, cash rushed out of the banks and into a panic buying spree that stripped many stores bare of their goods.  The resulting inflation took two years to tame….

 

…This same sequence erupted at the outset of the 1993-96 inflationary period.  Early, moderate inflation – again triggered by high food prices – rose far above bank deposit and lending rates.  Chinese citizens quickly began withdrawing cash and spending it, and corporations pounced on bank loans that were cheaper than inflation to splurge on investment projects.

Basically Chinese savers withdrew depreciating currency from the bank and exchanged it for hard goods that retained their value.  I was told by a Tsinghua professor that during the last major bout of inflation it was almost impossible to buy cigarettes, whiskey, and white goods in Beijing.  Depositors, by the same logic, would withdraw their savings even without inflation concerns if they were ever to become nervous about the liquidity of the banks.

The third interesting point is Keidel’s argument that the authorities must immediately raise domestic interest rates substantially to choke off inflation.  He says:

Some Chinese officials worry that raising domestic interest rates will attract unwanted speculative foreign capital.  This should be a secondary if not third-order concern.  China’s short-term capital account is still heavily, if imperfectly, regulated.  The scale of speculative inflows is manageable.  The central bank has ample resources to pull foreign cash inflows out of the economy by selling either treasury bills or its own bonds.

Here I disagree with Keidel.  As my regular blog readers know, I think the monetary expansion caused by the currency regime is at the heart of China’s imbalances, and I do not believe any solution which does not address this problem can work.  Higher interest rates will drag in more speculative capital and the PBoC is unable to sterilize them in a meaningful way simply by selling bills, which are a near perfect substitute for cash.  The resulting monetary expansion will make inflation worse, not better.

Unfortunately the solution must involve an adjustment in the currency regime.  Perhaps the RMB must appreciate at a much faster pace, as many believe, or the PBoC must engineer a one-off maxi-revaluation, as I believe, but without an adjustment of the currency that reverses reserve accumulation, China’s monetary problems are not going to go away.  Nor will inflation.

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