Why China Overheats

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May 2011

"Truck drivers at the Shanghai port of Baoshan are demanding relief
from rising fuel costs in a rare industrial action that will reinforce
government fears about the destabilizing impact of rising prices."
--Financial Times (April 23-24, 2011)


Despite efforts to rein it in, China's inflation rate has reached a point where it is sparking social unrest. Chinese premier Wen Jiabao's recent comment that inflation is a tiger that "once set free is very difficult to put back in its cage"[1] aptly characterizes the current inflation in his country. The world's second-largest economy faces some fundamental choices if it is to restore stability.

Key points in this Outlook:

  • China is facing destabilizing inflation; capital has flowed into China must faster than it has flowed out, in part because Chinese residents are prohibited from investing abroad.
  • China's reported inflation rate on consumer goods rose to 5.4 percent in March, but its implied inflation rate is 8.4 percent--a large discrepancy suggesting that China is underreporting its inflation rate.
  • Chinese authorities have taken some steps to lower inflation, but they may be delaying more drastic measures to avoid instability before the 2012 transfer of leadership.
  • China has the second-largest economy in the world--accounting for one-third of global growth in 2010--so a Chinese hard landing would be very damaging to the global economy.

China's economy is overheating because for years capital has been flowing into the People's Republic much faster than it has flowed out. Recently, capital inflows to China have accelerated so rapidly that even the usual measures to absorb the impact on growth of the money supply and spending have failed. Given the legal restrictions on nongovernment capital outflow, the only way China can slow the growth of excess liquidity and the upward pressure on inflation that has been building since last year is either to let the currency appreciate faster, raise interest rates more, or raise reserve requirements more. These steps would discourage banks from increasing lending and would slow the rush out of money into goods--the spike in spending--that is driving up prices.

China could solve its inflation problem in a more fundamental way by allowing its residents to export capital--that is, to invest abroad. The fact that only the Chinese government is allowed to openly invest abroad--and is doing so at a rate that, while rising, is still too low to avoid accelerating liquidity growth and inflation--illustrates the growing need to allow its citizens to invest abroad on their own. The resulting mix of foreign investments would probably be an improvement over that of the government, which has tended to focus on US and European government bonds. Rising inflation pressure resulting from bottled-up excess liquidity inside China would be relieved by allowing more capital outflows.

Flawed Stance on Wealth Accumulation

On a more fundamental level, China is tracking what one might call the Asian "work, save, and invest" model that proved so unsuccessful for Japan after its economic boom period in the 1970s and 1980s. During those decades, its financial sector failed to develop, and Japanese citizens were discouraged from investing abroad. Inside Japan, investment-allocation decisions were made largely by government agencies that recycled household savings deposited in Japan's Postal Saving System and its sheltered banks. As a result, Japan's financial sector developed far more slowly than its production sector. Saving was very high, as in China today, so there was a huge supply of funds for the government to allocate inside Japan. The government agencies favored investment in Japanese manufacturing facilities, especially those in the export sector.

As Japanese citizens grew wealthier, by the 1980s they looked for ways to store and enhance the wealth they were accumulating as a result of their hard work. They invested in the Japanese stock market and even more vigorously in Japanese real estate. In the late 1980s, the Japanese real estate bubble grew so large that the emperor's palace in central Tokyo was said to be worth more than the state of California. Of course, the bubble burst a year later, and Japan entered a lost decade that included wealth losses equal to nearly three years of national income followed by persistent deflation and generally stagnant growth. These are problems that persist to this day in Japan, which sadly has a whole new set of problems from its recent tragic earthquake and related nuclear disaster.

There are numerous parallels between Japan's "work, save, and (badly) invest" pattern and China's experience over the past decade. China's real economy has become a powerhouse, reaching a level of output that qualifies it as the world's second-largest economy, having surpassed Japan's gross domestic product (GDP) last year. That said, China need not repeat the Japanese bubble-bursting experience, provided that it allow its citizens to develop diversified asset holdings abroad while encouraging growth of its financial sector, including growth of more internationally oriented banks, insurance companies, and investment products like mutual funds. While capital outflows from China might rise as wealth-storage facilities are developed inside the country, foreign competition and China's great store of entrepreneurial talent would encourage growth of a financial sector in China on par with its sectors producing goods and nonfinancial services.

