China Domino

27 May 2011
Economics
Beyond the Cycle
www.sgresearch.com
Inflation Themes
The China Domino has Fallen!
The evolution and persistence of inflation in China and its consequences.
Chief Asia Economist Glenn B. Maguire (852) 2166 5438
glenn.maguire@sgcib.com
I am sure you have heard about it. Indeed, you have probably helped spread it. I have! The whispers of policy makers, economists and market players all suggest a new Domino Theory is being conjured up. This time it is inflation, not communism, that will inevitably topple all over the globe. As China moves into a cycle of generating autonomous structural inflation, it is widely anticipated that China will export this inflation to the rest of the world. Like any other economic variable in China it comes as no surprise that the nature of inflation is changing. Since 1978, as China engineered a historically unprecedented urbanisation and industrialisation path, both in terms of scale and velocity, the drivers of Chinese inflation have also been changing. In each of Chinas five major expansionary policy cycles, inflation has been the consequence. It appears that Chinese policy makers have not fully learnt the lessons of these lessons. High-powered money creation and/or broader monetary growth led by investment booms have been at the heart of all inflation cycles. They are clearly the leading culprit in Chinas current inflation cycle. Beijing has over relied on quantitative tightening, price capping, and regulation to contain inflation. That has not only failed to solve the medium term inflation problems but also create allocative inefficiencies given the mispricing of prices including interest rates and the yuan. The proportion of Chinas inflation that is structurally determined has ratcheted higher over previous expansionary cycles. Indeed Chinas ambitious 12 Five-Year Plan is
th
China Economist Wei Yao (852) 2166 5437

wei.yao@sgcib.com
Senior Asia Economist Joseph Lau (852) 2166 5441

joseph.lau@sgcib.com
Research Associate David Tam (852) 2166 5436
inherently inflationary. Inflation is the natural consequence of rebalancing. These developments have profound global consequences. The enormous outward shift in the global economys supply curve that came with Chinas WTO accession and the army of millions of workers it added to the global labour force has come to an end. A better balance of expenditures in the Chinese economy will engineer an outward shift in the global demand curve. In the post-crisis world we would suggest that the global supply curve has become more inelastic. That is, it has steepened and has a lower propensity to shift out further. Hence, the faster China rebalances, the greater the inflation it will generate.
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Inflation Themes
Contents
A new domino theory. ................................................................................................................................................................ 3 The first domino. Chinese inflation .............................................................................................................................................. 5 Changing drivers of inflation in China .................................................................................................................................... 6 From mahjong to dominos ............................................................................................................................................................ 7 Chinas five inflation cycles ....................................................................................................................................................... 7 Early days: Chinas three cyclical inflation waves. .................................................................................................................. 8 Cycle 1: 1987-89. China comes perilously close to hyperinflation. .................................................................................... 8 Cycle 2: 1993-94. Deng Xiaoping overstimulates the economy. ........................................................................................ 8 Chinas unusual deflation episode: 1998-2001...................................................................................................................... 9 Cycle 3: 2003-04. The first inkling of structural inflation ..................................................................................................... 9 Cycle 4: 2007-08. Food demonstrates its weight ............................................................................................................... 10 Cycle 5: 2010-??. China enters a new inflation paradigm .................................................................................................... 10 Why the fifth cycle is different? ............................................................................................................................................ 11 Not even China can escape Friedmans monetarist dogma. .............................................................................................. 13 SGs model of Chinese inflation key inputs.......................................................................................................................... 14 The arrival of structural inflation! ................................................................................................................................................ 15 Urbanisation, surplus labour and Lewisian turning points ..................................................................................................... 15 History is replete with lesser examples of the China episode ............................................................................................ 15 China is urbanising at a faster pace than previously thought. ............................................................................................ 15 Is Chinas move to structural inflation really that unique? ..................................................................................................... 16 China has reached its first Lewisian turning point .............................................................................................................. 17 However, the second Lewisian turning point is a long way away. ..................................................................................... 17 Productivity differentials square the hole ............................................................................................................................... 18 The productivity gains of urbanisation ................................................................................................................................ 18 Wage efficiency & productivity will prevent manufacturer flight ............................................................................................ 19 Urbanisations contribution to inequality prompts faster minimum wage gains ............................................................... 19 Urbanisation now involves two-way flows of labour and capital. .......................................................................................... 20 Labour flows outwards and capital flows inwards. ............................................................................................................. 20 The catch-up to developed world living standards may be surprisingly quick .................................................................. 20 Are commodity prices now structural determinants of Chinese inflation? ............................................................................ 21 Chinas liquidity legacy ............................................................................................................................................................... 22 Why has China printed so much money and, more importantly, why does it continue to do so? ....................................... 22 Has policy error contributed to inflation in this cycle? ........................................................................................................... 23 Is the PBoC slow in response? Yes and no. ........................................................................................................................ 23 The limitation of quantitative tools....................................................................................................................................... 24 Rate hikes have to step up, but now is not a good time ..................................................................................................... 25 The right cures: fiscal tightening and a new currency regime ............................................................................................... 26 What next? ................................................................................................................................................................................... 30 Global inflation dynamics are changing .................................................................................................................................. 30
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Inflation Themes
A new domino theory.

