My Blog

March 24, 2008

MON 24 MAR

The RMB and contradictory policies on inflation and unemployment By Michael Pettis

Today’s China Daily quotes remarks made by a senior advisor to the PBoC on RMB stability and the need to fight hot money inflows, which he delivered at a conference held over the weekend (“Advisor: China needs stable yuan to fight hot money”). I thought his comments were very interesting:

 

China needs a relatively stable exchange rate and should not use another one-off currency revaluation to curb inflow of overseas speculative capital, Fan Gang, an adviser to the central bank, said in remarks published on Monday.  “In order to reduce the inflow of speculative money and prevent speculation on a bigger magnitude, China is in greater need of a relatively stable exchange rate policy,” Fan was quoted as telling a weekend forum in Beijing.

 

Fan opposes the use of another one-off revaluation of the Chinese currency, or yuan, according to the Shanghai Securities News. Widespread expectations that the yuan would register further sharp gains against the dollar have been encouraging inflows of speculative money into the country.

 

Aside from the fact the financial authorities and their advisors continue warning about hot money inflows, I was intrigued by the fact that Fan had clearly been thinking about a one-off revaluation and was, at least in public, opposed to it.  Of course his public “opposition” might simply be caused by concern that any widespread belief that the government might engineer another one-off revaluation would spur further inflows – the article points out that he himself argues that expectations of a sharp RMB appreciation have been encouraging inflows of speculative money.

 

The skeptic in me wonders however if the problem for Fan is a one-off revaluation, or just widespread expectations of a one-off revaluation. In the latter case, we would expect the authorities to deny that a one-off revaluation is coming, whether or not they thought it was.  I remember Lopez-Portillo’s widely repeated claim in 1982 that “We will defend the peso like a dog”, which earned the Mexican president opprobrium (and, funnily enough, barking sounds whenever he subsequently appeared in public), when the currency was catastrophically devalued just weeks later, and of course in July 1997 the president of Thailand promised to defend the baht only days before it was devalued.  Watch what they do, in other words, not what they say.

 

What interested me most about his speech is that by now it seems that the option of a one-off revaluation is clearly one of the policies on the table, and it is being widely discussed, even if distastefully.  About a year ago when I first suggested that the government was moving, almost inexorably, in the direction of a maxi-revaluation, I pointed out that although at the time the prediction might seem unthinkable, even laughably wrong, I expected the consensus to shift fairly quickly– I said that within six months I expected the idea would be much more generally discussed, and probably within a year it would be one of the central policy options under discussion.  The direction and force of China’s monetary problems seemed to rule out most other solutions.

 

I still do not believe that the policy of a sizable and sudden one-off revaluation is a widely-supported option, but things certainly still seem to be moving in that direction.  I expect that if hot money inflows prove to be a persisting problem over the next month or two, or if inflation stays high in March and April and especially if inflation shifts away from food and towards other goods and services, both of which I expect, it is going to be increasingly hard to dismiss the idea of a more radical and efficient solution to China’s monetary problems.

 

Talking about hot money, this is what China Daily reports about Fan Gang’s take:

 

More overseas speculative capital is expected to flow into China in 2008 and next year as a result of the US subprime mortgage crisis, which has sharply driven down the US interest rates and the value of the dollar, Fan was cited as saying.

 

The credit crisis would drive more capital to high-growth countries such as China and India, he said, adding that it remained a key challenge and priority for China to resolve the problem of excessive liquidity in its banking system.

 

Excess liquidity really is a challenge, but I am not sure they are dealing with it to any serious extent.  The problem lies with net currency inflows, and the only way to address that is to address the currency regime.  Still, for all the hot money and persisting inflation, the authorities are talking bravely about their ability to control monetary conditions.  Over the weekend Vice-Premier Li Keqiang, China’s new financial tsar, spoke about economic stability and financial management.  According to the South China Morning Post:

 

The central government has the confidence and ability to take effective austerity measures to avoid wild swings in economic development, Vice-Premier Li Keqiang said yesterday, in his first public speech in the new post. “Under the circumstances of a complex world economy, China's fast and stable economic development is particularly important," he said at a forum held in B over the weekend.

 

Mr Li, who is tipped to succeed Premier Wen Jiabao when he retires in 2013, said the government would keep macroeconomic controls at a reasonable level in accordance with “new situations and new problems”.

 

It seems to me that we are still in an area of policy complexity and even confusion.  The government wants to constrain overheating and inflation, and they are also hoping to maintain economic stability (i.e. stable employment growth), but it is not clear that these two policy goals are compatible.  The former needs more rapid currency appreciation and a sharp contraction in credit conditions, while the latter would be adversely affected by those policies.

 

I interpret “new situations and new problems” to mean that they will maintain “flexibility” in their fight against inflation, or to put it in a much less ambiguous way, unemployment trumps inflation as a problem.  I was not the only one to see the official comments that way.  According to the same article, “Ha Jiming, chief economist of China International Capital Corp, said the comments showed Beijing's determination to maintain economic stability.”

