However, after five consecutive years of enjoying a high growth rate of more than 10 percent and a low inflation rate of less than 3 percent, signs of overheating in the economy have become increasingly ubiquitous since the middle of 2007.
In 2008, the Chinese government needs to grapple with three major challenges: the worsening in inflation, a significant slowdown of the economy, and a possible collapse in asset prices.
The Threat of Inflation
Since 1997, China’s inflation rate has been very low. The reference inflation target for 2007 was set at 3 percent. However, in July 2007, inflation measured by headline CPI suddenly jumped to 5.6 percent. Initially, the increase in CPI was caused almost exclusively by food prices, especially by pork prices. Therefore, it was argued by economists as well as government officials that, as soon as piglets grow up, the supply of pork will increase and pork price will fall, and as will CPI. Unfortunately, inflation has accelerated unabatedly since. In February 2008 the growth rate of CPI reached 8.7 percent, the highest in 11 years. Although CPI dropped to 7.7 percent in last May, the growth rate of PPI, which was very low until recently, increased to 8.2%. The worsening of inflation in recent months shows that current inflation is much more broadly based than people previously expected, and can worsen further before turning for the better. Now consensus has been reached in China that inflation is a serious threat to stability and fighting inflation should be the top priority of government policy. However, there are still serious differences in diagnosing the nature of China’s current inflation among Chinese economists. One school of thought holds that the inflation currently witnessed is one of cost-push, caused by factors such as interruptions in supply, increase in labor costs, higher environmental standards, external supply shocks, and so on. The other holds that the worsening of inflation is caused by excess demand, which in turn is attributable to excess money supply. My personal view is that China’s inflation is more demand-pull than cost-push in nature. In other words, overheating is the most fundamental cause for China’s current inflation. In the second half of 2008, the growth rate of GDP was 11.9%. When taking into consideration the new tendency of under-reporting, China’s actual growth rate may be even higher. For many years, the consensus was that China’s potential growth rate was 8%. It is hard to believe that China’s potential growth rate has jumped from 8%-9% to 11%-12% over the past few years. The existence of excess demand (domestic plus foreign), in other words, a higher actual growth rate than that of potential, is bound to lead to inflation. Demand for real estate investment and rapid increase in exports are two most important contributing factors to the excess demand.
Since the early 2000s, the growth rate of China’s real estate investment has been very high. Real estate investment is the single most important contributing factor to the increase in investment, accounting for more than a fifth of the total increase in investment and becoming by far the single most important contributing factor to investment growth, which in turn becomes the most important contributing factor to the overheating of the economy.
Demand for property—both residential and commercial—is extremely strong in China and there is no way for the supply of houses to keep pace with the rapid increase in demand, due to factors such as very limited supply of lands. As a result, house prices are soaring. However, real estate prices are not a component of CPI. This practice of excluding housing prices from the most important measure of excess demand in the economy is fundamentally flawed. CPI does not reflect excess demand in one of the most important areas of economic activity, and hence fails to reflect the presence of excess demand in the economy as a whole. I do not think there is any huge difference between prices of durables such as expensive cars and those of houses, at least in China’s context. While scarce resources are mobilized for real estate development, inflation pressure is bound to spread to other sectors of the economy. We can even find links between excess demand in housing sector and the shortage of piglets. Farmers are leaving the countryside to join the construction army in cities. Without a significant increase in pork prices, there is no way to persuade farmers to continue raising pigs or even engage in other farming activities.
China’s export drive is another important contributing factor to excess demand experienced in the country. China’s exports and trade surplus has jumped significantly since 2003. It is worth noting that the increase in exports is not a result of lack of domestic demand. In China’s context, trade surplus is not the result of savings-investment gap. The identity has said nothing about causality. In fact, due to the dominance of the processing trade, more than 60 percent of China’s exports are aimed at foreign market. The strong global demand and undervaluation of the RMB exchange rate are the two most important factors contributing to China’s excess foreign demand.
The most worrying aspect of current inflation is not the rise of prices per se, but that inflation expectations have been firmly established among the public. Inflation expectations are changing the behavior of consumers as well as producers. Competitive price hiking, hoarding, demand for higher wages and salaries are in turn making inflation worse. The vicious circle of cost-push—inflation—inflation expectations—demand pull is forming rapidly. Under an inflationary environment, competitive price hikes have become one of the most important ways for different social stratum to protect their incomes from being eroded by inflation. A prevalent phenomenon in China today is that many enterprises raise the prices of their products without any economic justification. They just take preemptive action to protect their own profit margins or use the opportunity to increase their profit margins. The restoration of price stability would become very difficult and time consuming indeed.
