There is still some upside left in the XLF as we head into 2018, yet I think there is greater risk i...
Playing politics with inflation pushes China toward a true inflation crisis
04/26/2011 8:30 am EST
I think it’s still unlikely that China’s political problem will turn into a political crisis—China’s internal security forces have met even the smallest demonstration with massive force and show no signs of wavering in their willingness to apply that force.
But I do see an increasing likelihood that the China’s effort to defuse the political problem short of violence will push the country into an economic crisis. The political solutions proposed and implemented so far seem certain to make China’s inflation worse and to push the country, finally, into what are drastic measures to get inflation under control.
Here’s how I see this interplay between the economic and the political working out.
Economic data released on April 15 showed that the Chinese economy is showing no signs of any significant slowing: GDP grew at a 9.7% in the first quarter. That was barely below the 9.8% growth in the fourth quarter of 2010. (For all of 2010 China’s economy grew at a 10.3% rate.) Underlying trends didn’t suggest that China’s growth rate is about to drop. For example, new bank lending increased by 16.6% in March from March 2010, indicating that the money flows driving China’s growth rate aren’t abating.
Why does China want to slow its economic growth rate? Because inflation has climbed to levels well over the government’s 4% target for 2011 and threatens to roar out of control. Consumer price inflation hit 5.4% in March. That passed the 5.2% rate in November, which had been the fastest rate of inflation in 28 months. March’s 5.4% is now the fastest rate in 32 months.
A high rate of inflation—especially if it threatens to climb even higher in the future—is a political problem in any country. It cruelly cuts most heavily into the buying power of the part of the population with the least money. In the United States, for example, as gasoline approaches $4 a gallon, it takes a big bite out of the income of workers who have no choice but to drive long distances to get their jobs. Higher food prices—and food prices are up about 6.5% so far in 2011—have the same effect. If you have to buy milk—and you’re already shopping carefully and clipping coupons to find the cheapest milk—you have to buy milk no matter the price increase.
But inflation is an especially big political problem in China for three reasons.
First, because China is still a poorer country than, say, the United States, families spend more of their income on basics such as food. Food consumes about 30% to 40% of the median family budget in China versus about 12% in the United States. Food price inflation of almost 12% in China (the annual rate in March) is about twice the rate in the United States of 6.5% in 2011, but it feels much, much worse to the average Chinese family.
Second, although China is on average much wealthier than a decade ago, some Chinese are much, much wealthier—and that has led to a rise in social tensions that high inflation exacerbates. According to a recent study by U.S. consulting firm Bain & Co., 585,000 Chinese have more than 10 million yuan, about $1.5 million, in investible assets. That’s twice the number it was in 2008. The fastest growth, Bain notes, is among those worth more than $15 million. The average employment income in China, on the other hand, (even adjusted upwards to take account of the higher purchasing power of the yuan in China) is just $4,325. (That average of urban and rural wages hides the huge difference between urban and rural incomes. Urban incomes were about 3.33 times higher than rural incomes in 2010. And that gap was actually slightly larger in 2010 than it was in 2008.) I think you can understand why inflation might increase the social tensions and resentment on the part of those that don’t belong to that upper 585,000. If you’re scrambling to find cheaper bok choy as food prices soar, you might find yourself thinking about throwing a rock at the next BMW you see on the streets.
Third, inflation is a big political problem in China because history as read by the Communist Party says it is. Unrest caused by higher prices, the official explanation goes, was a key component leading up to the Tiananmen Square protests of 1989. The army eventually put down that demonstration by firing on unarmed protestors. Hundreds or perhaps thousands were killed. And, official history also says, the inability of the Nationalist government to control inflation undermined popular support for that government in its war with the Communist Party for control of China after World War II and contributed to the Communist victory in that war.
As you might expect from that background, China’s leaders have been working hard on inflation. For example, effective April 21 the People’s Bank of China raised bank reserve requirements by another 0.5 percentage points to 20.5%. That’s the fourth increase in reserve requirements this year and the tenth since the end of the global financial crisis. On April 5 China’s central bank raised its benchmark interest rate to 6.31%. That was the fourth increase in five months.
China’s economy hasn’t responded, however, and consequently neither has inflation.
I think that’s because, if you look at what China has done in the context of what it hasn’t done, the country’s inflation measures have been smaller, far more incremental, and much more predictable than the job requires.
Take a look at the increase in reserve requirements, for example. Barclays Capital calculates that the most recent move took $56 billion out of the banking systems lending capacity. Seems like a lot—except that China added $197 billion potentially inflationary dollars to its foreign exchange reserves in the first quarter of 2011.
Or look at those interest rate increases—they still haven’t raised rates to the average 6.49% for the period from 1996 through 2010. The high in rates came at 10.98% in June 1996. I’m not saying China has to get back to that kind of punishing interest rate but I think you can make the argument that in historical terms China’s interest rates are still too low and too expansionary.
And look at what China’s leaders haven’t done. They haven’t raised deposit interest rates to the point where it pays to keep money in the bank. In the last interest rate increase the People’s Bank raised the deposit rate to 3.25%. With inflation at 5.4%, putting your money in the bank right now guarantees a 2% annual loss. If a government is trying to slow down the economy and the speed of money, this isn’t the way to do it.
