Don't Get Giddy About China
Growing inflation pressures in China is a theme that is starting to get more attention in the financial press in the wake of several related developments.
First came unexpected policy tightening moves (i.e. adjustments in overnight bill rates and the 50 bps hike in reserve requirements). Next came news that regulators were worried about excessive loan growth in January as loans hit 15 percent of the full year target in just the first two weeks of the new year, and finally we have the release of hotter-than-expected economic data for January just announced signaling a faster than expected expansion in China's manufacturing sector and an unexpected spike in producer prices.
The HSBC China manufacturing PMI index for January accelerated to the highest level since the series began in April 2004, surging from 57.4 in January from 56.2 in December. Meantime, the producer price index accelerated from 69.9 in December to 74.7 in January the highest level since July 2008.
Whereas only a few weeks ago the conventional wisdom had China's central bank refraining from rate hikes until the 3Q of this year, (given the still tepid gains in the consumer price index which rose 1.9 percent year-on-year in December 2009), the recent developments mentioned above suddenly have many private research firms and investment banks busy revising rate hike forecasts. For example, HSBC recently published a research report forecasting the PBOC’s first 27 bps hike as early as the 2Q, and many other experts have been busy revising assumptions about when we’ll see the first rate hike in China to the 1H10 as well.
Despite the greater attention on emergent inflation risks in China, the consensus view in the financial press appears to be that Chinese policy makers are moving preemptively to neutralize nascent inflation pressures by, for example, hiking reserve requirements and moving in second half of January to tamp down the pace of bank lending – and that any rate hikes when they do come will be well timed and successfully aimed at engineering a soft landing for the economy.
We believe China is already well behind the curve in tightening monetary policy; once the easy money genie is let out of the bottle, it is difficult – if not impossible -- to put back without a painful period of macro adjustment facilitating unavoidable deleveraging and reallocation of mal-invested capital. China can't avoid the natural laws of economics any more than the United States or any other country that hitched its wagon to the global easy money cycle facilitated by the Federal Reserve following the bursting of global tech bubble. By effectively pegging their currency to the dollar, Chinese policy makers facilitated massive foreign capital inflows and a concomitant easy money cycle over the past 10 years -- and again especially in the past year when bank lending surged to unprecedented levels.
Longtime China hands are vulnerable to the myth that Chinese policymakers have pulled all the right policy levers over the past 25 years, and that they will keep pulling the right policy levers going forward to ensure that China’s growth miracle continues.
The fact is, political reality in China is similar to what it is in more liberal political systems: policies that require short term pain for long term gain are often ignored for sub-optimal, temporary band-aid policy making. This is especially true during major periods of power succession in China as incumbents want strong growth to help ensure the succession of their favored clique. With the 18th party conclave scheduled in two years this dynamic is already in play.
In China's case, an important example of expedient, short-sighted policy making is evident in the decision to keep the yuan pegged to the US dollar in 2003-4 and then to engineer a crawling peg in 2005. Policy makers were unwilling to use a meaningful adjustment of the currency to dampen speculative foreign capital inflows into the country because doing so required a politically unacceptable hit to the export sector. Now, Chinese policy makers find themselves facing a dangerous inflation problem, which is a direct result of the massive foreign capital liquidity inflows that have flood into the country, reflected in US$2 trillion plus in reserves -- and encouraged by a fundamentally undervalued currency.
China bulls point out that China is a net creditor and holds huge foreign exchange reserves, and therefore doesn't risk a macro crisis such as the balance-of-payments crises which played out in neighbor countries during the Asian crisis of 1997-1998. While that is true, history has proven that countries tend to fight the last macro crisis, leaving themselves vulnerable for the next, new one. Chinese policymakers are keen students of history; they saw what happened in the Asian crisis and they've made sure such a disaster can't happen to China.
There is a Russian proverb that says our fate plays out on the exact path we take to avoid it. This is the story of China in a nutshell. Policy makers have accumulated forex reserves in large part to avoid a balance of payments crisis, and yet the massive reserve accumulation has meant a parallel accumulation of high-powered money and an epic credit expansion over not just the past year, but over the past four or five leading to dangerous asset and credit bubbles manifesting throughout China’s real economy and financial markets.