Price stability is the foundation for sustained economic growth. In a market economy, if inflation becomes serious, price signals will cease to properly exercise its functions, such as guiding resource allocation and deciding production and distribution, because economic agents will misinterpret market supply and demand. Another concern is that serious inflation tends to be followed by a rise in the Gini coefficient, further undermining the fight against inequality. Those hurt the most by inflation are low-income groups. Rises in staple food prices are pernicious to those struggling on low wages or social security. A widening wealth gap caused by inflation poses threats to social stability. Controlling inflation is not just for the sake of economic stability, but as Keynes once noted, also a matter of social justice.
The Subprime Crisis and Slowdown of the Economy
Unfortunately, just as China launched its anti-inflation campaign, the subprime crisis broke out in the US and spread across the world’s major economies. It also appears that the US economy is sliding to recession quickly, if it is not already in one. The slowdown of the US economy will definitely have a significant negative impact on Chinese economic growth via trade channels. The US is China’s second largest trade counterpart, next to the European Union. The slowdown of the US economy and global economy certainly will lead to a slowdown in China’s net exports, and hence China’s overall economic growth. In this regard, there are four important factors which could to bear in mind. First, the writedowns of US securities have caused direct losses to some Chinese financial institutions. Second, the fall of US share prices due to the subprime crisis have created an important psychological impact on China’s stock exchanges and led to falls in China’s share prices. Third, the credit crunch and falls in security prices in the US have created uncertainty in the direction of cross-border capital flows. Some capital may leave the US for “quality or safety”. Other may flows back the US to satisfy requirements of capital adequacy or into the US to buy cheap US assets. Fourth, the slowdown in the US economy will have important negative impact on China’s trade surplus. Experience shows that China’s net exports are not very sensitive to the changes in exchange rates because of the domination of processing trade, but they are sensitive to the changes in income levels. Hence, the growth rate of China’s trade surplus may fall significantly as a result of a US slowdown, which in turn may lead to a fall of China’s growth rate. My colleagues at Institute of World Economics and Politics are calculating the possible impact of a slow down of the US economy on China’s growth. So far we have not reached a firm conclusion yet. Taking direct and indirect impacts into consideration, according our calculations, for a one percent slowdown in the US economy, which will have negative impact on China’s other trade patters, may cause a slowdown in China’s growth rate by one percent.
China is a country which adds more than 24 million new working-age citizens to the labor market each year. Maintain a relative high growth rate something like 9% is a must. Therefore, the Chinese government must strike a fine balance between growth and inflation. The concern with growth will naturally have some influence on the fight against inflation.
Besides inflation and a slowdown in the economy, another danger China faces is asset bubbles and the bursting of these bubbles. There is no doubt whatsoever that China’s equity bubble was very serious. China’s stock exchanges had been in the doldrums for years. Thanks to favorable internal and external conditions, share prices began to soar since late 2006. By the end of May, 2007, the Shanghai composite share price index surpassed 4500 points, with 100 million retail accounts opened, (maybe half of them are active) at an average of 200,000-300,000 new accounts a day through April. More alarmingly, the speed of the price increase was accelerating exponentially. It took 18 months for the index to rise from 2000 to 3000 points and then took just 31 working days for it to rise from 3000 to 4000 points. The best reflection of the speculative atmosphere is the colossal turnover, which surpassed London, or Japan+13 major Asian economies in some trading days in May, and was 18 times of that of Hong Kong. The P-E ratio of China’s shares was more than double the international level. Alarmed by the madness, the government raised the stamp duty on transactions on May 30, which caused a mini crash of the market immediately. In July, the market recovered strongly, this time, the government was reluctant to take any direct policy measure to clamp down on the exuberance. The share price index soared to more than 6200, before falling back with a vengeance.
Now, after several serious corrections, the equity market is in a precarious state. A further collapse can happen at any time. A crash in the stock exchange will be painful for investors and cause resentment among retail players—which amount to hundreds of millions–who have gambled significant amounts of their own savings. A crash in share prices will hold back China’s progress in the development of capital market for many years. However, the economic consequences are unclear. To intervene or not intervene is a very big question for the government indeed.
The situation of the real estate market is more worrying. The housing market has started to cool down in recent months. In some big cities, especially in Shenzheng, the most modernized and open city in South China, housing prices are falling quickly. Now people started to talk about the possible collapse of China’s real estate market. Different from the share market, China’s real estate market is heavily dependent on Bank loans, which may account for as high as 80 percent of the finance of real estate development. The Chinese government is faced with a dilemma: On the one hand, a brake must be placed on the soaring housing prices, and the growth rate of real estate development must be slowed down, which implies that demand for real estate development must be brought under control. On the other hand, if a major correction happens in the market, the economic consequences can be much graver, because a dramatic fall of housing prices (say more than 30 percent of fall in housing prices) may bring down many commercial banks, and lead to a banking crisis.
