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Do not worry about inflation in China for now, worry about asset prices and quality

Louis Kuijs's picture

As China’s economy seems to be recovering, many people here have expressed concerns about inflation. I was able to air my views on the subject in an Op-Ed in China’s main English language newspaper, the China Daily, together with two other experts.

In motivating their concerns on inflation, people cite the unprecedented fiscal and monetary stimulus in many countries to combat the global economic crisis, China’s own large-scale stimulus measures, or recent increases in prices of several food items as possible reasons. In my view we do not have to worry about inflation for now. There is simply too much spare capacity across the world. However, the very loose monetary conditions in China can cause other damage if left unchecked for too long. It makes sense to try to avoid future asset price bubbles and problems for banks’ balance sheets.

Ample spare capacity globally makes inflation unlikely any time soon. According to Milton Friedman, “inflation is always and everywhere a monetary phenomenon.” However, in reality the link between money and inflation is very complex and not so obvious. That is why central banks in most high-income countries now base their monetary policy decisions largely on the balance between demand and supply in the markets for goods and services instead of monetary aggregates. At the moment, spare capacity is high in many parts of the global economy.  The OECD estimates that in the high-income countries the economy wide “output gap” will average 5 percent this year, and in China it is also sizeable. This is why international prices of manufactured goods are expected to fall 5 percent (yoy) in US dollar terms this year. Given the subdued global growth prospects, it will take quite a while to remove the slack.

Moreover, the monetary expansions in the US and other high-income countries are at the moment much smaller than many people think. Banks there have used the liquidity injections to restore their reserves, and the unprecedented measures are taken to avoid a credit crunch. It is once economic growth and bank lending comes on stream again that banks could lend out multiples of the hoarded reserves if central banks do not tighten. Thus, the risk of future inflation depends on central banks’ ability to reverse the liquidity injections and monetary policy loosening at the right time. Financial markets are not expecting such future inflation. But we cannot rule out that central banks err on the side of supporting a recovery at the risk of higher inflation. If China’s policymakers are concerned about this, currency appreciation could shield China from imported inflation.

Many in China are also concerned that US inflation will drive down the US dollar and thus the RMB value of China’s US dollar assets. It will be difficult to insure the existing stock of US dollar assets against such risks. Looking ahead, this risk may be an additional motivation to change the pattern of growth, to reduce foreign reserve accumulation. China can also reduce risks by buying the inflation-adjusted bonds issued in the US and Europe.

Raw commodity price increases could lead to high CPI inflation. However, raw commodity prices typically only soar when global growth and growth prospects are strong. Indeed, as global growth prospects came down sharply last year, primary commodity prices fell strongly, although they picked up again recently as growth prospects brightened somewhat. Moreover, the transmission into CPI inflation has to go via higher prices of manufactured goods.

In China itself, inflation is not a big concern either for now, given the ample spare capacity. Supply shocks or government policy can raise certain prices temporarily, as is happening now with eggs, grain and pork and may happen if the government raises some administered prices. However, given the subdued overall economic conditions, with spare capacity and many people looking for jobs, such developments are highly unlikely to cause sustained, general inflation.

However, unlike in most other countries, in China the monetary expansion is large, and it can have damaging consequences if left unchecked. Abundant liquidity in the banking system can lead to asset price bubbles and increase the risk of misallocation of credit, and thus of resources, as well as of bank loans going bad. The recent global financial crisis has shown the dangers of neglecting asset price increases in monetary and financial policy making. With monetary policy in key high-income countries geared only towards inflation, monetary policy remained loose for too long, even as asset prices rose to levels deemed worrisome by many.

Thus, China’s policymakers are rightly paying attention to the risks of the current policy stance. China’s government has decided that, since there are still downward risks to economic growth and inflation risk is low, the overall macro stance—determined by fiscal and monetary policy—should remain accommodative. But, they are looking for ways to mitigate the risks of asset price bubbles and NPLs, using prudential regulation and other largely administrative measures. As global and domestic growth prospects improve, the overall macro policy stance will have to be tightened as well, particularly monetary policy.