Proving that you can fool most of the people most of the time, the domino theory was promoted by various US administrations as a justification of US intervention during the Cold War period of the 1950s to 1980s. The theory was hardly rooted in any serious politicaleconomy school of thought. As an example, referring to communism in Indochina, U.S. President Dwight D. Eisenhower put the theory into words during an April 7, 1954 news conference: Finally, you have broader considerations that might follow what you would call the "falling domino" principle. You have a row of dominoes set up, you knock over the first one, and what will happen to the last one is the certainty that it will go over very quickly. So you could have a beginning of a disintegration that would have the most profound influences. Indeed, Eisenhower went on to argue at that April 1954 news conference that the fall of Vietnam, would eventually lead to the fall of French Indochina Burma, Thailand and Malaysia. Just as the dominoes impressively and relentlessly topple in those game shows hosted by Japanese university students, the domino theory postulated that Japan, Taiwan, the Philipiness, Australia and New Zealand would be next. Really? I mean really? Whilst we suspect that most conservative western policy makers struggle with the expectations augmented Philips Curve that postulates an inverse relationship, that is a policy trade off, between the unemployment rate and inflation, could you just imagine the policy implications of the new domino theory? Would Ben Bernanke and Tim Geithner have to express their preference for the right mix of communism and inflation at their confirmation hearings? Would the Beige Book, in fact, be a Red Book? Would the World Trade Organization (WTO) finally be empowered with the policy teeth to vigorously pursue anti-dumping legislation against cheaply built and inherently unstable dominoes? In our interactions with clients, peers and policy makers, we note a growing concern that the decoupling of emerging markets in the post-global crisis period may morph into these new engines of growth being engines for inflation. Given the worlds reliance on China as the lowest labour cost assembler, if wages, inflation and the exchange rate in China are all rising quickly, the structural inelasticity of supply poses problems for the rest of the world. Quite simply, the domino theory of 2011 is that when China comes under the influence of inflation, the surrounding countries, those with the most immediate trade ties, would also fall to inflation. It will only be a matter of time till those economies with the greatest trade ties; indeed the entire world has succumbed to the great inflation cascade emanating from China. Here is how the dominos will fall. The first domino is China creating autonomous structural inflation: Chinas domestic inflation accelerated at an unprecedented pace at the end of 2010 and policy makers remain well behind the curve. As China engineers its economy to a more domestically focused one, its demand curve is shifting outwards and the global supply curve has been inelastic in response. That domino has already fallen and is the focus of this paper.
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The second domino to fall is proffered to be that China will then export this inflation to the rest of the world. This dynamic seems as inevitable as gravity itself. The multi-decade process of globalisation now sees China and every other economy in the world in a nebulous web, intertwined on so many levels. The course of Chinas rebalancing; the course of Chinese inflation in particular, will have a profound effect on the rest of the world. With a growing risk of pricewage spirals in the emerging world, there is a chance that inflationary pressures could surface in the US. After all, emerging Asia exerted significant downward pressure on US core inflation over the past 15 years. We believe that those secular forces are starting to reverse. To be sure, China has already been exerting pressure on US upward headline
The second domino. China CPI leads US core goods CPI
10 8 6 2 China CPI (LHS) US Core CPI ex services, lagged by 20 months (RHS) 4 3 5
4
2 0
1 0 -1
-2 -2
-4 00 02 04 06 08 10 12
Source: Global Insight, SG Cross Asset Research/Economics
-3 -4
inflation in recent years by pushing up prices of energy
and industrial metals. More recently, this has spread to food and cotton prices. Could manufactured goods be next? The Chinese price-wage dynamic certainly points in that direction. To use the USA as an example, see the chart above, to the extent that Chinese import prices begin to rise, this gives US producers a bit more pricing power. These knock-on effects take a while to materialise, hence the 20-month lag between Chinese CPI and US core goods CPI (the lag to US import prices from China is much shorter, at just 4 months). Therefore, this is not a risk for US inflation in 2011, but one we should be more alert to 2012. The second domino is in the process of falling. The third domino is teetering. With domestic inflation rising in China and the pace of Yuan appreciation stepping up in Q2-11, China looks set to export its inflation to the rest of the world. Import price indices from China, for the developed economies, are turning up and given the stickiness of supply, the world will remain a China price-taker. That is, the past two decades of outsourcing that turned China into the worlds factory were long term trends. Manufacturing production cannot simply be transplanted quickly to another economy. For the global economy, the positive supply side shock that occurred with Chinas WTO accession has now, at the very least being halted. Chinas policy of rebalancing its own economy more towards domestic growth now sees China engineering an outward shift in the global demand curve. The first inflation domino has tipped, how many more will follow? This paper looks in detail at the first domino.
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The first domino. Chinese inflation

In this thematic, we present an analysis of Chinese inflation in three parts. First, we look back and examine the lessons China should have learnt from its previous Money Supply, Investment and Inflation nebulas. Second, we look at the relative performance of Chinas inflation in this high growth period to similar periods in Japanese and South Korean economic evolution. Finally, we analyze the liquidity dynamics of this inflation cycle and conclude that the tools that the Chinese government has been adopting are not sufficient and efficient to tackle inflation. Inflation accelerated over 2010 at the fastest rate ever. Most significantly, this fifth cycle shows the broadest price pressures of any previous inflation cycle. Inflation expectations are rising rapidly and as a part of rebalancing are likely to embed at a higher level than has been the case previously. As a surplus economy, we do not believe that China has moved through its Lewisian turning point and as the capital stock has grown significantly under the recent stimulus package, it therefore takes large, persistent and sustained growth in demand to push inflation above its trend. China has closed its output gap for some time, and statesponsored wage increases are contributing to a significant demand-pull inflation dynamic. This is augmented by a fairly broad cost-push dynamic across a whole range of goods. We note that South Korea and Japan tolerated higher levels of inflation during their corresponding periods of rapid urbanisation and industrialisation. Indeed, given the stark difference in real exchange rate behaviour over these periods, South Korea and Japan may well have adopted inflation as a policy choice to more rapidly converge prices and living standards towards developed economy norms.
Growth is running above potential
Real GDP YoY - SG Forecast
YoY% and HP-Trend
Inflation is above, and will move further above, trend

Inflation - SG Forecast
YoY % and HP-Trend
16 14 12
10 8 6 4
10
2
8 6 Jun-1995 Jun-1999 Jun-2003 Jun-2007 Jun-2011
0 -2 Jun-2001
Jun-2003
Jun-2005
Jun-2007
Jun-2009
Jun-2011
Source: CEIC, SG Cross Asset Research
At the macro level, we still find China to be a surplus economy in terms of both labour and capacity. At the micro level we find important determinants of frictional or more structural inflation including skills mismatch and a productivity deficit relative to income growth. Besides, the monetarist nightmare of torrid money growth and a poorly policed shadow banking system that continues to siphon high-powered money into the real economy and the capital market. This, following the greatest counter-cyclical stimulus exercise of all
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time as China threw its entire banking system at arresting the exogenous shock of the 2008 financial crisis, is Chinas Legacy Issue just as public debt is Europes. What should the government do about inflation? The government may have to tolerate the higher structural inflation as Japan and Korea did. However, higher trend inflation makes their job more difficult, as additional cyclical factors could easily boost the inflation to uncomfortable levels. In current cycle, we think the administrative and monetary policies that have been adopted so far are either sufficient or efficient in addressing the inflation problem. Eventually, faster Yuan appreciation is needed. A rapid appreciation, along with some oneoff revaluations of the Yuan, may be the perfect antidote to Chinas inflation problems. But for the rest of the world, that antidote will see China export its endogenous inflation as an exogenous shock to the rest of the world. The bitter backwash that the rest of the world must swallow of monetary and fiscal policy normalisation will be all the more sour with some Chinese flavoured inflation added to the brew.
Changing drivers of inflation in China

