China: The heat is on

The latest Chinese economic data and the policy announcements emanating from Beijing make it very clear: inflation is back in China, as the FT notes, and almost every economic commentator worth their notes is venturing an opinion as to what the mandarins should do about it.

After nearly a year of declining prices, November data, published last Friday, has deepened the dilemma for Beijing’s policymakers as they try to consolidate a strong economic recovery.

The figures show that China’s rebound remains firmly on track, with industrial production and imports both increasing well in advance of forecasts.

But a key risk facing the economy is a surge in inflation following the massive monetary and fiscal stimulus measures introduced this year. Consumer prices rose 0.6 per cent in November from a year ago, after falling 0.5 per cent in October, while prices at the factory gate fell 2.1 per cent in November compared with October’s 5.8 per cent.

The return of even modest inflation, in the FT’s view, will feed into the intense discussions in Beijing about how quickly to ease stimulus measures and whether to abandon a de facto peg against the US dollar and to allow the renminbi to appreciate.

There is no doubt, in the view of Gavekal’s Arthur Kroeber, that the Chinese economy is overheating and policymakers remain behind the curve.

What’s more, he says, the acceleration in property prices is now “severe” and M1 money supply growth outpaced M2 growth for the third consecutive month:

All the numbers make it clear that the China’s recovery is in full cry, with property investment taking over the lead from government infrastructure spending. The price indices, while still low in absolute terms, have been racing upward on a month-on-month basis… CPI is now positive, and jumped more than a full percentage point between October and November… Producer prices are also accelerating, and M1 growth soared to nearly 35%.

Meanwhile, notes Kroeber, policymakers “keep talking about the risks to growth, continue to increase consumer subsidies, promise another strong monetary infusion in Q1 2010, and fiddle around the edges of the property market”.

Many economists believe Beijing will not shift currency policy until there are clear signs that Chinese exports are recovering, notes the FT. November export data were among the few figures that were worse than expected. Exports fell 1.2 per cent compared with the year before, compared with a 13.7 per cent drop announced in October.

Some economists say that the most likely trigger for an appreciation of China’s currency, however, would be rising commodity prices. After all, adds the FT, Beijing’s officials have admitted in recent weeks that even if inflation were to pick up, it could be risky to increase interest rates well in advance of any similar action by the US, because that could attract a fresh wave of capital inflows to China.

However, Kroeber argues:

The time to start tightening is now, but this looks unlikely to happen. By Q2 2010, Beijing will face an unpalatable choice of slowing growth, tolerating higher inflation, or appreciating the currency — or most likely, will try to cook up a nostrum containing all three ingredients.

General monetary tightening, he adds, is likely by the second quarter of 2010.

In a separate, daily client note, Gavekal foresees growing political pressure on Beijing to do something about its currency. It explains:

The US has recently been happy to sit tight, let the dollar go down, and let the Chinese increasingly take the heat for it… The next stage could see increased political pressure on China, and possible punitive tariffs. Yet hardball tactics to force Beijing’s hand could actually delay the process as Chinese policymakers are loath to be seen as kowtowing to international pressure.

Nevertheless, with rising food and energy prices, and domestic consumption still lagging targets, China has a lot of good internal reasons to seek a revaluation. One way or another, we think 2010 will be a big year for the renminbi.

Meanwhile, Andrew Smithers, of Smithers & Co, strays from his usual focus on Japan, US and Europe to examine the dynamics of the renminbi.

In brief (our emphasis):

1. Even if it were correctly priced today, the Chinese currency needs to strengthen either in nominal terms or by Chinese inflation being higher than that of the US.

2. High Chinese inflation is likely in the medium-term with an unchanged exchange rate as expansion of Chinese foreign exchange reserves leads to a rapid increase in domestic liquidity, against which it is difficult to immunise. It is also likely in the shorter term unless money growth slows.

3. Immunisation can occur through bond issues or by increasing the level of reserves that commercial banks hold with the central bank. The Chinese bond market does not seem sufficiently mature for this purpose and changes in reserve requirements have been the preferred policy weapon in the past.

4. Their use, however, produces a wedge between the returns on bank deposits and the returns available in the economy. This leads to bank disintermediation with funds flowing into other investments with the usual result of driving up asset prices… The process now seems to be starting again.

5. A rapid rise in Chinese inflation is undesirable. Experience suggests that once inflation rises to even 4% or 5%, expectations of further rises mean that inflation will rise even if there is no output gap. To prevent this, central banks have to depress demand. The result is a needless loss of output and employment and a highly volatile economy.

6. Creating a sufficient gap between Chinese and US inflation, without such disturbance, requires US inflation to be very low and probably negative. Even moderate US inflation will add to problems with China.

7. While it is generally agreed that marked deflation is as disturbing as inflation, there appears to be an exaggerated concern over mild deflation, despite historic evidence that it has often been associated with periods of strong growth in output and productivity.

8. Zero inflation or mildly falling prices in the US is desirable as a way to achieve a smooth adjustment of real exchange rates without political drama or protectionism. This illustrates that the US can no longer ignore the rest of the world in setting its economic policies. We doubt, however, whether this is yet fully appreciated in Washington.

Related links:
Inflation complicates China policy – WSJ, Heard on the Street
Two ways to play: China’s uptick in CPI – Minyanville
China’s baozi economy – FT Alphaville
Urban (commentary) combat in China – FT Alphaville

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