Rising Inflation Pressure

The need to allow Chinese capital outflows unfettered by foreign exchange controls is growing more intense with each passing month. During the first quarter, China's foreign exchange reserves grew by another $197 billion, pushing total reserve holdings over $3 trillion. Because China was unable to sterilize the positive impact of money inflows (that is, neutralize their impact) on the growth of its money supply, inflation has accelerated while economic growth has remained at a level high enough to be generating more inflation. China's reported inflation on consumer goods rose to a 5.4 percent year-over-year rate in March, an acceleration from 4.9 percent in February. This is the highest inflation rate since July 2008 and is substantially above the level of 3-4 percent that China says it desires.

Moreover, there are suggestions that China may be underreporting its inflation rate. Recently, Chinese authorities reduced the weight of food in the country's index of consumer prices. That move reduces reported inflation, since foodstuffs constitute one of the most rapidly rising price categories in China and tend to account for most of the volatility in the inflation rate. Chinese food prices are also politically sensitive in view of the increased burden on China's lower-paid workers from higher food costs. Such increased burdens have already produced successful demands for sharp increases in China's minimum wage. The result of two double-digit increases in the minimum wage and other wage increases in China is to further exacerbate inflation.

China's actual inflation rate can also be inferred by comparing nominal year-over-year GDP growth and real growth, since nominal growth is the sum of real growth and the rate of inflation. In March, nominal year-over-year growth was reported at 18.1 percent, while real growth was reported at 9.7 percent. The difference, 8.4 percent, is the implied inflation rate, one that is substantially above the official 5.4 percent rate.

One of the major drivers of faster inflation is accelerated growth in money and credit. Here again, revisions to the data series have pushed down reported growth in M2, one of the more inclusive measures of money supply, in 2011. Even given that, the reported growth rate of M2 climbed to 16.6 percent year-over-year, up from February's 15.7 percent.

China's central bank, the People's Bank of China (PBOC), has attempted to lower inflation pressure by rapidly increasing the reserve ratio required of banks and by increasing one-year lending rates. Right after the report in mid-April of accelerating inflation, the PBOC boosted the reserve requirement ratio for major financial institutions to an unprecedented 20.5 percent, the tenth increase in the past year. Further, early in April the PBOC increased one-year lending and deposit rates to 6.3 percent and 3.25 percent, respectively. That said, even based on probably underreported inflation of 5.4 percent, the rate of return on deposits is still less than negative 2 percent once the inflation rate is subtracted from the 3.25 percent deposit rate.

None of the other economic data released in mid-April covering the month of March suggested any slowdown in China's rapidly overheating economy, despite aggressive tightening moves in the form of the boosts in reserve requirements and interest rates by the PBOC. Year-over-year GDP growth in March, as already noted, was 9.7 percent, even above the already-high expectation of 9.4 percent. Retail sales rose 17.4 percent, also above the expectation of 16.5 percent. Industrial production and investment indices were reported to be higher than expected, too. Residential investment, a favorite vehicle of wealth storage for Chinese investors unable to invest abroad, rose at a year-over-year rate of over 33 percent, while prices for units in newly constructed residential buildings in major cities continued to rise. These results are striking, particularly in view of policy efforts to slow the flow of funds into real estate.

Somewhat ironically, China's first steps toward expanding the international role of its currency, the renminbi, have intensified the already-rising inflation pressure inside China. (See the February 2011 Economic Outlook for further discussion of the internationalization of the renminbi and potential benefits for China and the global economy from liberalizing controls on the currency.) A broader international role for the Chinese currency, including a rising role as a medium of exchange and unit of account in lending and borrowing activities outside China, has boosted the demand for renminbi purchases from China. The result has been even more capital inflows to China and more growth of liquidity that is exacerbating Chinese inflation. Of course, if the renminbi were made fully convertible, in effect allowing free capital outflows, China would satisfy conditions for an expanding global role for its currency while simultaneously helping control its own inflation rate.

Taking Inflation Seriously

The intensity of the rising inflation pressure in China and the rising official concern associated with it is perhaps best captured by a change in the official Chinese tone on two important issues: allowing more appreciation of the renminbi, at least against the dollar, to moderate inflation pressure inside China, and a suggestion that the China Investment Corporation (CIC), China's sovereign wealth fund, is considering additional investments abroad. On April 19, the PBOC governor, Zhou Xiaochuan, suggested that China reduce its foreign exchange reserves because they exceed the level that the country requires. This unusual admission by the head of the central bank is a clear indication that capital inflows to China have become so rapid that they have exceeded the central bank's ability to sterilize them, that is, to neutralize their impact on liquidity growth and inflation inside China. The act of buying foreign exchange--that is, dollars--to prevent the dollar from weakening against the renminbi adds liquidity for the Chinese economy, and the head of China's central bank has now suggested that reserve accumulation needs to slow or be reversed. The only way to achieve that outcome is for China to buy less foreign exchange, which means the renminbi will appreciate faster.