Submitted by kashif on
Looking at the scenario since the past six months, it seems inevitable for china to acheive sustainable economic growth in the near future. Given the increased emphaseis on internal demand and wise monetary policy china is most probably going to pull itselfout of the the current global economic situation.

Kashif, I agree that China's economic performance is respectable this year even though the world economy excluding China will shrink, and China is likely to continue to grow respectably next year. Indeed, if China is able to make good progress with rebalancing the economy, the prospects for sustainable economic growth are good.

Submitted by Hao on
Louis, you are right that we now have ample spare capacity in China. To make things worse, with the soaring bank lending and fiscal stimulus, we are creating more overcapacity and unproductive investment. No doubt, as you said, that will result in NPL problems. But the more important thing, sure this isn't your topic here, is China's growth is even more unbalanced. This crisis should have been a good chance for China to rebalance the economy, but we just missed the opportunity. Just take a look at the yuan's trade weighted value in the past year -- that was not the right attitude for balancing the economy. I don't think the government-engineered recovery will be self-sustaining.

Hao and Danny, Your comments with regard to the impact of the global crisis on China and resulting policy stimulus are well taken. Hao, you say that the (infrastructure-oriented) policy stimulus by itself it does not really lead to sustained rebalancing—away from investment and industry, towards consumption and services—but that it [would have been] a good opportunity to rebalance. You also say that the government engineered recovery is probably not self-sustaining. I much agree. Actually, China’s senior leaders, including prime minister Wen Jiabao have actually said very similar things. I think that the large policy stimulus was the right kind of response to a large shock hitting the real economy. It has helped create activity and shore up confidence in China and other parts of the world. It is like a kick-start. But we cannot expect that market-based activity will automatically surge in response to it, regardless of the global economic conditions. The good thing is that global economic conditions have at least stabilized. For China, this means that in 2010 net exports will not be as much of a drag on growth next year as it was this year. This, combined with likely better real estate activity, is set to do a lot in keeping growth at a respectable rate, even with a much smaller contribution of government stimulus and somewhat subdued market based investment. Here I think it would be good for China's policymakers to have realistic or modest ambitions with regard to short term growth. The kind of growth that we are seeing in China at the moment is really very good, relative to that in other countries. If growth of around 7-8 percent is accepted as good enough, there is no need for additional short term stimulus on current projections. That would allow policy making to focus on rebalancing and structural reforms. Danny, you say that it is difficult for China to sustain a prolonged contraction in export demand. I agree that that will be hard. It would lead to substantial closure of companies and lay offs in the export sector—much more even that what we have seen so far. Now, this is off course true for countries around the world. If there is no recovery in world demand that is going to be very tough for many countries. You also say that China is “buying time” until external demand recovers. I somewhat agree. In a way this is happening across the world at the moment, with government’s having stepped in to dampen the impact on the real economy of a major financial crisis. However, China’s government has actually been quite explicit in saying that the gobal crisis—and the sharp decline in demand for China’s exports—means there is more urgency to the project of rebalancing and getting more growth out of the domestic economy. Is rebalancing happening? In my mind it is impossible to deny that there has been a large number of policy initiatives rolled out in the last 2 years in the direction of rebalancing and that this is starting to show it impact. There is more to China’s domestic demand growth than infrastructure investment. Our upcoming China Quarterly Update—to be released October 29—will try to spell out and support this argument. Has China done enough rebalancing? No, not yet. I think the array of policies implemented so far is not yet enough to rebalance. The traditional pattern of growth has a strong momentum, meaning that rather forceful policy changes are necessary to change course. I am personally particularly encouraged by the policy action in the areas of health, education, social security and policies toward the rural sector. But there is indeed need for more policy reforms towards rebalancing.

Submitted by Danny on
It seems doubtful to me that an export oriented economy the size of China can sustain a prolonged contraction in export demand(20-25%). I believe the Chinese are buying themselves time with expanded lending and stimulus spending hoping for export demand to recover to pre crisis levels within a relative short period of time, maybe mid 2010. In the meantime they are stockpiling alot of what they produce hoping to be able to unwind their inventories at a later date. It must be very dificult for China in my opinion to target their loose lending and stimulus packages efficiently considering the rapid decline in global trade.

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