Domestic liquidity conditions to remain loose for sometime given constrained monetary policy tools that are reaching their effective limits. The positive output gap narrows or closes on a bumpy path as growth returns to trend. Inflation expectations continue to rise and remain highly sensitive to high frequency purchases such as food. Capital inflows to remain persistently strong if yuan continues to appreciate at gradual pace. Yuan determination mechanism is expected to move away from a crawling peg to a more flexible mechanism. Food and Energy: China is moving into a period of structurally higher demand for food and energy as a result of urbanisation.
Inflation Cyclical
The cyclical part of this inflation cycle will be much more difficult to contain, due to the liquidity legacy created in past two years and continued strong appetite for investments.
Inflation Structural
We now find increasing evidence that a growing proportion of Chinas inflation is structural. This will provide a floor, or base, that means headline inflation (structural + cyclical) will trend higher.
Urbanisation: we expect urbanisation in China to continue at a rapid pace, driving housing growth and therefore, demand for materials and resources. Income: continues to increase on the back of mandated minimum wage increases that are now approaching 20% yoy. Potential Growth in China will fall in coming years as the economy matures. High labour productivity growth may be hard to sustain if inward foreign direct investment slows.
Know your traffic signs: Stay Alert. Potential Problem. Source: SG Cross Asset Research/Economics.
Needs to be better controlled.
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Inflation Themes
From mahjong to dominos

Chinas five inflation cycles
China has had five significant inflation cycles and each have common culprits.

Been preceded by a significant acceleration in money supply growth.
The second derivative of CPI (that is the acceleration or deceleration in inflation) has turned positive coincidentally with negative real deposit rates.
Administrative measures, such as price capping, RRR hikes and interest rate hikes have not
been successful tools in containing inflation in previous cycles. First, lets revisit Chinas previous cycles so that we can examine in more detail what makes this fifth cycle unique.
Chinas five inflation cycles
Five Inflation Cycles
CPI YoY%
30
25
20
15
10
-5 1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
Source: CEIC, SG Cross Asset Research/Economics
The structural underpinnings of inflation in China have become apparent in the third and fifth cycles. In the third cycle, 2003-04, productivity growth fell below wages growth as the credit crunch following the 2001 US recession led to a marked slowdown in FDI into China and the
productivity lifting technology and skills transfer that went with it. The fifth cycle, 2011-12, is again marked by wages growth overtaking productivity growth, but the distinction is that Chinas marginal worker now appears to be moving through the
tipping point of subsistence spending and into discretionary spending. This has led to a structural shift (to the right) in the demand curve of Chinese households for goods such as consumer staples, food and clothing; which continue to have an upward sloping supply curve. Indeed for many of these goods, or their commodity inputs, supply curves are quite steep, if not inelastic due to physical and finite constraints on resources.
The crucial dynamic that differentiates the fifth cycle is the Legacy Issue of Chinas own
version of quantitative easing, which used the commercial banks as fiscal agents to pump liquidity into the real economy. The increase in the money supply by around 40% of GDP over the course of 2009-10 was simply unprecedented. Chinas liquidity problem is endogenous and cannot be adequately tackled with existing policy tools. Maintaining a targeted exchange rate has significantly reduced Chinas scope for
monetary policy, as the Mundell-Fleming trilemma would suggest, most evident in rising inflation and the failure to fully sterilise hot money inflows.
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Inflation Themes
Early days: Chinas three cyclical inflation waves.

Chinas first three inflationary cycles were cyclical. In the two decades following Deng Xiaopings modern economic reforms, China displayed persistent boom-bust cycles through which periods of unsustainably high economic growth were followed by periods of overtightening, austerity and slower growth. Deflationary episodes however, were the exception, not the rule. Chinas inflation and growth cycles in these two decades closely track the broader pattern of the political-economic business cycle. Expansionary and inflationary phases have typically accompanied significant decentralising reforms and relaxed administrative guidance to both the industrial and financial sectors. Indeed, the expansionary and inflationary phase of the cycle has often accompanied significant institutional reforms, with policy kept too lax in order to accommodate these reforms. In these early episodes; transport and energy, or more generally, capacity bottlenecks were the first warning signs that inflation was building up a considerable head of steam. They were also usually a prelude to the subsequent overtightening of policy, slower pace of reform and halting of the decentralization process.
Cycle 1: 1987-89. China comes perilously close to hyperinflation.

Monetary supply growth accelerated dramatically after the 1984 National Party Congress, which rubber-stamped many new reform packages and spending initiatives. Overheating of the economy became apparent in 1985 and the government adopted counter-cyclical policies in an attempt to cool the economy. Fears that policy had over-tightened were unfounded and the subsequent loosening of monetary policy in 1986 became strongly pro-cyclical. This was early days for Chinese policy makers so we should not be surprised that policy error played an important role in contributing to the inflation dynamic. The governments decision to liberalise the price system in an attempt to contain inflation had the opposite effect, exacerbating the situation. As one of Chinas first strong inflation dynamics, inflation expectations became unhinged and panic buying and hoarding of goods immediately after price liberalisation pushed inflation to its cycle peak of nearly 30% yoy. Lessons Learnt: Policy was too slow to react as policy makers were focused more on the yoy change in inflation, rather than the actual sequential developments in inflation. Price liberalisation is not necessarily an appropriate tool to contain inflation. expectations are real and powerful. Finally, inflation
Cycle 2: 1993-94. Deng Xiaoping overstimulates the economy.

