January 03, 2010
Inflation in China
Why hasn't inflation caught up with a monetary-induced boom in China?
One might argue that China's policy of keeping the renminbi cheap amounts to an export subsidy that has been an important factor fueling its growth. But that thesis is puzzling to economists who reason that a cheap-currency policy can only get you so far. Paul Krugman explains:
Consider the real exchange rate, defined as RX = EP*/P, where E is the exchange rate measured as the domestic currency price of foreign currency (so an appreciation of the renminbi is a fall in E), P* is the foreign price level, and P the domestic price level. Basic international macro says that there is a "natural" level of the real exchange rate, determined by trade competitiveness and international capital flows. And the economy "wants" to get to that real exchange rate.
If you have a floating exchange rate, you get there via a rise or fall in E. But if you have a pegged rate, there's pressure on prices instead. By deliberately keeping E higher than it would be under floating, China is creating pressures for P to rise; the inflationary pressures are directly related to the exchange rate policy.
So why hasn't domestic inflation in China undone the stimulus from the exchange rate? I've been forming the opinion that U.S. inflationary dynamics may be more governed by relative price changes than was historically the case, and raise the possibility that China could be ground zero for this phenomenon. Specifically, I'm wondering if the pent-up inflationary pressure takes the form of inducing consumers and businesses in China to try to acquire any hard assets they can, with the result that rather than overall inflation we see remarkable increases in the relative prices of such items. I've commented before on this interesting account from last September:
Private investors in China, the world's largest metals user, have stockpiled "substantial" quantities of copper as the government ramps up stimulus spending to spur the economy, according to Sucden Financial Ltd.
Pig farmers and other speculators may have amassed more than 50,000 metric tons, Jeremy Goldwyn, who oversees business development in Asia for London-based Sucden, wrote in an e-mailed report after a visit to China. That's about half the level of inventories tallied by the Shanghai Futures Exchange, which stood last week at a two-year high of 97,396 tons.
Sucden's estimate underscores the difficulty analysts face in gauging metals demand in China amid increased speculation by retail investors, whose holdings remain outside the reporting framework undertaken by exchanges. Private investors in China also had as much as 20,000 tons of nickel, Goldwyn wrote.
"People who have nothing at all to do with the copper trade have been buying copper as a store of value, much like they would with gold," said Jiang Mingjun, an analyst at Shanghai Oriental Futures Co.
We're also hearing reports of the real estate markets in China's big cities taking off again:
In big cities like Beijing, the red-hot real estate market has seen prices raise more than 50 percent the past year-- six times the country's total economic growth rate. According to Shanghai Uwin, which tracks housing prices in China's richest city, average new apartment prices in the Pudong district soared by 57 percent to a record $4,061 per square meter, while overall prices in the city rose by 26 percent to $2,434.
Andy Xie, former Morgan Stanley chief economist for Asia, believes that China's real estate and stock markets are a "bubble" that will burst when inflation accelerates in 2011. "China's asset markets are a Ponzi scheme," Xie told Bloomberg. "Property is heading for one huge bust that will take a year and a half to unfold."
This account from November is also intriguing:
Wholesale garlic prices in Beijing are now 15 times as high as in March, and still rising.
Jerry Lou, a Morgan Stanley China strategist who has researched the opaque market here, said speculators-- fueled by the abundant liquidity sloshing around China-- have moved into the small market and strategically driven up prices.
"You need a warehouse, a lot of cash and a few trucks. That's how it works," Lou said, describing garlic speculators' tools of the trade. "Basically, what you do is try to arrest as much supply as possible, then you bid up the price. Moving garlic from one warehouse to the other, you make millions of dollars."
Maybe this is just a rational price response to the belief that garlic helps prevent H1N1. But I can't help noticing that they look a little like tulip bulbs, don't you think?
Posted by James Hamilton at January 3, 2010 08:43 AMdigg this | reddit
Maybe the Hunt Brothers moved to China?
But enough about finance and back to economics.
Productivity growth is the reason we always give for low inflation in the US, and it may be even more applicable in China(sarcasm). Since manufacturing equipment is an industry, all it takes is money...well, and some knowhow, and you can buy yourself a state-of-the-art factory.
Of course then there is overcapacity in manufacturing, 400 million un or under employed keeping wages low, and weak export markets all weighing on prices.
Then there is the 30% savings rate. So low consumption rate and money looking for investment/yield/store of value.
In addition to a garlic bubble, they have a real estate bubble. Brack Swan!!!!!!
Posted by: Cedric Regula at January 3, 2010 11:13 AM
Thank you very much. I'd love to see more development on this.
Posted by: benamery21 at January 3, 2010 11:29 AM
A New Year's greeting & thanks for all the hard work and wisdom you and Menzie share with the world through Econobrowser. May your karma be perfected in a more rational business world.
