Tuesday, May 13, 2008

The Not So Brilliant Chinese Leaders

When I last analyzed the Chinese economy, I noted that during the first quarter China was hit by a negative supply shock in the form of severe winter weather. But as the winter weather was highly unlikely to continue during the second quarter, I reckoned China's growth would pick up again during the second quarter. Now China has been hit by another negative supply shock. Not cold and snow, but an earthquake. The main effect of this earth quake is of course mass deaths and suffering, but it will likely also have an effect on the Chinese economy similar to the severe winter weather in the form of lower growth and higher inflation.

At the same time, growth in domestic demand seems to be picking up as retail sales grew at a record 22% rate in nominal terms. The combined effect of the negative supply shock and rising growth in domestic demand is that price inflation will likely stay high. To combat this, Chinese leaders are mainly relying on raising bank reserve requirements.

At the same time, Chinese leaders are noting the conflict between on the one hand reducing demand to reduce inflation and on the other hand boosting consumer demand to reduce dependence on exports. To quote People's Bank of China leader Zhou Xiaochuan:

"On the one hand, we need to boost consumption to adjust the economic growth structure, but on the other hand we also need to prevent excessive demand from fueling inflation."

It seems that Zhou must have failed his international economics class. There is in fact one way of solving this apparent conflict, one way to increase consumer demand without increasing overall demand. Namely, to let your currency rise in value. That will boost consumer purchasing power and so help rebalance the Chinese economy, while not increasing overall demand as it reduces net exports. But after accelerating the rate of appreciation earlier in the year, the yuan appreciation has stalled in recent weeks. Chinese leaders should again accelerate the rate of appreciation (or better yet make a really big one off revaluation, or even better, allow the yuan to float) if they want to decrease the dependence on exports while containing price inflation.


Blogger Reginald said...

I believe China to be the true source of global inflation in regards to the excess supply of US dollars. According to the Federal Reserve’s statistics the inflation rate under M1 is mostly benign, if not tight. The Fed’s exchange of its limited supply of treasuries for MBS is not inflationary; that will of course change once the Fed begins purchasing treasuries to replenish its limited supply. Also, US banks are overall making fewer loans, which decreases bank credit in the economy (the main source of inflation). Thus, it must be an even larger drop in *demand* to hold US dollars for the rise in prices. In the past China not only lowered prices with an increase in goods, but its Chinese bank had an accelerating demand for US dollars under a fixed exchange rate policy. All of that has changed with the yuan’s appreciation. The consequence is not only do Chinese exports rise in price for Americans, there is also a significant drop in demand to hold US dollars in aggregate due to China’s huge trade surplus with the US. The excess supply of US dollars no longer has a home at the dubious Chinese central bank, but traverses the world driving up prices in everything priced in the same currency. In addition, Chinese politically connected banks are essentially ignoring bank reserve requirements, expanding bank credit (the main source of inflation), and finally forcing China’s central bank into a corner of letting the yuan appreciate. Other than gold, China will likely emerge with the strongest currency in the world, unless the dubious central bank can stop the much needed deflation that will entail.

2:56 PM  
Blogger stefankarlsson said...

Reginald, M1 is a far too narrow measure of money supply. For reasons I've explained several times on the blog I prefer MZM as a money supply measure. And MZM has been increasing rapidly, and so has bank credit if you look at the actual statistics.

So it is in fact the Fed that is the source of inflation. Still, it is true that China as a source of price deflation is decreasing in importance.

8:06 PM  

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