Deng Xiaopings famous 1992 tour of the southern provinces achieved many things. Unfortunately, a perilous flirt with hyperinflation was one of them. The 1993-94 inflation cycle has many similarities to the present cycle. First of all, China faced an exogenous shock that significantly curtailed its export-led growth model. The Tiananmen Square incident of 1989 saw almost universal trade sanctions imposed against China and the government had to respond by stoking domestic demand. Using the banks as fiscal agents, lending for real estate and other investments, particularly in Southern China, where the first Special Economic Zones were located, surged over the course of Dengs mandated investment boom.
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Inflation Themes
Again, inflation expectations became unhinged, particularly as food prices started to rise dramatically. China had a de-facto food security policy so that substitution of domestic production with foreign production was not automatic. Moreover, with trade sanctions in place, this was not possible at the time anyway. With grain prices, in particular, soaring, farmers began to hoard grain and were unwilling to sell it into the Chinese market in 1994. This combination of hoarding, which was not only a grain dynamic but more general across all food produce, strongly exacerbated the upswing of the inflation cycle. Lessons Learnt: Food inflation is a particularly powerful dynamic in China when unleashed, complicated by Chinas political reluctance to import food. Inflation expectations, again, are very powerful dynamics. On the demand side, they can lead to panic buying as in the 198788 cycle. The 1993-94 cycle also demonstrated that inflation expectations can work on the supply side with suppliers withholding stock in anticipation of even higher prices in the future. When both of these dynamics combine, the inflationary consequences can be profound; indeed, this was one episode where China ventured very close towards hyper-inflation.
Chinas unusual deflation episode: 1998-2001.

From an historic standpoint, Chinas deflationary episode from 1998-2001 appears to have been one singular sensation. It certainly doesnt suggest that the Chinese economy has had binary price dynamics previously, that is, it either had inflation or deflation. The episode is explained purely by supply and demand dynamics at the time. In the lead up to WTO ascension in 2001, China departed from its social contract with its proletariat workers to an unprecedented degree. To ready State-owned enterprises (SOEs) for participation in the global trade arena, massive job shedding and investment in new plant and equipment occurred over this period. This is perhaps the only episode where Chinas supply
Massive decline in employment
No of Employee: State Owned
Person mn
110 105 100 95 90 85 80 75 70 65 60 Mar-1995 Mar-1999 Mar-2003 Mar-2007 Mar-2011
Source: SG Cross Asset Research
capacity has raced well ahead of actual demand. In short, deflation was triggered by a classic over-supply problem.
Cycle 3: 2003-04. The first inkling of structural inflation

This is the first example of structural inflation emerging in China. China has been able to sustain double digit wages growth for several decades as its productivity has grown so rapidly and its demographics have been so favourable. One of the key inputs into Chinese productivity has been Foreign Direct Investment and the technology transfer and skills transfer corresponding with that investment. China is somewhat unique in this case, in that its rules on FDI are quite strict and facilitate a rapid transfer of new technology and skills. Indeed, it is not uncommon for a new SOE, or State-sponsored enterprise to open shortly after a foreign enterprise is established, producing very similar goods with very similar technologies (i.e. reverse engineering of imported technology) and enjoying all the benefits of State support, including not having to remit profits as dividends. One of the readily observable dynamics following a credit crunch is the abrupt slowdown in foreign direct investment, particularly that FDI originating from the developed economies. After the tech-wreck recession of 2001, US foreign direct investment into China slowed
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markedly in 2002-03. As a result, Chinese productivity growth waned below that of wages growth in 2003-04 and a structural pick up in inflation was the result. Lessons Learnt. Rapid income growth is all well and good, but productivity growth must remain firm.
Cycle 4: 2007-08. Food demonstrates its weight

The inflation dynamic of 2007-08 was another episode where Chinas de-facto food security policy did more harm than good. There are a range of policies a hangover from the Mao Zedong era that maintains China should be able to feed its domestic population entirely with domestic production. So, when the supply of the major protein staple in the Chinese diet was sharply curtailed, as millions of pigs died of the blue ear virus, China did not
Food inflation and the CPI
Food Inflation is not Hogwash
25
20
15
10
-5 Mar-2001
Mar-2003
Mar-2005
CPI YoY
Mar-2007
Food Inflation YoY
Mar-2009
Mar-2011
resort to importing frozen pork from other countries. Instead, it encouraged farmers to rapidly rebuild their pork breeding stocks. Lessons Learnt. Once again, given its high weighting in the CPI basket, food inflation is a powerful dynamic in China. Its ability to unhinge inflation expectations is particularly robust. Price capping does not work when there is a significant and genuine hit to supply. Substitution policies have to be introduced at this time. Lifting reserve requirements ratios or interest rates will not boost the supply of pigs.
Cycle 5: 2010-??. China enters a new inflation paradigm

As of March 2011, inflation is showing unprecedented breadth and considerable momentum in China. The State-sanctioned investment boom engineered in November 2008 is still running and Chinas demand for the worlds bulk commodities remains particularly high. At the same time, the attempt to rebalance the economy away from investment/exports towards consumption, facilitated by hefty minimum wage increases, is triggering significant first time demand from Chinese households for cloth, higher calorific content food, and cheap domestically produced consumer durable goods. All this has been a pretty heady mix for inflation, which hit a 32-month high of 5.4% yoy in March. From a cyclical point of view, there are most probably four factors behind the current inflation cycle. First, the cyclical rebound from the global slowdown where China appears to have led the recovery. Second, the ultra-expansionary monetary policy of the advanced economies is being imported via the exchange rate mechanism. Third, the extraordinary fiscal policy support that China created itself. Finally, higher commodity prices as a result of generous liquidity conditions globally and the investment-led nature of fiscal stimulus globally, but particularly in China.
10
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This current price cycle is different from 2007-08

% YoY
Narrower dispersion indicates broader-based inflation

Sum of squares 2002-04 2006-08 2009-10 324.1 901.4 231.2 1,368 327.1 10,310 88.2 113.9 1,815 418.4 983.7 543.4 6.4 445.3 50.7 263.1 735.8 156.0 710.3 1,106 501.3 133.4 293.8 374.0 237.1 355.1 40.9 107.4 609.0 372.0 2,400 1,453 501.3 195.4 2,889 280.3 F-test statistic 2002-04 2006-08 2009-10 10.2 20.7 4.9 23.1 9.7 10.0 8.3 2.8 20.3 15.4 23.1 22.4 1.7 43.8 1.3 12.4 20.4 3.7 32.1 11.8 1.9 5.7 8.3 5.4 6.3 2.2 0.4 4.8 15.9 3.8 54.8 13.9 1.9 4.0 12.6 2.5
25
20
CH CPI: Headline CH CPI: Food CH CPI: Energy CH CPI: Housing
15
10
5
0
-5
-10 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
CH HK IN ID JP KO MA PH SG TA TH VN
Note: Statistical variance between food, housing, energy and non-durable components of inflation during past three inflationary cycles; the smaller the test statistic, the higher degree of covariance between drivers.
Why the fifth cycle is different?

