Hard landing possible as Chinese inflation spirals ‘out of control’

On Saturday I wrote about the Scylla and Charybdis of anchoring inflation expectations, geared toward developed economies in North America and Europe. You tighten too aggressively and you get unwanted disinflation or deflation. You remain too loose and inflation rises. Inflation expectations are rising but they are still anchored in large part due to labour market slack. China faces a completely different macro environment. The PBoC is well behind the curve and may have to become very aggressive in tightening and revalue their currency. That risks a hard landing.

Here’s George Soros on the situation.

China’s decision to keep its currency weak has caused the government to lose control of inflation and risks fuelling wage-price gains, billionaire investor George Soros said.

While the policy helped insulate China from the financial crisis in 2008, the world’s second-biggest economy has missed its chance to allow the yuan to appreciate to tame inflation, Soros, chairman of Soros Fund Management LLC, said yesterday at a conference in Bretton Woods, New Hampshire.

“It would be very advantageous to allow the currency to appreciate as a way of controlling inflation,” Soros said. “The authorities missed that opportunity. You now have inflation somewhat out of control, and causing some serious danger of wage-price inflation.”

At this time last year, it was already clear that the Chinese economy could overheat. The fact that labour is now in shorter supply there is significant because it is through the wage-price channel that inflation expectations can become unanchored quickly.

From a Chinese domestic perspective, the Lewis Turning Point will crater productivity levels as wage rates rise. The corollaries of this increase in wages and lower productivity are slower GDP growth, higher consumption, lower savings and a deteriorating external balance of payments aka current account deficits.

Labour shortage could spell inflation and trade deficits for China, April 2010

All indications are that this is now happening. The official measure of inflation is at 4.9% and rising. Unofficial estimates are much higher. And this past quarter, China threw in its first quarterly trade deficit since 2004. Chinese policy makers are clearly worried. There have been mammoth shifts in Chinese economic policy. They have raised rates four times, increased bank reserve requirements to a record level and started regulating loan growth in the banking system. I don’t think this will be enough unless commodity prices start to fall. In December, when discussing China on Business News Network with Howard Green, I said we will see a lot more tightening.

The Chinese economy, like the two other big EM economies in Brazil and India, is growing very quickly. This has been a boon for global growth and has caused capital to move to emerging markets. However, these economies are growing at rapid rates that are stoking inflation. China’s inflation rate is running at the fastest in two years. To date, the Chinese have focused on tightening reserve requirements as the principal way to bring their property bubble under control and to prevent inflation. Reserve requirements have been raised for three times in three weeks to 18.5%, a record high for most of the country’s banks. Price controls have also been introduced. This will almost certainly not be enough. The price controls, in particular, are more likely to spawn shortages than contain inflation. At the weekend, the Chinese failed to raise interest rates and this has caused markets to race higher and commodity prices like copper to hit new multi-year highs. In the video linked below, I say that the Chinese certainly will move to revaluation and interest rate hikes in the new year.

Here’s the problem: the accumulation of US dollar reserves.

The U.S. is engaged in quantitative easing while the Chinese have pegged their currency to the USD at an undervalued rate. The US dollar is falling and the Yuan along with it and commodity prices are rising. The Chinese are then forced to buy up U.S. dollars, importing inflation into their domestic economy, a problem that can only be solved by more aggressive tightened coupled with currency revaluation. One year ago, before this problem had become acute, it was already clear what needed to be done. I wrote in March:

How do we get them to stop accumulating reserves? One way is to revalue their currency. But for fear of the repercussions in the domestic export economy, this is likely to happen slowly. Another way, would be to decrease stimulus, putting the government into a surplus position. In China’s case, this is promising. Signs of overheating are everywhere. The Chinese needs to reduce excess fixed capital investment.

This is the problem with China’s currency peg

Clearly, there is significant malinvestment in the Chinese economy. Dealing with it will be difficult. The first problem is that the Chinese refuse to let their currency appreciate more quickly, relying on monetary policy to slow fixed capital investment. I don’t think that will be enough. Second, believers in the Chinese growth miracle are many. GMO’s Edward Chancellor, author of the famous book on financial manias ‘Devil Take The Hindmost‘, wrote an insightful commentary last year outlining ten ways to spot a bubble. And China definitely has most of those hallmarks. Yet, you still get excuses based on three justifications: China has low debt, China has lots of foreign currency reserves, and Chinese policy makers are better than ours. I wrote a post outlining the flaws in these three justifications for having rose coloured glasses on the malinvestment problem.

Most importantly, however, if the Chinese did reduce excess fixed capital investment, the non-performing loan problem would rear its head.

Property bubbles are inherently related to land prices since the cost of building materials do not rise as quickly as property prices in a bubble. Municipalities know this and have been speculating in land purchases…

When this bubble pops, there will be lots of non-performing loans accruing in the financial sector. And unless the Chinese loosen liquidity again, as they did in late 2008, non-performing loans will be a big problem.

Patrick Chovanec thinks that Chinese bank profits are illusory. Would the Chinese be able to socialise these non-performing loan losses without a serious slowdown, a hard landing? I say no. China bank regulators have warned of property bubble risks. But, once bubble psychology takes over, it is difficult to dislodge it. Look at the hoarders of commodities and the games people are playing with commodity as collateral for loans. To stop inflation from creating civil unrest, that means more revaluation and much more aggressive tightening will be necessary. Let’s hope that commodity prices come to heel.


Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.

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