China risks overcooking the economy
While China has been outspoken in expressing concern about the United States printing too much money, those worries might be better focused at home. No country beats China when it comes to effective monetary easing.
Beijing has scrapped lending quotas, adopted a loose monetary policy and kept interest rates at a four-year low to boost liquidity and promote growth. The policy has worked. China has lent out more money in the first four months of this year than the whole of 2008. Money growth in China is up more than 25 percent this year, versus about 10 percent in the United States. Click here for a related graph.
Beijing’s “monetary emissions” will have major consequences, and China might suffer from inflation before other countries in the world. The flood of liquidity that has been injected will almost certainly overwhelm the country’s seemingly indestructible overcapacity. History has shown that China can have inflation even during times of severe overcapacity, such as in 2008.
So far, China remains in a honeymoon period. Cheap money is sloshing about but thus far it has only generated asset price inflation — the sort of inflation that investors like. Meanwhile consumer prices are still falling — by 1.4 percent in June versus the same period last year. Factory gate prices were down 7.2 percent.
These price declines must be seen in context. They reflect a high base of comparison last year, showing China needs to worry more about inflation than deflation. Chinese policy makers might have misread the symptoms — the big drop in manufacturing activity late last year has been exaggerated by a sharp destocking process, which means end demand did not fall as much as the authorities thought.
Beijing has prescribed a strong remedy in flooding the market with liquidity. And businesses, banks and local governments are only too happy to swallow it, for commercial as well as political reasons. Banks make money when they lend, businesses like cheap money, and local government officials get promoted when local economies perform well.
As one might imagine, equity prices have been the first to respond to this liquidity injection. Chinese stocks have been a top performer this year, up some 63 percent, while the Dow is down 3 percent over the same period.
Next in line is the property market. House prices in America are still falling, but in Chinese cities such as Shenzhen and Shanghai, they have risen by up 20 percent since April. Long queues increasingly form when new apartments go on sale, and the government is talking about increasing the supply to help cool the market.
BLAME THE PIG
It will not be long before asset price inflation starts to infect the real economy. People buy televisions and refrigerators to go with their new apartments and a buoyant stock market prompts investors to order shark fins and hairy crabs for lunch.
In China, the first signs of real economy inflation will almost certainly be seen in pork prices. Over the past decade, pork prices have acted like a coal mine canary in predicting inflation. In 2004 and 2007, inflationary bursts were preceded by spikes in pork prices.
A jump in pork prices in 2007 and 2008 prompted the authorities to introduce new incentives to promote pig farming, which increased supply. As a result, pork prices have dropped by 39 percent from the high seen in early 2008. Pig farming has become unprofitable and farmers have cut hog numbers as a result. This simply paves the way for another round of pork price increases. Click here for a related graph.
It will only be a matter of time before inflation is transmitted to the country’s factories. After sharp de-stocking during the last quarter of 2008, Chinese companies have started restocking in anticipation of higher commodity prices later this year, which in turn has helped drive global commodities higher.
The price of some manufactured goods such as clothing and toys has already risen as the export slump forced thousands of factories to close, causing supply to drop more than demand.
When inflation reaches consumers and factories, policy makers will start to raise interest rates again. Asset prices might then experience a last round of euphoria as a wider spread between domestic and international interest rates attracts foreign inflows. But higher interest rates will reduce corporate earnings and home buyers’ spending power, and asset prices might start to fall.
Inflation is always and everywhere a monetary phenomenon, as monetarists like to say. China is on a money-go-round ride that can only end with higher prices. Watch out for the next export from China — inflation.
— At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund —