The headline risk here, folks, is that if you wait for your central banker to give you insight into ...
China Creeps Toward a Crisis
04/26/2011 9:00 am EST
By taking a weak stance on inflation, China is inviting political unrest. That sets it on a dangerous course toward greater political repression and even less action on inflation.
China's leaders have turned an economic problem—rising inflation that is projected to go from 5.4% in March to 6% in April—into a political problem. They now face increasing protests over higher prices for everything from cooking oil to diesel fuel.
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 Beijing has shown no signs of wavering in its willingness to apply that force.
But I do see an increasing likelihood that China's efforts to defuse its political problems before they flare into 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 drive the country, finally, to impose drastic measures to get inflation under control.
Here's how I see the interplay between the economic and the political working out.
Economic data released on April 15 showed that China's economy isn't slowing significantly. GDP grew by 9.7% in the first quarter, which 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.)
Nor do underlying trends suggest that China's growth rate is about to drop. For example, new bank lending increased by 16.6% in March from the same month in 2010, indicating that the money flows driving China's growth 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 cuts most heavily into the buying power of the part of the population with the least money.
A good example: As gasoline approaches $4 a gallon in the United States, it takes a bigger and bigger bite out of the income of employees who have no choice but to drive long distances to work.
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, you may be shopping carefully and clipping coupons to find the cheapest milk, but you have to buy it no matter how high the price increases.
NEXT: 3 Problems for China|pagebreak|
3 Problems for China
Inflation is an especially big political problem in China for three reasons.
- China is still a poorer country than, say, the United States, so families spend more of their income on basics such as food.
Food consumes 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 6.5% rate of the United States' in 2011. But to the average Chinese family, it feels much, much worse than that.
- Although China is on average much wealthier than it was a decade ago, some Chinese are much, much wealthier—and that has led to a rise in social tensions, which high inflation exacerbates.
According to a recent study by US consulting firm Bain, 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.
On the other hand, the average employment income in China—even adjusted upward to take into account the higher purchasing power of the yuan in China—is just $4,325.
And 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 slightly larger in 2010 than it was in 2008.
I think you can understand why inflation might increase social tensions and resentment on the part of those who don't belong to the lucky 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.
- Inflation is a big political problem in China, because history, as read by the Communist Party, says it is.
Unrest caused by higher prices was a key component leading up to the Tiananmen Square protests of 1989, the official explanation goes. The army eventually put down that demonstration by firing on unarmed protesters. Hundreds, perhaps thousands, were killed.
China's official history also says that the inability of the Nationalist government to control inflation undermined popular support for that government, during its war with the Communist Party for control of China after World War II. This contributed to the Communist victory.
As you might expect, given that background, China's leaders have been working hard to control inflation.
For example, effective April 21, the People's Bank of China raised bank reserve requirements by an additional 0.5 percentage points to 20.5%. That's the fourth increase in reserve requirements this year and the 10th since the end of the global financial crisis.
On April 5, China's central bank also raised its benchmark interest rate to 6.31%—its fourth increase in five months.
But China's economy hasn't responded by slowing down, nor has inflation.
NEXT: Why China's Inflation-Fighting Measures Aren't Working|pagebreak|
Why China's Inflation-Fighting Measures Aren't Working
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 bank system's lending capacity.
That seems like a lot—until you weigh it against the potentially inflationary $197 billion China added to its foreign-exchange reserves in the first quarter of 2011.
Or look at China's interest-rate increases—officials still haven't raised rates to the average 6.49% for the period from 1996 through 2010. The rate top of 10.98% came in June 1996.
I'm not saying China has to get back to those kinds of punishing interest rates, 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 another thing 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 an annual loss of more than 2%. 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 US dollar guarantees that the country will remain wedded to its export growth model. Chinese products will remain artificially cheap on world markets, regardless of 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 would be if the renminbi bought more in everything from oil, to Coach (COH) handbags, to US chickens.
Since every currency trader in the world is convinced that the renminbi is headed upward against the dollar, the artificially cheap currency guarantees big flows of overseas cash into China. That, of course, makes inflation tougher to tackle.
Why Isn't China Doing More?
China could really ramp up interest-rate increases, increase the rate of appreciation in the renminbi, and pay bank depositors a positive rate of interest. But so far it hasn't.
A combination of fear and politics stands in the way. Ramping up interest rates, 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 big sources of income and wealth for current and retired members of the People's Liberation Army and the Communist Party—and their children and grandchildren.
I'm sure those interests are only too ready to make the argument that any change would force such companies to lay off tens of thousands of workers.
NEXT: A New Round of Political Repression|pagebreak|
A New Round of Political Repression
What China's leaders have instead adopted is a pattern of incremental economic change and political repression, balanced with concessions.
The truck drivers' strike last week in Shanghai is a good example of the latter.
- The protests began April 20, when about 2,000 drivers protesting rising fuel prices and increased port-loading fees 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 patrol car.
- On April 21, 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 the previous day's violence.
- On April 22, city and port authorities said they would rescind a fuel surcharge that had been imposed on the drivers and reduce the 50-yuan increase in loading fees to 20 yuan. 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 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 its 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 Beijing's political response to inflation.
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, Chinese news Web site Caixin.com has calculated.
For a plan that has been billed by government leaders as a major attack on China's growing economic inequality, the move is so disappointing that it has been blocked by officials who want to raise the no-tax threshold to 5,000 yuan a month.
Second, the political response actually works against a solution to the inflation problem. Economic history argues pretty convincingly that if you embed expectations for rising incomes (through an increase in the minimum wage or through somewhat lower taxes), 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. And those expectations of future inflation create expectations for future pay increases. Countries that have tried fighting inflation by indexing wages to inflation have had to abandon the policy when they discovered that 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 driving up interest rates.
We need to see something significantly above the average of the last ten years. This delay, and the expectations about inflation that such a policy of political incrementalism engenders, will ultimately increase China's difficulties in getting inflation under control.
A Hard Landing Could Be Coming
Does all of 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 even a bout of 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? That 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 the US 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 this year, or instead 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 column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. The fund did own shares of Home Inns and Hotels Management and Mindray as of the end of March. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.
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