My Blog

February 27, 2008

WED 27 FEB

Will inflation affect China and the US differently? By Michael Pettis

Andy Xie has an interesting Op-Ed in today’s South China Morning Post in which he argues that the US, with Europe not far behind, is entering into a period of low growth and rising inflation.

 

It feels like the 1970s: economies weakening, inflation accelerating, the US dollar tumbling and oil prices surging. Most prominent economists abhor the comparison. The arguments against it are that, first, oil is a smaller part of the economy today and, second, that central banks have learned not to accommodate inflation. I hope so, but I am not convinced. Central banks are putting growth above inflation in their policy priorities. They hope they will have the time to deal with inflation when economies recover. Down this slippery path, central banks may get trapped; economies may take time to recover, which forces them to tolerate inflation for longer and longer. The end could be similar to that in the 1970s, when only a severe recession could cure inflation. Even though central banks know more now than three decades ago, they may still be heading down the same path.

 

As I’ve said many times before I am not as pessimistic as many about the depth and duration of a US slowdown for mainly two reasons:  First, I think the flexibility of the US financial system has weakened the transmission mechanism from financial crisis to economic contraction (they are not necessarily linked except though a change in the financing of investment and consumption).  Second, high commodity prices and high trade surpluses in Asia means that we are still in a cycle in which trade deficits (the US and, increasingly, Europe) are being recycled.  This is likely to keep risk appetite high, and once the markets bottom out, perhaps in the next two or three months, investment flows into risky assets will re-ignite.

 

Nonetheless I do agree with Xie that we are increasingly likely to see a combination of stalling growth and rising inflation.  What he says next is intriguing:

 

China is in a tight spot. The US is in a much better position to tolerate inflation. Foreigners hold over US$14 trillion of America's financial assets, about 100 per cent of its gross domestic product. Inflating away paper assets is a net positive for the US economy. Moreover, America's low-income group is more indebted, and inflating away debt benefits most Americans. China is a net creditor, as reflected in its US$1.5 trillion foreign exchange reserves. Low-income earners in China are net savers. Inflation decreases the purchasing power of low-income earners and decreases the value of their savings.

 

Inflation may be politically popular in the US but is certainly destabilizing in China.  China and the US both face inflation this year, but they will take different approaches to deal with it. China will maintain a tight monetary policy to contain inflation, while the US will loosen monetary policy to stimulate demand. The yuan is obviously an appreciating asset in such a macro scenario. To stop the currency from overshooting, China has to tightly control capital inflows.

 

I hadn’t really thought of the differing impacts of inflation on the various major economies, and I need a little more time to think about this, but if Xie is right, and certainly his argument seems plausible, we may see very different policies implemented in different economies to deal with rising inflation.  These different approaches to dealing with inflation may create more strains in the world economy.  I suspect that in the short term China may be hurt more by rising inflation, but if this forces it to deal strongly with inflation while the US dithers, in the medium term the Chinese economy may emerge in healthier shape – as long as the fight against inflation does not undermine the banking system.  

 

Of course my model of the Chinese economy implies that the only way China can deal seriously with inflation is by adjusting the currency regime.  I had a conversation earlier today with an economist at a major Australian bank (I haven’t asked his permission to identify him, so I won’t), but he believes, as I do, that the key issue is to adjust the currency very rapidly (via a large, one-off revaluation), although he thinks it may be several months before the authorities have the courage and incentive to do so.  In his opinion, it will take significantly higher inflation to force anxiety levels to the point where the authorities will finally agree to a one-off revaluation, but he does think it is inevitable. 

 

We both think that this will happen late this year or perhaps early next year.  His conversations with various Chinese analysts led him to expect inflation in February and March to be much higher than consensus forecasts (which already have risen dramatically recently).  He has also heard that pork production is not as high as it will need to be to bring pork prices down.  If I remember correctly I think he even implied 10% for February would not be a surprise.

 

 

On a very different note, Martin Wolf has an article in today’s Financial Times which includes a graph prepared by the World Bank that lists the fiscal costs, in GDP terms, of various bank bailouts since the Spanish banking crisis of 1977 (which cost around 17% of Spain’s GDP).  The worst two were the Argentine crisis of 1980-82 and the 1997 Indonesian crisis, which the World Bank estimates to have cost around 55% of GDP.  In comparison the1980’s S&L crisis in the US (the least “expensive” of the lot) cost just under 4% of GDP, and the Mexican crisis of 1994 weighed in at around 19% of GDP (I am reading these numbers off a bar chart, so I may be off by a point or so).

 

The World Bank estimates that the Chinese banking crisis of the 1990s cost the country around 46-47% of GDP.  That is a big number.  One of the wilder things I often hear from analysts who argue against any slowdown of the Chinese economy or of a crisis in the banking sector is that naysayers have been warning about crises in China for nearly three decades and yet have always been wrong.  Why should we believe that this time they will be right?

 

There are many reasons why this argument is nonsense, but the most obvious is that the naysayers were not wrong.  China has indeed suffered from at least two, possible three, crises during the reform period (as is natural – a fast-changing fast-growing economy nearly always has a rough path to follow).  Just because a non-marketized economy with a rudimentary financial system experiences financial or economic crisis differently than countries with very different financial systems doesn’t mean that things in China have progressed smoothly – although I guess if Wall Street bankers don’t lose their jobs it hardly seems like a real crisis, does it?  

 

I haven’t been able to get the figures for the 1985-87 inflation period, whose most obvious manifestation may have been a political showdown in 1989 but which also has an economic counterpart, but the World Bank estimates of the fiscal cost of the Chinese banking crisis in the 1990s suggests that it was pretty ugly – indeed it was the third most expensive crisis among the 15 listed..  Among other things the World Bank figures show why we need to be skeptical about reports that China’s total government indebtedness is less than 20% of GDP.  Much of its debt still exists in the form of unrecorded contingent liabilities.

 

Finally, one last think that struck me while I was reading a Bloomberg article about China Railway Construction Corp’s upcoming RMB 22.3 billion IPO.  There are rumors that it has already drawn RMB 3 trillion in bids (oversubscribed 135 times).  I have already written why this process is fraught with risk for eager investors, but I was struck by the following comment:

 

“Investors are moving their money to the primary market to hedge against the decline on the secondary market, as the returns are quite secure,'' said Wu Kan, who manages the equivalent of $41 million at Dazhong Insurance Co. in Shanghai. ``The first-day gain of China Railway Construction won't be amazing, but at least investors won't be running the risk of losing money.”

 

I know from personal experience how easy it is to be misquoted or to have one’s quotes taken out of context, so I really hope that Mr. Wu didn’t mean what he sounds like he said, but if so, it is very scary when a professional money manager believes that bidding in these IPOs does not involve the risk of losing money.  Just because IPOs shot up in the past is no guarantee that they will shoot up in the future, and the size of the first-day IPO surge has declined dramatically in the last few months.  What is more, because of the subscription mechanics even a small decline will be very costly to the poor retail investor, who because of the expected oversubscription needs to leverage up the amount of risk he wants to take by an astronomical amount.  If the deal is successful the investor on average may profit on 1/135th of the money he puts up, but if it is unsuccessful, he may find himself with a large part of his order, or perhaps even all of it, filled.  That is not a reassuring thought.