Finally, of course, there’s the exchange rate. Keeping the renminbi limited to 2% or so of annual appreciation versus the U.S. dollar guarantees that the country will remain wedded to its export model of growth—Chinese products are artificially cheap on world markets—no matter how many speeches the country’s leaders deliver about the need to rebalance the Chinese economy. (The renminbi is up only 4% against the dollar since the beginning of 2010.) In addition it makes Chinese consumers less well off than they could be if the renminbi bought more in everything from oil to Coach bags to U.S. chickens. Since every currency trader in the world is convinced that the renminbi is headed upwards against the dollar, the artificially cheap currency guarantees big flows of overseas cash into China. That, of course, makes inflation tougher to tackle.
Why not really ramp up interest rate increases, increase the rate of appreciation in the renminbi, and pay bank depositors a positive rate of interest?
A combination of fear and politics stands in the way. Ramping up interest rate increases, for example, might produce a real slowdown in growth of exactly the sort that’s probably needed to stop the growth of inflation. But that kind of real slowdown strikes many of China’s leaders as too risky. It could, they worry, endanger the legitimacy of Communist Party rule in China, which rests on the ability of the party to deliver the growth bacon.
Some of these changes, especially if carried out at the level necessary for them to be effective, also run smack into the self-interest of powerful economic groups in China. Significantly increasing the speed of appreciation of the renminbi would drive many of China’s least efficient exporters into the red. These companies, which are officially profitable at the moment, are a big source of income and wealth for current or retired members of the People’s Revolutionary Army or the Communist Party--or their children. And I’m sure these interests are only too ready to make the argument that any change would force these companies to lay off tens of thousands of workers.
What China’s leaders have instead adopted is pattern of economic incremental change and political repression balanced with concessions.
Last week’s truck drivers’ strike in Shanghai is a good example of the latter. The protests began last Wednesday, April 20, when about 2,000 drivers protesting rising fuel prices and increased loading fees at the port smashed the windows of trucks belonging to drivers who wouldn’t join the protest. Police are reported to have arrested eight or nine drivers who tried to overturn a traffic patrol car. On Thursday a second day of protests brought hundreds of truck drivers and hundreds of police to a testy face off in Shanghai. The huge police presence prevented a replay of Wednesday’s violence. On Friday city and port authorities said they would rescind a fuel surcharge that had been imposed on the drives and reduce the 50-renminbi increase in loading fees to 20 renminbi. The drivers have continued to press for an end to the entire loading-fee increase but the concessions seem to have defused the protests.
I’d characterize the policy on exhibit here as one that addresses the unrest created by inflation rather than addressing inflation itself. It’s the same policy that has led local governments, with Beijing’s encouragement, to start low-priced food stores that use the bulk-buying power and negotiating leverage of the local government to secure lower prices for Chinese consumers. It’s the same policy that has led the government to slap on price controls on 17 industries—and counting. It’s the same policy that’s led Beijing to promise an annual 15% increase in the minimum wage over the life of the new five-year economic plan. And it’s the same policy that has produced a proposal to lower taxes for the poorest Chinese. Under the proposal Chinese who make less than 3,000 yuan a month would pay no income tax. Currently, the threshold is set at 2,000 yuan.
Two things strike me about the political response to inflation by Beijing.
First, like the economic response, the changes are incremental—and probably therefore insufficient to get ahead of the political problem. For example, a taxpayer making 21,500 yuan a month would see a tax reduction of $10 to $50 a month, Caixin.com has calculated. That’s so disappointing, in fact, for a plan that has been billed by government leaders as a major attack on China’s growing economic inequality that the tax reduction plan has been blocked by officials who want to raise the no-tax-threshold to 5,000 yuan a month.
Second, this political response actually works against a solution to the inflation problem. Economic history argues pretty convincingly that if you imbed expectations for rising incomes linked to inflation (through a guaranteed increase in the minimum wage, for example), you also embed expectations for future inflation. Producers of goods see a promise of a higher minimum wage as a promise that they’ll be able to raise prices in the future. Expectations for future inflation create expectations for future pay increases. Countries that have tried fighting inflation by indexing wages to inflation have had to abandon that policy when it only embedded inflation in the economy.
The danger in China now is that the government will increasingly rely on political incrementalism—rescinding a fuel tax surcharge or raising the minimum wage to battle the effect of inflation--while resisting the big steps such as speeding up the appreciation of the renminbi or really cracking on the interest rate increases to something significantly above the average of the last ten years. And that this delay and the expectations about inflation that this policy of political incrementalism engenders will increase the ultimate difficulty of getting inflation under control in China.
Does this lead to a political crisis in China? I don’t think so. The government has done too good a job of delivering economic growth and rising incomes for a bout of even serious inflation to undermine the current system. Especially when that system operates one of the world’s most effective security forces. (I would expect to see a continued increase in Chinese spending on internal security, however.)
An economic crisis? Depends on what you mean by crisis. I can certainly see an increasing chance that inflation will get so out of control that China will have to go through its own version of the Paul Volcker years that the U.S. needed to crush inflation in the 1980s.
If that’s your definition of an economic crisis, then, yes, one is certainly possible in China.
Look to see if Beijing discovers the courage to take stronger, indeed shocking, action against inflation during 2011 or creates the need for a true hard landing in 2012.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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