The authorities are walking a very tight line. On one hand persistently high inflation and excessive levels of investment have the authorities very worried about social unrest or the possibility of a sharp economic adjustment, and on the other there is good reason to worry about the impact a global economic slowdown might have on Chinese exports and, therefore, on Chinese growth. To address the former, China is pushing out a whole slew of administrative measures. The PBoC has indicated that it plans to cap loan growth and that this time it is very serious about enforcing the caps, although as Xinxin Li of the Observatory Group points out, capping annual loan growth at 13.9% (his calculation) is not exactly draconian.
They raised the minimum reserve requirement again by 50 bps to 15% yesterday, but even this is not as tough as it seems. It is expected to take out about RMB 200 billion in liquidity, but as I wrote in October, we are going through a period of very large maturities of central bank bills and repos and this, combined with the continuing large monthly trade surplus, means that we can expect about RMB 1.2 trillion of money entering into the system this month (although given that we are in the run-up to the Spring Festival, when families typically hold more cash, the numbers are a little less frightening than they seem). Perhaps there is some increasing fear of tightening too much because the PBoC probably could have raised minimum reserves by 100 bps, as they did last month.
In addition to their investment-related tightening measures yesterday the authorities made additional statements about restricting price increases for food and other items. These measures to curb price rises, a government spokesman claimed, are aimed at combating speculation and illegal manipulation, not to prevent the normal functioning of the market, whatever that means.
Already we have seen a sharp slowdown in loan growth, although it is too early to say whether or not this is going to continue through 2008, and especially after March, when the new senior political appointees will take on their responsibilities along with their traditional eagerness to flex their spending muscle (and when the Olympics will be closer than ever). Nonetheless the fear is that, like a man scalding himself and then freezing himself as he tries to adjust the temperature of the shower, the authorities may push too hard on the constraining side just as the US recession kicks in.
Let’s assume for the sake of argument that all this happens – loan constraints severely restrict investment just as the US goes into a recession that disrupts Chinese export growth – will it at least end the inflation scare?
I was reading a piece by economist John Tamny, at Investors.com in which he claims that in the US “empirical evidence suggests that economic slowdowns correlate far more with rising, rather than falling, prices.” This is because, he argues, inflation is monetary, and not necessarily affected by changes in aggregate demand.
I agree with Tamny on this, and if he is right, even an overly successful attempt to slow the Chinese economy might do nothing to prevent inflation from persisting and even growing. Part of the reason is that most of the cooling measures involve restraining investment growth, not consumption, and so might simply reduce output even as the money base continues to expand. This would be good in the long term because a reduction in output would eventually translate into a reduction in the trade surplus, but it is hard to see how it would cause inflation to retreat. Price controls, the other favored policy response, might be effective in dampening inflationary expectations if current inflation is really caused by a one-off, reversible set of factors (temporary high food prices), but if inflation is monetary, they will have little impact except to further distort the economy.
I am not as pessimistic as most about a sharp decline in global growth – although I am more pessimistic than many about what such a decline would do to Chinese growth – and I am still a little skeptical about how binding the investment constraints are likely to be, so I don’t really think we will see the worst case scenario of a sharp investment slowdown coinciding with a sharp export slowdown. Nonetheless I am worried that the wrong monetary diagnosis and the effect of administrative measures could easily push China’s economy further along the extremes than anyone would want without addressing the fundamental monetary problem.
One thing I might add. In China a “stagnant” economy is not one in that is recession. It is one in which employment growth fails to keep up with the growth of the labor population, which when I first came to China six years ago everyone assumed to be GDP growth below 7%. Given the much higher growth we have seen in recent years and the still-upward pressure on unemployment, especially among university graduates, I suspect that the minimum level of GDP growth is probably much higher.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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in which he claims that in the US “empirical evidence suggests that economic slowdowns correlate far more with rising, rather than falling, prices.” This is because, he argues, inflation is monetary, and not necessarily affected by changes in aggregate demand. 
January, 2008