We must stress that the fifth and current inflation cycle is not just a food dynamic as many believe. The Fifth Cycle is a much more broad based inflation impulse than any of the cycles that went before it. In the table above, we conduct an analysis of variance of the major subsets of the consumer price basket. For all of Asia, the dispersion of inflation in the various subsets is much lower than the 2006-08 cycle, but this is particularly the case for China. As the table above shows, the dispersion of inflation in the various sub-sets of the CPI has fallen sharply. That is, inflation is more uniform and broadly based than in previous cycles. Though it may sound technical overkill, if we take the third-difference in Chinas CPI, which is the rate of change of the rate of change (i.e. how fast Chinese inflation is accelerating), we can see that at no time in Chinas modern economic history has inflation built up such formidable momentum.
Trend inflation to be higher as China rebalances The consequence of lessons forgotten. Inflation accelerated over 2010 at the fastest rate ever.
Third Difference in the CPI
60 50 40 30 20 10 0 -10 -20 -30 -40 -50
160 140 120 100 80 60 40 20
China CPI 2001=100
0 1991
1995
1999
2003
2007
2011
1985
1990
1995
2000
2005
2010
The fundamentals in this current inflationary cycle are different from the 2007-08 period, but there are passing similarities. The food price dynamic is the most obvious common characteristic between the two cycles, albeit the current one is still well short of the highs seen in 2007-08. Yet this inflation cycle is also more broad-based than in 2007-08 with the dispersion of inflation components being considerably tighter this time. With the exception of energy, this confirms that China is experiencing a more general rise in the price level in this cycle, while the fourth cycle of 2007-08 was almost singularly a food inflation dynamic,
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supplemented by an exogenous energy price event, which eventually led to wider pressures for pass-through to a range of goods derived from energy or food. Government policy, however, does appear to have been more successful in the fourth cycle than in the previous cycles. Inflation peaked five months before the Lehman Brothers collapse so we cant tap that as the cause for Chinas inflation slowdown in late 2008 and 2009. Still, the onset of the global financial crisis ensured that there was no risk of price pressures reemerging (the average length of inflation up cycles in China is 23 months) and the emergence and persistence of large output gaps in the rest of the world around 75% of the global economy was in recession effectively disguised rather than treated the underlying causes of the 2007-08 inflation cycle. Moreover, the National Development and Reform Commission (NDRC) went to extraordinary lengths to regulate prices over this period. At the peak of price regulation, we believe that over 70% of the Chinese CPI basket was set by the NDRC.
This cycle is still getting started or nearly run through?
1986-88 2002-04 1991-94 2006-08 1999-2001 2009~11
Index level, 1986=100
Wage rises have stayed ahead of food costs

2,400 2,200 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0
5 10 15 20 Months into the inflation upcycle
25
This government intervention to cap prices is particularly noticeable in the most politically sensitive subset of prices food prices. We also note that Chinas food price escalation did have a similar profile to 2007-08; a pause in inflationary momentum at the 11-14 month point into the upswing, likely caused by government intervention measures to cap rises. However, a second phase usually emerges and extends the food price cycle by at least another 12 months, though this could be considerably longer (the 1991-94 cycle lasted six years). So far, the 2009-11 food price cycle remains moderate in comparison to the 2006-08 and 2003-04 food inflation cycles and is modest compared to the most severe food inflation cycle in 1988-89. Still, there is no sign yet that food prices have come under control, and we would not have a significant disagreement with many analysts, indeed policy makers, who now argue that food price inflation is indeed a structural, not cyclical dynamic. The political response to food inflation also becomes one of the most important defining features of the Fifth Cycle in that powerful structural dynamics (rapid income growth etc) are being offered in response to cyclical inflation pressures. The political response appears to have shifted to rely on wages hikes to absorb the burden of inflation, rather than using administrative measures, especially as China becomes less of a price taker and more of a price setter, especially in the global commodity space due to its role as the dominant importer and consumer.
12
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1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
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140 135 130 125 120 115 110 105 100 95
CPI price level, rebased at starting m onth to 100
Food CPI level Urban income level Rural income level
Inflation Themes
Labour demand exceeds supply

City Labour Markets: Demand-Supply Ratio
1.10
Minimum wage growth increasingly faster than CPI

CPI versus Minimum Wage Growth
PY=100,
20
1.05 1.00 0.95 0.90 0.85 0.80 0.75 0.70 0.65 0.60 Mar-2001
18 16 14 12 10 8 6 4 2 0 -2 2001
Mar-2003 Mar-2005 Mar-2007 Mar-2009 Mar-2011
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
CPI Year Average %
Shanghani & Beijing - Avg growth in Minimum Wage %
A further cyclical consideration is that the Chinese labour market is considerably tighter in the Fifth Cycle compared to all four previous inflation cycles. The ratio of labour demand to supply hit a record high of 1.07 in the first quarter, up from 1.01 in Q4-2010. This quarterly survey of job centres in 100 cities is clear evidence that Chinas labour market is very tight and tightening further. Rural wage growth accelerated to 13% yoy in Q1 2011 from 10% yoy in Q4 2010. In response to the tightening labour market and the healthy gains in rural wages, provinces have to raise minimum wages by a significantly faster amount to attract surplus rural workers back into city jobs. Thirteen provinces and cities raised minimum wages by an average of 21% in Q1 2011. Wages growth of this magnitude will continue to feed into higher manufactured goods prices.
Not even China can escape Friedmans monetarist dogma.