Alongside Zhou's comments, the actual behavior of the renminbi against the dollar has suggested that China has decided to allow more currency appreciation to control inflation. Since last September, the renminbi has appreciated by about 4 percent against the US dollar, with markets expecting another 3 percent appreciation over the coming year. While such movement is modest, it represents a change in policy from the period that ended last summer, when the renminbi was kept at a rigid exchange rate against the dollar. Apparently Zhou's statement about excessive Chinese foreign exchange reserves reflects an intention to allow faster renminbi appreciation to counter rising inflation rates that threaten to destabilize China.

Just as significant is a hint from the chairman of the CIC that it is considering more investment overseas. The CIC receives its -capital from China's rapidly growing pool of foreign exchange reserves, which are in turn a result of rising currency intervention. If the CIC uses its foreign exchange allocation to invest abroad, that is the equivalent of official capital outflows from China, which would tend to mitigate the upward pressure on the renminbi. If the CIC wants to buy assets in the United States or Europe, it needs to buy dollars or euros. Still, the CIC is making the decision about what foreign assets to buy instead of Chinese private investors--who, driven by consideration of profit, might make better choices about where to invest.

China's Overheating May Continue

Despite currency appreciation, higher reserve requirements, higher interest rates, and hints of further foreign investment by the CIC, China's economy shows every sign of continuing to overheat. In effect, the Chinese authorities have been hesitant to move aggressively enough to contain accelerating inflation. China's wealthy are becoming increasingly restive as they seek alternative ways to store wealth outside China. There are growing indications of covert capital outflows--engineered by underreporting of export receipts or overreporting of outlays on imports--seeking investment opportunities outside China's overpriced real estate sector and negative real interest rates. Meanwhile, the Chinese have been more present in upscale art auctions over the past year and have become aggressive purchasers of fine wines and Ferraris. Of course, these are suboptimal ways to store wealth outside China, but China's strict controls on capital outflows tend to make such steps necessary.

It may be that the delay in efforts to slow China's inflation and risk a hard landing is due to a desire to avoid instability immediately before the transfer of leadership inside China that will occur in 2012. This concern may account for some of the efforts to manipulate data to make inflation and money growth appear less intense than they are.

China's next premier, Li Keqiang, has said that Chinese statistics, especially GDP statistics, are "man-made" and intended "for reference only."[2] He prefers to look at real numbers for activity like electrical consumption, railway freight, and credit growth, all of which are rising strongly. However, such candor as Li's suggests that Chinese statistics may become less reliable over the coming year. The pressure for Chinese overheating is likely to continue.

There is a serious problem with delaying the implementation of policies strict enough to curb China's accelerating pace of inflation. As inflation rises, it begets more inflation. Producers, anticipating higher prices for products, bid more aggressively for raw materials. Households, fearing higher prices, begin to accelerate purchases and resort to hoarding storable commodities and goods whose prices are expected to keep rising. Evidence of accelerated moves toward more inflation and spending is contained in the latest data reports discussed above.

While it may be politically expedient to delay adequate tightening measures to contain China's rising inflation pressure, it would be unwise. Experience shows that once households and firms see signs of accelerating inflation coupled with an official hesitancy to rein it in, they respond in ways that push up inflation even more rapidly. The result--a need for belated, aggressive tightening that could precipitate a hard landing for the Chinese economy--is an outcome whereby bad economics also produces a bad political situation. Further, a Chinese hard landing would be very damaging to a global economy that is facing headwinds while recovering only at a modest pace.

China, as the world's second-largest economy, has outgrown its financial system, which offers too little in the way of wealth-storage facilities for residents who are rapidly adding to their wealth with their hard work, entrepreneurial spirit, and high saving rate. It would be far better to let Chinese investors export capital and to encourage more rapid development of the financial sector. China and the world economy would both benefit from more diversified Chinese investment and reduced imbalances. The new generation of Chinese leadership should seriously consider an expanded global role for its currency and its financial sector. Such a new set of policies would enable China to avoid the "work, save, invest" pattern, culminating in investment bubbles, that has caused Japan so much pain.

John H. Makin ([email protected]) is a resident scholar at AEI.

Notes

1. Financial Times, April 25, 2011.

2. This remarkably candid comment along with some doubts about possible biases in recently revised Chinese statistics was reported by Logan Wright and Daniel Sternoff of Medley Global Advisors in an April 14, 2011, note to clients.

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