In short, in the near-term, the Chinese government is facing three major challenges: inflation, growth recession (growth rate falls into an inadequate level), and asset market instability. To deal with the three challenges simultaneously is something the government has never experienced.
Some Policy Issues
First and foremost, the key task in macroeconomic management faced by the Chinese government is to identify the policy priority. There should be no doubt whatsoever that bringing inflation under control should be China’s number one policy objective. Economists in China have tended to play down the importance of current inflation until recently, and some even argued for creating inflation to reduce nominal appreciation pressure on the RMB. Fortunately, early in the year, at the national people’s congress (NPC), the Chinese authorities have decided that the most important policy target is to prevent “structural price rises from turning into serious inflation”. Though what “structural price rises” entail is not very clear, the policy direction is absolutely correct and the government should not waver over this objective, even if the growth rate of the economy needs to fall significantly.
To fight against inflation, the following policy instruments should be adopted. First, as a first line of defense, unwanted capital inflows, no matter whether they are aimed at gains in capital markets or the carry trade, should be prevented from entering China. Second, the RMB should be allowed to appreciate to absorb the pressure created by twin surpluses (trade surplus and capital account surplus), and other unofficial capital flows (including speculative capital and carry trade capital) that evade capital controls. Third, sterilization policy should be maintained to mop-up remaining excess liquidity. It seems that there is still some room for selling more central bank bills and raising reserve requirements. Fourth, the interest rates on households’ demand for money should be increased further. By raising nominal interest rates, the central bank should be able to increase households’ desire to hold more money in the form of household saving deposits. Raising interest rates will reduce excess liquidity that comes from the demand for money. Last but not least, interest rate hikes may undo the necessity for credit rationing, which has worsened efficiency of allocation of financial resources, and curb-markets are prosperous thanks to credit rationing. Of course, interest rate policy should be used with discretion.
Owing to the fear of negative consequences of RMB appreciation on exports, China has tried countless methods to prevent a rise in the RMB. Among them are bloc purchases in the US, cutting export tax rebates, encouraging domestic enterprises to invest overseas, opening up the financial services industry, easing capital controls etc. Some of the measures have significant side-effects. Since 2003, the PBOC’s policy has been “easy out, difficult in”. The problem is that under current levels of appreciation expectations, such policies are ineffective. The unattractiveness of QDII is clear evidence for lack of demand for outflows. Using easier capital controls to solve the Mundell Trinity, without making the exchange rate regime more flexible first is indeed “putting the cart before the horse”. Capital controls is China’s last line of defense and cannot be eased until China’s financial reforms are complete. Growth is cyclical and a sudden change in China’s situation could prompt massive capital flight. Capital account liberalization should be treated as a segment of China’s structural reform, and not as a stop-gap measure to solve China’s short-term imbalances. Now that the US subprime crisis is still unfolding, it is difficult to judge the direction of cross-border capital flows. We can’t rule out either the possibility of large scale capital repatriation away from developing countries back to the US, or a sudden unwinding of hot money which has been parked somewhere in China, triggered by whatever reasons.
China is facing the twin threat of inflation and a slowdown in economic growth. The tumult in its capital markets have yet to settle. To maintain sustainable growth, China has to tighten its monetary policy. This means that China has to continue its sterilization policy. At the same time, China has to raise interest rates. In order to do so, China must improve its management of cross-border of capital flows and to minimize the flows aimed at exploiting the inefficiencies of China’s nascent capital markets. Following the narrowing of interest rate spreads between China and the US, the carry trade into China has become increasingly attractive. Because China’s capital controls are quite leaky, the PBOC’s monetary tightening can be neutralized. If capital controls fail to stop inflows, the RMB must to be allowed to appreciate at a faster pace. At the same time, China must be vigilant about the possibility of large scale capital flight, which will have grave consequences for the economy.
Despite the grave challenges the world’s largest developing economy faces, the prospects for the China remain bright. Short-term difficulties such as inflation and a slowdown in net export growth are surmountable, but concurrent reforms will ensure adjustments in the country’s economic structure portent long-term progress. Institutional frameworks are improving by the day, resulting in a healthier financial system and sustained competitiveness in manufacturing. The country will continue to welcome foreign investment and play its part in helping the global economy overcome one of the most difficult periods in recent memory.