China's Economy: The East is Red

A week before the 1929 market crash, which led to the deepest global depression in modern history, Irving Fisher, one of the most famous American economists at the time, said US stock markets were at a permanently elevated plateau. In the 1980s, political elites, pundits and financial market participants all thought Japan had figured out a new and superior “managed market system.” Both booms were illusory, fueled by easy money credit bubbles, and both predictably ended in bust.

The China story is following the same pattern, with the seeds of economic crisis being sown by an easy money credit-fueled investment boom facilitated by the People's Bank of China, the central bank, which has set a target of a 17 percent year-on-year increase in broad money supply in 2010, according to a March 7 story by the Xinhua news agency.

It is very difficult if not impossible to know when the China macro bubble will burst, but we do know that a key trigger variable is inflation as measured by the Consumer Price Index. Chinese policy makers are acutely sensitive to inflation given the history of social upheaval in China caused by inflationary episodes, including after WWII and preceding Tiananmen Square protests of 1989.

As general price inflation pressures continue to build, China's policy makers will eventually be forced into drastic action, which can't help but trigger a macro crisis. Credit booms eventually end in bust. That is an iron law of economics.

Although the CPI still remains relatively well behaved in China, that doesn't mean that China's recent policy moves, including hiking reserve requirements, are in any way pre-emptive and thus capable of neutralizing rising inflation pressures before they beg an unavoidable catch-up response by the People's Bank capable of derailing the economy. This is because consumer price inflation is a result of easy money credit-fueled “monetary inflation”. As Milton Friedman observed, it takes roughly 24 months for easy money conditions to manifest in a generalized rise in the price level as measured by CPI.

With the epic credit boom last year in China coming on top of several years already of aggressive growth in credit, the seeds have been sown already for higher consumer price inflation in China as easy credit fueled monetary inflation inevitably turns into a generalized inflation across the economy.

What this means is that China is already behind the curve fighting inflation. Assertions that the tightening of reserve requirements are evidence of China preemptively fighting inflation are erroneous in the context of the above framework.

There has recently been an enormous amount of speculation whether China will revalue the yuan in an effort to neutralize growing domestic inflation pressures. Conventional wisdom has it that a stronger yuan would dampen domestic inflation by reducing demand for Chinese exports and by making imports less expensive. This is what the textbooks all say, but such textbook analysis is contradicted by recent history. In China's case, we believe a modest revaluation of the yuan is more likely to increase inflationary pressures rather than reduce them – in a repeat of what happened from 2005 to 2008 when CPI climbed virtually in a straight line from 1.8 percent in 2005 year on year to a decade high of 8.7 percent year on year in February of 2008, all the while the yuan gradually appreciated roughly 20 percent versus the US dollar.

During this same three year period, exports doubled and the China trade surplus boomed. Such historical evidence suggests that there is unlikely to be any dampening effect on domestic inflation pressures from the export side in the wake of a stronger yuan. Chinese companies have proven they are keen to grab market-share (and sacrifice margins) in the face a strengthening currency and they are likely to continue to do so going forward.

Meantime, if we look on the import side of the equation, we see a similarly weak argument for a stronger yuan leading to reduced domestic inflation pressure in China. In the first six weeks of China's yuan appreciation experiment in 2005, global commodity prices spiked 10 percent while the currency appreciated less than 5 percent. Over the next 3 years, commodity price inflation far outpaced the 20% gain in the yuan. In fact, the Commodity Research Bureau's Continuous Commodity Index shot up by 20 percent in 2005 alone.

Meantime, as mentioned above, China's Consumer Price Index continued to rise during the whole period from 2005-2008 in China when it peaked at 8.7 percent right before the global panic of 2008.

The bottom line is that anything short of a significant revaluation (in the range of 20 percent or more) is unlikely to dampen inflationary pressure in China. Modest appreciation is more likely to increase inflationary pressures as evidenced in 2005 to 2008 period for three reasons: modest one-way appreciation will tend to attract foreign capital inflows chasing further appreciation (and the highest-growth economy in the world), exports are not dampened in any material way, and global commodity prices rise faster than the yuan appreciation.

Unfortunately for China, the kind of revaluation required to dampen inflation (i.e. greater than 20 percent) is also likely to trigger a major macro shock via the export sector. The same goes for interest rates. The kind of interest rate hike China needs to slow growth enough to neutralize it is also likely to trigger a macro crisis given the sensitivity of the corporate and especially the highly leveraged real estate markets in China.

Thus Chinese policy makers are stuck between a rock and a hard place. No matter what they do, inflation is headed higher because the credit boom/monetary inflation horse is already out of the barn. CPI inflation follows monetary inflation like the day follows night – unless a credit bust intervenes. Thus, by deductive logic, we can see that the only solution to China's inflation problem is a macro bust – painful now but even more painful later.