The list of causes for Chinas current inflation run-up seems to be a long one, and so far we have only considered the cyclical drivers of inflation. In order to quantify the contributions from each factor, we have developed a model for Chinas headline inflation since 2001. The most statistically significant factors,
Many play parts, but money has the leading role
Contributions to CPI run-up in 2010/11 Inflation Expectations 3.28 0.73 Output Gap 9.62 0.47 Money growth 3.39 1.24 Commodity prices 4.90 0.75 CNY NEER 8.64 0.75 from smallest significance/contribution to most
Source: SG Cross Asset Research/Economics
Statistical Significance
as our model suggests, are the output gap lagged by one quarter, CNY nominal effective exchange rate lagged by four quarters, global commodity price, money growth lagged by four quarters, and inflation expectation lagged by one quarter (please refer to the Appendix). Compared to the big inflation cycle in 2007-08, the most distinct factor this time around is money growth. Back then, the economy overheated badly on strong investment dynamics, but money supply growth was much more muted at 15~17% yoy. This time, the economy is not as overheated as in 2007, but liquidity bubbles, resulting from Chinas bank lending tsunami, have more than compensated for the role of a sizable positive output gap, by being the No.1 inflation contributor.
For your information, the key inputs and outputs of our top-down fundmantal China inflation model are printed on the following page.
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SGs model of Chinese inflation key inputs

SG model of Chinas CPI
10 8 % yoy CPI Headline
10
8
%, yoy CPI Headline Inflation Expectations (lagged by 1Q, RHS)
90
CPI: SG Model 6 4
80
6
4 70
2 0 -2 -4 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 10
8 %, yoy CPI Headline Output Gap (lagged by 1Q, RHS)
2
60 0
-2 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 3
2
10
8 %, yoy CPI Headline M2 grow th (lagged by 4Q, RHS)
50
35 30
25
% of potential GDP
% , yoy
6
4
1
0
6
4 20
2
0
-1
-2
2
0
15 10
-2 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 10
8 %, yoy CPI Headline IMF commodity index (RHS)
-3 80 60
40 20
-2 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
% , yoy
10
8 6
%, yoy
% , yoy
-10
-5
6
4
4
2 0
0
5
2
0
0
-2 -4
-20 -40
10 CPI Headline CNY NEER (lagged by 3Q, RHS, reverse scale)

15
-2 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: CEIC, Bloomberg, SG Cross Asset Research/Economics
-60
-6 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
20
14
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The arrival of structural inflation!

Urbanisation, surplus labour and Lewisian turning points
History is replete with lesser examples of the China episode
Modern economic history, particularly that of North Asia from the 1940s through to the early 1990s, is abundantly rich with evidence that rapid development can be engineered via the process of centrally planned urbanisation and industrialisation. Japan and South Korea stand as guiding lights of this process though, through the less kindly tint of hindsight, the ultimate success of these rapid industrialisation policies has been questioned. The most important dynamic, that millions were lifted out of a life of poverty in an unprecedentedly short period of time, is often overlooked. It should, however, be a clear benchmark by which the success of development policies is measured.
China is urbanising at a faster pace than previously thought.

The two most powerful and evidentially transformative examples of rapid urbanisation in the past century are that of Japan after the Second World War and South Korea shortly after the end of violence on the Korean peninsula. The evidence is indisputable. At the time, the urbanisation and industrialisation of Japan was without precedent. It was only the South Korean experience that surpassed this. Then from the modern economic reforms of Deng Xiaoping, announced in 1978 to Chinas dramatic and irreversible accession to the WTO in 2001, the greatest multi-year migration of people in history ushered in the largest poverty reduction outcome ever achieved. One of the most important results of Chinas census, released in late April, is that the pace of urbanisation has been significantly quicker than previously thought. As of the end of 2010, 49.7% of the population lived in urban areas. That is 3 ppt, or 44 million people, higher than the National Bureau of Statistics last estimate for 2009. More importantly, it is well above the standard United Nations projections for 2010. This means that China will achieve a very important milestone in its development: over the course of 2011, a majority of Chinas estimated 1.35 bn people will become urbanised. However, a significant and important qualification is that four in every ten urban residents did not hold a local registration, known as a hukou, up from three in ten urban residents in the 2000 census. One of the most difficult variables to capture in China is the size of the socalled highly mobile migrant workforce. Indeed, given the size of this population and the fact that it is so mobile, it can often be considered the marginal worker in terms of changes in employment and changes in labour costs. Hence, the actual urbanisation rate could be lower than 40%, if we exclude those who work in cities but do not settle there. It is here that we must stress that an urbanised population greater than 50% is NOT the same as the economy having moved through its Lewisian turning point. China is still around two decades away from reaching the type of urbanisation rates that characterised Lewisian turning points in Japan and South Korea during their most rapid periods of industrialisation. The most significant differentiating factor, in the Chinese case, is that the pace of industrialisation does not necessarily match the pace of urbanisation. Migrant workers, who do not hold hukou registration, are not necessarily economically active in urban areas though they may actually be physically located there.
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Pace of urbanisation and real wages growth

18 16 14 12 10 8 6 4 2 0 -2 -4 -6 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 13 12 11 10 9 8 7 6 5 4 3 2 1
Chinas Lewis turning points: one down and one to go

20 18 16
Nom inal Wage Growth, % YoY
Urban Lewis Turning Point Rural Lewis Turning Point
14
12 10
8
Urban Rural 6 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Real Wages YoY % LHS Urban Population Growth - Rural Population Growth RHS
Is Chinas move to structural inflation really that unique?