As for RX = EP*/P, I agree that Chinese prices must rise. However, I expect that they will do so selectively. Like Japan, China's political system will formulate an industrial policy subsidizing low industrial costs with higher prices for modern consumer goods and services. I'm sure that we will hear about a great many shortages and bubbles in the years ahead as 1.3 billion people simultaneously try to buy urban apartments, garlic, or tulips. What I will not expect, is a government displaying disfunction in trade, industrial or social policy.
Posted by: MarkS at January 3, 2010 11:51 AM
Is this sort of a restatement of "bad money drives out good"? When you suspect that money itself may be bad, you hoard what you think will prove to be good, ie: hard assets.
Posted by: wally at January 3, 2010 12:27 PM
Remember that the excess income from exports is divided between providers of labor and providers of capital. Income that goes to providers of labor is likely to increase current consumption (food, housing, etc.) Income that goes to providers of capital (profits) is likely to be re-invested, driving up the prices of capital assets (stocks, real estate, commodities.)
Note that in China, a disproportionate amount of income and savings accrues to businesses instead of individuals. Thus, you would expect that more of the price-level pressure would show up as asset price rises compared to consumer price rises.
Posted by: Rajesh at January 3, 2010 12:54 PM
Yes the do resemble tulip bulbs, because both garlic and tulips are members of the lily family.
Just remember that soy sauce makes it Chinese
tomato sauce makes it Italian, and
cream sauce makes it French, but
garlic makes it good.
Posted by: Fat Man at January 3, 2010 07:51 PM
Wally may have it succinctly expressed.
PBoC has created a lot of Yuan in the course of pegging it to the expanding number of US$. But they haven't dropped it from helocopters. They have done it through their banking system. Therefore, the 1st place we see inflation is in investment assets effected by a cornucopia of loanable funds. Real estate, stocks, gold, commodities.
Having said that, stockpiling base metals & garlic is rather singular.
Posted by: bryce at January 3, 2010 08:55 PM
the average monthly income in china is about $250. after paying for food and rent, there is hardly any money left to spend on other things and thus spur inflation. some knowledgeable readers from china can share the level of food production subsidies, but anyways, most food production is local and exchange rates are not a variable in the price of foods. furthermore, demand will not increase when prices fall becuase people do not engage in binge eating because it is cheaper. exports demand is also very inelastic.
on the other hand, if you look at stock and real estate prices, inflation is there and in overdrive. the artificially low rate of the yuan attracts as well plenty of real estate speculation from hong kong and macau.
Posted by: baychev at January 3, 2010 11:48 PM
James, the reason is very simple. There has been no monetary-induced boom in China. The accumulation of all the so-called "international reserves" has been financed by people's savings in state banks, invested abroad through the People's Bank of China. This has been true since the reforms of January 1, 1994 (the day I arrived in China to live there for three years and work as an economic adviser to the World Bank Mission in Beijing). The idea was to invest abroad an increasing share of the flow of savings deposits--a flow that was increasing and that had been invested largely in loans to state enterprises.
Posted by: E. Barandiaran at January 4, 2010 02:00 AM
The PBoC also issues bills. So when an exporter in China makes a deposit of USD, the PBoC can give the exporter a bill, and some renminbi, rather than all base money. Yes, no? My understanding is that the US Fed cannot (does not?) issue its own bills.
Posted by: RHarris at January 4, 2010 04:42 AM
One inflationary effect of China's trade policy has been the failure to completely sterilize their acquisition of dollar assets.
My understanding of the process is: a Chinese company sells $1M in goods to a U.S. firm; the Chinese firm is required to convert the currency through the central bank, which buys $1M in Treasury bonds (or other dollar asset) to prevent the Yuan from appreciating; then they issue domestic bonds to soak up the Yuans they created, (the sterilization.)
Brad Setser used to write about this on his blog, and I think he estimated the assets had about been about 65-80% sterilized. If they just lowered that they would be providing a stimulus to both our economies.
If I have my facts wrong, feel free to correct them.
Posted by: Bob_in_MA at January 4, 2010 06:26 AM
To readers that have sent comments: As long as you think in terms of monetary theory and policy, you're going to misunderstand what has been going on in China. Think in terms of financial economics: Chinese people investing abroad through the banking system. It has nothing to do with money and inflation.
Posted by: E. Barandiaran at January 4, 2010 07:31 AM
You've got the financial flow process correct, but they have one more monetary tool they have used successfully in addition to selling sterilization bonds. When the global economy was strong, they raised reserve requirements on the banking system, requiring them to hold more of all the RMB the PBoC printed in order to match dollar inflows.
One of the things they did as part of the 2009 stim program was to reduce reserve requirements. The banks responded with lots of lending, and it looks like lots went into real estate.
As far as the Chinese stimulus working to stimulate the US economy, I think the interactions here get much more complicated to figure out, but it would be easy to take a leap of faith and say it won't work that way.
Posted by: Cedric Regula at January 4, 2010 08:01 AM
I was reading an article on daily reckoning by Adrian Ash about China overtaking India as the worlds No1 Gold purchaser in 2009.. Helping pump up the price.
So now they own bucketloads of Dollars,Gold and GARLIC.. haha..
