From Lombard Street Research:
China’s ballooning current account surplus has fuelled domestic overheating. Beijing identified battling inflation as their top priority. Further tightening should include yuan appreciation. China is exporting inflation, tying the Fed’s hands in the ongoing credit crunch. The savings glut is increasing, but the desire to borrow has been hampered by heightened uncertainty in financial markets.
Monday’s Chinese inflation data for July showed the headline figure at 5.6% and food inflation at 15.4%, up from 4.4% and 11.3% respectively in June. The rise in inflation was expected following on from last week’s hawkish Q2 Monetary Policy Report. In it the People’s Bank of China warned that the risk of the economy overheating has increased. Indeed the build-up of inflationary pressures is not a surprise. China is expanding much faster than its trading partners. As a result its real effective exchange rate has to increase. This could happen either through inflation, an increase in the nominal exchange rate or a combination of both.
Maintaining the de-facto yuan-dollar peg was Beijing’s crucial mistake in this cycle. The authorities believed they could keep international influences at bay, failing to realise that this was the first cycle in which China’s economy had a global reach and hence it could not avoid being affected by the rest of the world. The yuan was re-pegged in July 2005 and
allowed to appreciate at a snail’s pace against the dollar. With external demand over the past few quarters switching from the US to Europe, the authorities were astute enough to see the benefit of allowing a faster appreciation against the dollar — so far the yuan has gone up by 8%. They remained competitive against their current export growth market, while throwing a few bones to the increasingly belligerent US Congress. Yet overall mercantilist attitudes prevailed and the nominal exchange rate is now 10% down on its early-2002 high. The result: China’s trade and current account surplus explosion and domestic overheating.
July trade data, out last week, showed the trade surplus continuing to balloon. China’s exports, around $100bn. a month, are growing at roughly 30% annual rate. Meanwhile, imports, around $80bn. a month, are growing at roughly 20% annual rate. At these levels a substantial reversal of the growth rates will be required to start narrowing the trade surplus. Currently, demand from Europe, which accounts for a fifth of China’s total exports, remains strong. Chinese exports to the region were up by an annual rate of 38% in the Jan-Jul period, compared with the 18% increase in exports to the US. The US slowdown is likely to persist, while Europe’s growth should taper off by the end of the year. The Chinese authorities have cut export tax rebates and are about to introduce new restrictive rules on processed exports. But even so annual Chinese export growth is unlikely to fall off a cliff. Meanwhile, the authorities are dedicated to slowing the domestic economy in order to curb the advance of inflation. The PBoC conceded that price increases are not solely the result of “temporary factors” and that rising wages could present a problem. This would argue for a volume hit to imports, which would result in the unwelcome further expansion of the trade surplus.
Indeed this is what happened in 2004/05. China overheated which showed up in significant energy and transport shortages as the authorities were administering the price of energy. The rise in costs was not translated into an increase in the value of the end products. The exchange rate was kept stable. As a result import growth weakened, but exports continued to power ahead. At the time the value of exports and imports was the same, but it has since diverged. This time around the Chinese will have to allow a faster appreciation of their effective exchange rate if they are to stem the surge of domestic liquidity and inflation and fend off protectionist measures from the rest of the world. Beijing has always walked a tight rope between its fears of slow growth and high inflation, both of which have been associated with possible social unrest and a challenge to the Communist’s Party hold on power. In contrast to the usually bland reports of the past, the Q2 report had a decidedly hawkish tone. The PBoC announced that it would continue to use the reserve ratio and open market operations, but it needs “new instruments” to soak up excess liquidity. Currently, China’s problem is not a domestic credit boom. Banks’ deposits are far in excess of their loans. While credit growth remains strong, it could have been much faster. China’s liquidity problems stem from the undervalued currency.
But whether the yuan appreciates fast, Chinese producers continue to pass on increased input costs to the global consumer or there is a protectionist back-lash, China is set to export inflation. This is the last thing the US economy needs. Output growth has been below potential for a few quarters and is likely to stay below potential at least until the start of next year. Cost-push inflation will make it hard for the Fed to ease policy fast enough to get the economy back on its feet. Moreover, in the current global credit crunch the Fed may be needed to perform its function of a lender of last resort. Uncertainty is making it difficult to assess the need for such action, but persistent inflation worries may slow the Fed’s response.
China’s current account expansion means that the savings glut is expanding. Europe has become China’s object of desire and should benefit from the flows. But while the credit crunch has originated in the US sub-prime mortgage and CDO fiasco, it has had global repercussions. Heightened uncertainty worldwide has caused the demand for credit to dry up. There is no glut without willingness to borrow. The virtuous cycle of ample liquidity, boosting asset prices, allowing the take-up of further debt may have been broken. Still the Chinese may find that the best use of their money is foreign direct investment in the healthy non-financial corporate sectors of Europe and the US.
Diana Choyleva