There is no rulebook for best economic practices when an economy rapidly industrialises and urbanises. There are precedents in Asia however with Japan and South Korea paving the way. The idea that China was approaching its Lewisian turning point, that is, had moved through the point of surplus labour, and that, rapidly rising real wages would reflect the new labour market dynamics in China were arrested by the global financial crisis. The issue of wages and surplus labour drew ever more attention over the course of 2006 and 2007, particularly as the economy was growing well above potential, but the recessionary impact of the financial crisis and the sharp reduction in demand for Chinese exports in late 2008 and early 2009 led to a large and sharp reduction in demand for labour in the coastal provinces. Though no doubt severe, the pull-back in labour demand reversed surprisingly quickly. Indeed, the shortages of unskilled labour and rising real wages returned with extraordinary strength in 2010 in response to the expansionary monetary and fiscal policy put in place. More so, due to the labour-intensive infrastructure projects that were put in place in the central and western provinces; lower housing and living costs coupled with abundant job prospects temporarily reversed migrant labour from rural to coastal areas. This dynamic of rural to urban labour migration has been one of the key structural underpinnings of Chinas rapid productivity growth over the past two decades.
Chinese inflation in the modern economic period
30
25 CPI: % Y oY
Relative performance of inflation during high growth periods

35 30 25
Consumer Price Index
China (2000) Japan (1960)
20
15 10
Korea (1970)
5 y ear av erage
20 15
10
5
5
0 -5 1985
0
1990 1995 2000 2005 2010
-5
9 10 11 12 13 14 15 16 17 18 19 20
16
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Relative performance of wages during high growth period

500 450 400 350 300
Relative urbanisation during high growth periods

90 80
Real Wage Index

China (2000) Japan (1960) Korea (1970)
Population: % Urban
70
60
250
200 150 100
50 40 Korea (1965) China (2000)
30
Japan (1950)
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
20
10
15
20
25
30
35
40
45
50
55
60
65
70
Relative performance of GDP during high growth periods

20 China GDP Y oY % (2000) 15 Korea GDP Y oY % (1970) Japan GDP Y oY % (1960)
Relative performance of GDP per capita during high growth periods

450
400
350 Korea (1970)
10
300 5 250 200 150 -5
100 -10
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51
50
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
China has reached its first Lewisian turning point

China reached its first Lewis turning point back in 2003. The income gap between rural migrant workers and agricultural labourers has provided a powerful incentive for the latter to try to find better-paid non-farm jobs. The massive labour flows out of rural areas eventually led to labour shortages in agricultural sectors starting in 2003 and 2004. Since then, rural wages have been growing significantly faster than urban wages. Between 2004 and 2010, the average wage growth was 3.5 ppt higher in rural areas than in urban areas. As rural regions supply the low-skilled labourers, fast-rising rural wages largely determines the wage growth in those industries that relies on marginal workers. This is why we have heard so many stories about labour shortages in the export-oriented coastal cities, especially in years when food inflation makes rural jobs more appealing.
However, the second Lewisian turning point is a long way away.

Although migrant workers earn only about USD1,500 per year on average, the income gap between them and agricultural labourers provides a powerful incentive for the latter to try to find better paid non-farm jobs. Naturally, this competition in the labour market suppresses non-farm wages: whereas labour productivity in non-farm sectors increased by 10-12% annually in the past 15 years, migrant workers real wages have increased by only 4-6% per year. As a result, income disparity between low-end labour, on the one hand, and professionals and investors, on the other, has also increased.
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Another sign that China still has a big surplus of labour is the stagnant income growth for college graduates. Around 6 million students complete their tertiary or higher education every year in China. It seems they are not exactly riding the tide of rising wages as rural migrant workers. The Chinese Academy of Social Sciences, one of the leading think-tanks in China, showed in its report on Chinas Population and Labour that salaries of those much better educated graduates are not much higher than the wages of rural migrant. The mismatch between supply and demand of white-collar jobs reflects the underdevelopment of Chinas service sector. In 2010, services contributed to 43% of Chinas total GDP, which was much lower than the levels Korea and Japan reached during similar phase of development. All this means that the process of industrialization in China still has a long way to go. According to research published by the US Bureau of Labor Statistics in 2009, Chinese manufacturing workers' hourly wage was only USD0.81 in 2006 or 2.7% of comparable costs in the US, 3.4% of those in Japan, and 2.2% of those in Europe. After five years of growth, inflation, and currency appreciation, we estimate that the wages of Chinese workers are still just around 5% of the levels in the G3. If assuming an annual wage growth of 15% for another decade and cumulative 20% appreciation of the yuan, Chinas wage level could approach 25% of the G3 still an ocean apart. To reduce farm labour to 10% of the labour force (the point at which, judging by historical experience elsewhere, China may achieve worker-farmer wage equilibrium), the economy needs to create about 150 million new non-farm jobs. Even if the economy continues to grow at 8% per year, China might need 20-30 years to reallocate agricultural labourers and reach full employment. But this requires generating eleven million new jobs every year, including five million for farmers leaving the countryside.
Productivity differentials square the hole

The productivity gains of urbanisation
There is one simple reason why China has been able to sustain such a long period of real wage growth without generating a wage-price inflation spiral. It is simply to do with the marginal output of rural and urban employment. China has been engineering the greatest human migration of all time as it rapidly urbanises its previously large rural peasantry. The productivity of the rural and urban workforces is starkly different. Farms are collectively owned with little incentive for individuals who do not possess land rights to significantly boost their output as the profits or gains are socialised. What we find then is that when a worker moves from rural to urban employment, the total output of the economy rises significantly. There is a significant increase in urban output, but little or no reduction in rural production. It is then just a simple process of arithmetic; rural productivity also rises as you have the same output with less workers. The specific economic characterisation of this dynamic is that for a surplus economy, there is significant redundant rural labour; hence the marginal product of labour in rural areas is very low, if not zero. The evidence of labour shortages on the Eastern seaboard became apparent in early 2010 and labour shortages were more generally recorded across cities in the central and western provinces by the beginning of 2011. As many migrant workers had left the cities to find jobs in the central and western provinces, with its considerably cheaper living and housing costs; wages had to rise significantly in the coastal provinces to attract these workers back. Hence, what we find with the global financial crisis, that led to a temporary reversal or rural to urban
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migration and the China stimulus package, is not so much an acceleration of urbanisation but a resumption of a trend that had been interrupted by the impact of the global crisis on the manufacturing heartland of the Eastern seaboard. Indeed, we are probably just one decade into this multi-decade dynamic of real wages starting to rise in urban areas on the back of productivity differences. Chinas nominal wages essentially fluctuated with inflation for the first two decades of the reform period with only small increase in real wages. It was with WTO accession, and Chinas rapid march up the value added chain, that saw real wage growth start to lift sharply. Indeed, real wages growth has been running in double-digits from 2000 onwards. Until 2003, real wages grew less strongly than average productivity; but in 2004 and 2005 wages growth ran ahead of productivity.
China can sustain higher wages growth due to outstanding productivity growth
15 Real wage growth, in %, 2005-07 10
CN
ZA KR
BR
0
CZ MY CL HU PL ID
Productivity growth, in %, 2005-07
TR
-5
-10 -5 0 5 10 15
Wage efficiency & productivity will prevent manufacturer flight

