Tuesday, June 27, 2006

Look, I am one of the few people today who believes that serious inflation is possible in China. I have also spent much of my short career examining inflation hawks in China. Nonetheless, I find it amusing when people periodically "discover" a monetary over-hang in China, even though it has existed since 1981. Besides underreporting of GDP figures, there are two further factors that explain this inflationless (relatively) over-hang. First, as more and more commodities and goods in the economy are monetized, the economy simply needs more money to deal with the increasing volume of transactions. But as government officials have told me, we are now in the final stages of monetization, with land being the final good to be monetized. So, people in the government are a bit worried about this. Furthermore, there is still a sizable amount of capital flight, especially from corrupt officials. I have no idea whether today it is statistically significant, but it once was very significant.

I do agree with the author of the following article that the political price of stopping inflation, at least in the old way of "one-knife cut" lending freeze, is likely to be higher today than previously. Before, state provision of housing, food, and jobs provided a cushion for many city dwellers during monetary contractions. This is likely not the case today. However, the PBOC has at the same time developed many more tools to fight inflation beyond just lending freeze. As current policies demonstrate, measures like raising interest rates, reserve requirement, and sterilization are somewhat effective, although we cannot rule out lending freeze at some point if inflation really picks up.

Trouble Is Coming to Beijing

By David Frum

National Post (Canada)
Publication Date: June 24, 2006

At a financial conference in the Rockies a few days ago, a leading American economist presented a simple formula to attendees:

Over the past 12 months, China's money supply (cash plus bank deposits) has grown by 17%.

Over that same period, China's economy has grown by no more than 10%, and probably less.

If we assume that Chinese people have no greater willingness to hold Chinese cash today than they did a year ago, it follows that China's reported inflation of 1.4% is dramatically understated. The real inflation rate must be at least 7%, probably more. And indeed, the signs of inflation in China are widely reported: surging real estate prices, shortages of gasoline and other basic goods, intensifying wage disputes.

Too bad for them, you might be tempted to say.

But the problems of the world's biggest country have a way of becoming problems for the whole planet. And so it is with China's inflation.

China's inflation, like all inflations, has been created by China's government. The government of China wants a cheap currency, to keep the exports growing, the factories turning--and the workers quiet.

But in the self-balancing international financial system, a country that exports a lot will sooner or later see its currency go up--just as a country that imports a lot will sooner or later see its currency go down.

The Chinese Central Bank has invested hundreds of billions of dollars to build a seawall against the economic tides. Rather than let the yuan rise, it has printed hundreds of billions of dollars worth of them and used them to buy US dollars. That keeps the dollar up, American interest rates down--and American consumers buying.

It is a vast transfer of wealth from China's poor to America's rich.

The side effect of this export-friendly policy however is to create much more Chinese money than anybody wants inside China or outside. And when you have too much of something … its value declines. When that "something" is money, that decline in value shows up as inflation.

China could stop its inflation anytime by printing fewer yuan--but only at a political price. The currency would begin to appreciate against the dollar. China would export less, and Chinese real estate would decline in value. Workers would lose their jobs; recent purchasers of apartments would see their investments decline in value. Chinese citizens--80% of whom now tell pollsters that they are satisfied with the way things are going in China--would suddenly begin to express anxiety, discontent, and ultimately dissent.

Meanwhile, doing business in China would become more costly and the flow of foreign investment dollars would slow--as would China's overall economic growth and its hope of gaining ground on the United States.

Thus far, China's future looks very like Japan's recent past. Like China, Japan chased growth in the 1970s and 1980s with an artificially cheap currency. Like China, Japan suffered accelerating inflation in the 1980s: at one point, the 250 acres of the imperial palace complex in Tokyo were estimated to be worth more than all the land in California. It all came to an end in 1989. The yen rose, real estate values crashed, exports slumped, workers lost their jobs, and the Japanese political system unraveled.

But Japan possessed one great resource China lacks: democracy. The Liberal Democratic Party, which had governed Japan since 1955, lost power in the election of 1993 after Japan's free press exposed a huge party-financing scandal. The shattering defeat forced the LDP to embrace economic and political reforms.

China's press, however, is not free. Chinese scandals (at least those involving the ruling elite) go uncovered. Chinese citizens are offered no peaceful avenue by which to change rulers whose policies fail. Which likely means that China will remain politically stable only so long as its rulers succeed.

So far, those rulers have delivered success--almost uninterrupted success over a decade and a half. And who know? Perhaps they will continue to succeed. But if and when they fail--expect trouble.

Indeed, the trouble may already have started. The Chinese government reports a rising number of disturbances in the country: 58,000 protests or strikes involving more than 100 people in 2003, 74,000 in 2004, 87,000 in 2005. Exactly why the repressive Chinese state has decided to publicize this number cannot easily be understood. Perhaps it wishes to frighten an anxious middle class into rallying to the Communist party as a bulwark against disorder. Perhaps it wishes to frighten economic elites into accepting policy changes. Or perhaps it wishes to obtain international acceptance of harsher internal policing.

Whatever the motive, the conclusion seems apparent: There is trouble coming in the world's largest country. And it will affect us all.

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