Inflation in China?

michael pettis

It’s always a pleasure to be asked to guest-blog for such a much-admired and widely-read blog.  In about an hour I will be meeting up with Brad here in lovely smog-free Beijing (sick joke).  As usual I have to warn Brad’s regular readers that I am so enthralled by China that sometimes it is hard for me to notice what is going on in the rest of the world unless there is some China angle (although it is getting harder and harder to discuss anything nowadays without there being a China angle), and so my posts are likely to be highly China-centric.                                           

Apologies in advance to those of you who like to read more about the rest of the world.  Regular readers of my own blog know that in the past few months concerns about inflation have taken center stage in China.  I thought for my first entry I would summarize a little what we know and what we think we know about inflation.  In another week or so we are going to get the October CPI numbers for China and that will allow us to calculate inflation for the most recent month.  After three months of inflation numbers (6% on average) that significantly exceed the PBoC’s comfort level, everyone is going to be looking very closely to see what the new number may imply about the various issues bedeviling China. 

To summarize CPI inflation behavior over the recent past, China’s CPI prices have been fairly stable until recently, rising by 2.8% in 2006.  Prices started to trend up in 2007, but not enough to create any alarm.  During the first five months of 2007 CPI inflation year-on-year (which tends to smooth out changes) hovered around the PBoC target of 3%, remaining on average under 3%.  In June, the year-on-year increase in CPI prices jumped to 4.4%, and then accelerated to 5.6% in July and 6.5% in August, before “moderating” to 6.2% in September.  For the first nine months of the year average CPI inflation has been 4.1%, well above the PBoC’s 3% target.                                                                                                      

Much of the recent inflation has been blamed on the sharp increase in the price of food, which comprises about one-third of the total CPI basket, especially of pork, of which China is easily the world’s largest consumer.  Excluding cyclical components of the basket, price increases have stayed around 2% or less.  According to the authorities, food prices rose largely because of certain one-time events that created significant shortages – primarily flooding in the south and blue-ear disease among pigs.  They insist that these food price increases will reverse themselves over the next few months.  In that case what looks like inflation is really a one-off price shock that will soon work its way thought the economy unless it ignites inflationary expectations.                                                                                        

I am not sure I agree with this explanation.  My understanding of price increases caused by one-off supply shocks is that the increase in the price of a particular product is not inflationary.  As consumers are forced to spend more on that particular good, they divert spending from other goods and so exert downward pressure on the price of those other goods.  In a frictionless world, a price increase caused by a sudden or unexpected supply constraint should have zero net impact on inflation because it would be perfectly matched by deflation in other goods.  This seems to be what happened in Hong Kong.  The big rise in food prices in Hong Kong over the past few months was met by a drop in the price of most other goods, so that overall inflation has been very low (well under 2%).  Hong Kong may not be a great comparison because food comprises a much smaller share of the CPI basket, but the point is that one-off supply shocks are not automatically inflationary.            

Of course we do not live in a frictionless world, and so it may be possible for a significant price rise in an important good to cause a temporary net increase in average prices, but I would imagine that the main source of friction might be downward price-stickiness cause by some kind of money illusion.  If that is the case, we might not expect a big rise in Chinese food prices to cause a sufficient decline in non-food prices to counterbalance it, but at the very least if the prices of non-food items were anyway rising too, the rate of increase would decline.                                                              

That has not happened – structural inflation in China is positive and has actually inched upwards in the past few months.  PPI inflation has also risen recently, from 2.6% in August to 4.0% in September, and this has been caused almost exclusively by non-food items – steel and cement being the main culprits.  None of this is consistent, in my opinion, with the argument that inflation is a temporary problem caused by a series of one-off supply constraints.  At any rate price shocks are spreading – the government recently increased gasoline and diesel prices (which are subsidized) by 8-10% and there are rumors that more subsidized prices are going to be relaxed.                                                                                       

It is probably no surprise to people who know me to hear that my argument is that the problem is the currency regime which has locked China into an overly expansive monetary policy.  At first monetary expansion tended to be deflationary because in China it led to overinvestment, not excess consumption (the banking system channels monetary growth primarily into loans to the industrial sector).  At some point, though, all this money growth runs the risk of creating not just asset inflation (which we clearly already have) but also CPI inflation, and maybe this is what is beginning to happen.                                                      

Whether or not inflation is rising is never a purely academic debate but in China it has a particular urgency for at least two reasons.  First, previous periods of inflation – which usually begin with food price inflation – have led to bank withdrawals and the threat of social instability.  With one-year deposits at 3.8%, it will be increasingly difficult to convince depositors to leave their money in the bank if inflation stays at 6% or more, and deposit withdrawals are likely to end up in even more stock and real estate speculation.     

Second, there are a number of constraints on the ability of the PBoC to raise interest rates sharply, and with nominal rates quite low, real rates in the official banking system in China may be very low or even negative (I specify the “official” banking system because there is strong evidence of a large and active “informal” banking sector paying much higher rates – my friend Dan Rosen has told me that he has even seen these rates quoted in some local newspapers).  If inflation rises too quickly and if the ability of the PBoC to raise lending rates is constrained by fears of accelerating NPLs, declining real rates caused by inflation may increase overinvestment and capital misallocation.                                                           

By the way I have heard people argue that one good thing about rising inflation is that at least it helps to solve the currency undervaluation problem – if China’s inflation is higher than that of its trading partners, the net result is the equivalent of a further appreciation of the RMB.  Besides the fact that this would be too slow a way to adjust the currency, it is not necessarily true – the one is only like the other if real interest rates are allowed to adjust automatically, and of course they are not.  Also it should be remembered that even if real rates are constant, rising nominal rates have the effect of accelerating principle payments, and so inflation can place cash-flow pressures on borrowers if interest rates fully or partially adjust.  All of this can hurt an already weak banking sector, and I am definitely not one of those who believe that the banking sector is finally in good shape.                         

There is really nothing good about rising inflation in China, although perhaps China, which has acted like a hyper-charged proxy for the rest of the world, is simply experiencing an exaggerated version of the inflation that seems to be emerging in the rest of the world too.  Most of my conversations here suggest that at least some people in the PBoC are extremely worried.