Personally I still think gold price is going to be supported above $1000 for a 2nd push up in 2010.. So other base metals will also be in demand..
Posted by: dynamicsoul at January 4, 2010 08:09 AM
A New Year's greeting & thanks for all the hard work and wisdom you and Menzie share with the world through Econobrowser (copied).
Yours is a very insightful post. I wish people at the FOMC will read it, instead of fighting yesterday's battle. The extraordinarily low (and uncalled-for) fed funds rate in mid 2003-2006 fueled commodities price increases then, while the FOMC insisted worrying about deflation. And I think we will see this movie again in 2010.
On Chinese inflation:
1) Measurement issues: last time I looked, almost 50% of Chinese CPI are food related, which may be vastly underweighing expenditure shares on housing, education, healthcare, and the like, at least in major urban areas.
2) As Rajesh above pointed out, the income distribution (and I may add, access to credit) plays an important role in Chinese inflation dynamics. In addition to the consumer/producer divide mentioned by Rajesh, inflation for goods and services for higher income consumers have been high in the past 5 years or so, even though inflation for basic food items may be low. Again, housing is an example. But it's not just housing. While big-mac index may suggest RMB is still ~40% undervalued, a Starbucks index (if one is constructed) will likely show that RMB is already a little overvalued.
Posted by: pat at January 4, 2010 08:32 AM
My understanding is that the Chinese sterilize ~ half of their Yuan pegging. That still a lot of Yuan creation. M2 grew y-o-y 28-9% as of Oct. I think.
M2 growing at 3 times GDP for a year is going to distort the price of something.
Posted by: bryce at January 4, 2010 11:40 AM
"Specifically, I'm wondering if the pent-up inflationary pressure takes the form of inducing consumers and businesses in China to try to acquire any hard assets they can, with the result that rather than overall inflation we see remarkable increases in the relative prices of such items."
I have been saying this for a while, excelent!
Posted by: Doc Merlin at January 4, 2010 10:36 PM
Do they use the American dollar a lot there, especially for items that are non-core?
Posted by: Jim at January 5, 2010 04:14 AM
Is there any reason that a pegged exchange rate couldn't cause a P* to fall instead of P to rise?
Or rather, with falling P*, P doesn't need to rise to move toward the natural RX rate. Does a deflationary US situation explain this?
Posted by: richard at January 5, 2010 07:51 AM
@ Doc, From my understanding, the American dollar is used there, but not for items that are non-core. I had some family that traveled all over China for a year.
I find this very interesting about the Garlic Prices. The tulip comment reminded me of when a few hundred years ago that tulip bulbs were used as currency in the Scandinavia area. Maybe they are transitioning to Garlic as their currency? I joke.... It was a great read.
Posted by: Jon Carter at January 5, 2010 08:45 AM
Better question to start with might be, why have prices not been falling over time?
They should be falling, given the IT revolution and the new ability to manage production around the world in real time, and the lowering of trade barriers, plus the truly unprecedented addition of many hundreds of millions of workers to the world labor force in a short period of time, as China moves people from the rural areas to the cities. This has all combined to create a huge positive supply shock. Consumer prices should have been dropping for the last decade, but monetary policy has been aimed at having them rise by about 2% per year, through unusually loose policy. Deflation is to be expected when there is a large positive supply shock, cet. par. If deflation is prevented from occurring, asset prices must rise by a large amount because they have to rise in value relative to manufactured goods and relative to labor. If debt were denominated in real terms instead of nominal terms, or if much less debt existed, we could endure deflation with few problems, and would not have to support consumer prices with easy monetary policy. Instead, both mortgage and corporate debt are highly subsidized through tax policy, our debt load is enormous, and the Fed has come to fear deflation above all else.
Posted by: K at January 5, 2010 08:58 AM
"By deliberately keeping E higher than it would be under floating, China is creating pressures for P to rise; the inflationary pressures are directly related to the exchange rate policy."
I'm not sure that conclusion follows. Scarcity drives up prices, but what if there is no scarcity, owing to a vast untapped labor supply (the labor supply for producing traded goods is more or less perfectly elastic)? Wouldn't the pressure on prices then have to wait until the unutilized or underutilized labor is first absorbed? So, instead of resulting in pressure on prices, at least for a time, the exchange rate polciy results in higher growth.
Posted by: don at January 5, 2010 02:32 PM
China does not have a fractional reserve lending system. so for a given increase in the money supply, inflation there will be up to 10 times greater in the USA. Im surprised that most people don't know this. Since everything, we.. over %70 of their economy, is owned or controlled by their government, and the government sets prices on lots of commodities, they won't see inflation the same way we would here in the West.
Posted by: Mike McMack at January 7, 2010 06:06 AM
I am still skeptical about the situation, but this article and comments are certainly answering some of my questions. If you have time, I found an interesting video on newsy.com that summarizes what analysts predict and explains multiple opinions: http://www.newsy.com/videos/analysts-fear-china-s-housing-bubble-may-burst
Posted by: El at January 15, 2010 08:30 AM