 

In the past several months, we heard a lot about tackling inflation, but now the top leaders are saying to find an appropriate balance between curbing inflation and economic development,” Mr Ha said.

 

An “appropriate balance” is a little hard to define, but the anecdotal evidence suggests to me that unemployment is the key factor.  But even if it weren’t, I see no evidence that they have the tools really to constrain monetary growth.  By the way Gene Ma of ISI-CEBM sent me a research report today that has some very interesting numbers.  I don’t want to suggest that the folks at ISI-CEBM are as pessimistic as I am about monetary policy, but according to them, the PBoC was able to mop up 77% of foreign currency inflows in 2006 by net new selling of sterilization bonds and hiking minimum reserve requirements. 

 

In 2007, although net reserve increases jumped from $247 billion to $463 billion, the total amount of net new sterilization bonds and minimum reserve hikes took out only 72% of foreign currency inflows.  I am not a big believer in the effectiveness of either measure in constraining underlying liquidity growth, but even if I were, it seems to me that in the face of much larger inflows they have become less, not more, effective.  The “un-mopped” portion of inflows was 2.3 times as high in 2007 as in 2006, which would be a bad thing even if like me you didn’t think the mopping up was very effective in the first place.

 

Meanwhile there is a new problem in the fight against inflation.  Last week I discussed reports of fuel shortages in China.  Here is what the South China Morning Post had to say today (“Beijing under pressure as fuel shortage spreads”):

 

Fuel shortages at petrol pumps have spread from southern China to key economic centres in eastern and western parts of the country, pushing Beijing into a quandary as it faces mounting pressure to raise retail petrol prices amid its biggest battle against inflation in a decade. The shortages came as state leaders including Premier Wen Jiabao reiterated that Beijing would not waver from its goal of wrestling down inflation, which surged to a 12-year high of 8.7 per cent last month, even as Mr Wen conceded that it would be hard to reach the 4.8 per cent target for this year.

 

In a report on Saturday, the Huaxia Times speculated that Beijing would raise state-stipulated retail fuel prices as soon as early next month, without citing a source, although some industry executives doubted it given the high level of inflation. In the past 21 months, Beijing has raised retail fuel prices once, on November 1, by 9 to 10 per cent.

 

As I understand it, domestic fuel prices need to be raised by about 25-30% for local refiners to break even.  According to the South China Morning Post article, Jiang Jiemin, CEO of PetroChina, China’s second largest refiner, “last week said its refining division could break even only at a crude oil price of about US$67 a barrel at prevailing domestic fuel prices.”  That is still well below the $100 or so price per barrel in international markets.

 

Because the authorities are so concerned about inflation, the decision to raise fuel prices is a difficult one.  This is because they worry that a fuel hike will, by causing a variety of prices to rise, feed into inflationary expectations and so help inflation to spread away from food and into other goods and services. 

 

But I don’t think this is what will happen.  If inflation is indeed a monetary problem, which I think it is in China, keeping fuel prices low will not help to combat inflation.  It will simply encourage the spread of inflation into other goods by transferring inflationary pressures away from fuel and into other goods. 

 

This is just the flip side of what has happened already – the recent food supply constraint caused by disease and bad weather, by forcing up food prices very quickly, has absorbed overall inflationary pressures and kept them from spreading into other goods and services as quickly as they might otherwise have done.  That is why non-food inflation has been low (and rising).

 

Too much money causes the average price level to rise.  When the prices of some goods rise very quickly because of specific supply constraints, as food did in China, the process actually puts downward pressure on prices for other goods and services since it causes consumers to divert spending from other goods and services into food.  However if prices of some goods like fuel are kept artificially low, rather than reduce inflation by lowering inflationary expectations, the policy simply transfers the inflationary pressure to other goods by diverting money spent away from fuel and to other goods and services. 

 

It all depends crucially, I guess, on whether Chinese inflation is a monetary problem or a one-off food problem – money or pork – and what the role of inflationary expectations is in the process.  This is a case where the wrong explanatory model can lead to very adverse consequences.

 

This has been a very long entry, but before closing I did want to add one last think.  Geoff Dyer has an interesting article in today’s Financial Times about a recent McKinsey Global Institute report, which I have not yet read, which predicts that within two decades 40% of urban dwellers in China will be migrants from rural areas.  Geoff summarizes like this:

 

On top of the existing 103m urban migrants, Chinese cities will face an influx of another 243m migrants by 2025, taking the urban population up to nearly 1 bn people.  In the medium and large cities, about half the population will be migrants, which is almost three times the current level.

 

These are extraordinary and very interesting numbers.  The challenges faced by Chinese cities in the next two decades are going to be huge.  One can almost predict that the success of China’s modernization will, to a large extent, depend on the success with which migrant workers are absorbed by Chinese cities.