Bank credit acts in a similarly self-reinforcing manner (both positively and negatively) to foreign debt in a macro crisis. When times are good, foreign debt promotes economic growth which facilitates further expansion of foreign debt accumulation; forex debt ratios superficially appear sustainable as long as GDP growth and foreign debt inflows stay robust. Macro dynamics remain self reinforcing as long as the country continues its rapid pace of GDP growth and the currency is stable. If an internal or external macro shock derails growth and/or the currency, however, the effects can quickly turn a seemingly favorable macro ratio analysis into a nightmare scenario.
That is because as a currency naturally weakens into a macro shock, foreign debt holdings explode, causing a huge drag on the economy – forcing an even weaker currency, weaker GDP growth and thus a further explosion of foreign debt ratios. A negative reinforcing spiral for the economy suddenly replaces the positive self reinforcing spiral, exactly what we saw in the Asian crisis.
Domestic bank credit acts in a similarly pro-cyclical way to foreign debt. When growth is booming, credit growth hides bad loan formation in favorable nonperforming loan ratios because assets are growing so fast – leading to a booming economy. The problems only show up when a macro shock inevitably short-circuits an unsustainable credit boom. In the case of China, the shock is likely to be a combination of higher inflation and interest rates. As inflation begs draconian monetary tightening and the economy naturally down shifts, the risk rises that superficially "safe" NPL ratios suddenly reverse dramatically and risk sinking the whole macro ship. As NPLs spike into monetary tightening, banks are forced to pull back on loan expansion, and growth slows even more, creating a new wave of NPLs.
If consumer price inflation picks up faster than policymakers and markets anticipate, as we expect will be the case in 2010, this will inevitably trigger a re-rating of China Inc. risk because new assumptions about more aggressive monetary policy tightening will serve as a potential trigger for setting off the negative reinforcing cycle outlined above.
The global macro implications for a protracted derailing of the China Inc. growth miracle, include a coincident (but less durable) correction of global commodity prices and possibly even a forced "beggar-thy-nation" devaluation of the yuan as policy makers have no choice but to turn to the export sector for growth, which could instigate a painful tit-for-tat trade war with important global trade partners, such as the US and EU.
China's economy is unlikely to implode or go completely off the rails, although the unavoidable social fallout from a surge in unemployment is likely to further encourage policymakers to continue to pursue Band-Aid, expedient policy aimed at fixing symptoms of underlying easy money fueled distortions, meaning a self-sustaining, durable productivity-led recovery is likely to be much slower to catch hold going forward than most people will expect.
The policy news is not all bad in China. The recent announcement that Beijing has approved stock index futures, margin trading and short selling is good news. However, facilitating short selling on a market that trades fundamentally on technicals -- liquidity and government policy -- is no panacea for improving the macro function of equity markets based the allocation of capital.
Chinese policymakers appear to be trying to spur private consumption by building out social safety nets. While better social safety nets are an important and positive development, the fundamental answer for policy makers to improve the allocation of capital (and in so doing to shift China Inc. away from its export/production orientation to a more sustainable consumption driven model) is only going to come from a combination of four key policy initiatives, in order of importance:
· Interest rate liberalization
· Exchange rate regime liberalization
· Major reform liberalization in the service sector, especially in financial / banking sector, which is currently dominated by state players.
· Liberalization of rural land ownership rules.
None of these is likely to happen soon, unfortunately, given the political reality – even in a one-party country like China – that it is difficult to implement tough-medicine reforms during a period of global economic stress, and this is especially true for President Hu Jintao and Premier Wen Jiabao as the country gets closer to its next leadership transition cycle in 2012.
If I am wrong about the bearish scenario for China above, I think it will be because I am too optimistic. A possible worst-case scenario is that the bursting of China's credit bubble leads to a second-wave global credit crisis and a freeze in global financial markets no matter what the People's Bank of China or the US Federal Reserve does to reflate markets – and we get a classic global liquidity trap scenario and a major debt-deflation Great Depression redux.
Sam Baker is director of Asia research for Trans National Research Corporation, a US-based political and economic consultancy specializing in global emerging market research.