The key question that arises from Chinas recent wage dynamics is whether the Chinese labourer becomes too expensive for cost minimising multinational or platform companies. Chinas export juggernaut represented the very apex of decades of globalisation and exponential improvements in real-time distribution management. Parts could be produced in various countries of Asia, and then assembled into final goods in the country with the lowest labour costs. For over a decade, that has been China and the result of this has been Chinas subsuming of the Asian trade surplus into its own trade surplus as the final assembler and exporter of goods. Are wages now rising at such a pace that the economy is at risk of the manufacturing sector becoming flighty? Vietnam, Bangladesh and even Mozambique show little reluctance or hesitation to replicate the China growth model, taking advantage of their even cheaper labour costs to become the new final assembler at the end of the Asia supply chain.
Urbanisations contribution to inequality prompts faster minimum wage gains

The two-decade process of urbanisation has underpinned the formation of Chinas army of low cost workers but it has also contributed to growing income disparity in China. Indeed, the extent of income disparity, as most evident in the complete inability of non-urban residents to be able to access the property market, became a serious social tension in 2010, thereby
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prompting the government to embark on more pro-actively support rural incomes and income growth, including a gargantuan economic housing building program and interventions in the labour markets (at various levels) to force minimum wages higher. The rapid wages growth we are seeing in some provinces, minimum wages have increased by more than 30% is part of a multi-pronged strategy aimed at reducing inequality. Beijing and Shanghai, for instance, announced a second round of wage increases this year and other provinces are likely to be forced to follow suit in order to retain or attract labour. But there is a very important distinction that should not be overlooked: the minimum wage is normally much lower than the effective or the actual wage that is paid in China. As such, the dramatic increase in wages has not changed the fundamental relationship between wages and labour productivity, which remains extremely high. So, despite the strong gains in headline wages, the efficiency of wages remains high.
Urbanisation now involves two-way flows of labour and capital.

Labour flows outwards and capital flows inwards.
A simple way to think of the change of the inputs into production as a result of urbanisation is simply to think of labour and capital as a two lane highway. We will ignore the Solow residual for the time being and assume that capital flows are travelling in one lane and that labour flows are travelling in the other. The early period of modern economic reform, indeed the latter stages following Chinas accession to the WTO, were characterised by a one-way flow of both labour and capital (more in the form of bulk commodities) from the interior regions to the coastal provinces. November 2008 turned out to be a dramatic turning point for this dynamic with Beijing engineering a rapid and profound reversal of this unilateral flow in both labour and capital. The instigator for splitting the flow was the massive State sponsoring of financial transfers from the State banking system to the workers and companies, via the State utilising the banks as fiscal agents, primarily to lend to SOEs and Local Governments. As early as 2009, it became obvious that both capital and labour flows were following financial transfers into the interior central and western regions. This proved to be the powerful foundation for the capital and labour flows that were to follow. Financial transfers from the coast to interior regions, via government fiscal allocation, improved infrastructure, including education (higher skilled workers), transport (more accessible workers) and public goods (schooling, hospitals etc), to improve the quality of life in these regions.
The catch-up to developed world living standards may be surprisingly quick

Chinas real manufacturing wages in US dollars in 2010 were about 7.6 per cent of those in the US. Korea was a little below that at 5.2 per cent in 1975, yet some 20 years later, it had risen to 50% of the US. With reference to the charts above, the pertinent question is will it take more or less years for Chinas labour costs to rise to half that of the US? A third important factor is the rate of wage inflation. The role of wages in inflation dynamics in emerging markets has received attention from two major angles. One is that an exogenous wage shock can lead to cost-push inflation if the monetary authorities follow an accommodative policy. The other is that the backward-looking indexing mechanism, by which current wages follow past inflation, can give rise to strong persistence effects. Dornbusch and Fischer (1993) note two specific features of the indexation mechanism in the high- to moderate-inflation economies that could produce such effects. First, indexation encourages longer-term contracts, which make the inertia effect particularly strong. Second, the typical
20 27 May 2011
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indexing formula tends to make real wages a negative function of inflation, implying that real wages and unemployment increase when the inflation rate is reduced. The resulting output cost may discourage authorities from engaging in a process of sustained disinflation. In addition, the wage indexation mechanism may play a role in the transmission of exchange rate movements to inflation, since the frequency with which wages are revised tends to increase when the inflationary pressures are driven by exchange rate depreciation (Leviathan and Piterman, 1986). This has been an important factor in the inflation episodes of some of the Latin American and transition economies, where devaluation-induced inflation has had higher persistence effects than inflation driven by domestic factors.
Are commodity prices now structural determinants of Chinese inflation?

It is not difficult to understand the reason for our expectations of generally rising commodity prices. It is simply a result of several billion people living in emerging economies that are gaining economic clout and improving their standards of living, often in an extremely commodity-intensive way. This generational shift in global consumption patterns leading to a secular rise in commodity prices was temporarily thrown off course by the Great Recession of 2008, but the longer-term direction is clear. A common argument for ignoring commodity prices when calculating or predicting longerterm measures for inflation is that these prices mean revert, meaning large rises in prices are followed by equally large drops. We think this is true to the extent that we do not expect continued 80% increases in grain prices like we saw in 2010 or the 50% rise in oil prices we saw in the first half of 2008. Both those rapid increases in prices were due to special weatherrelated factors that exacerbated the fundamental long-term tightening in natural resources that we are living through (although they do underline the points that supply lines are generally stretched and weather patterns are becoming more volatile). We feel that although commodity prices may show tendencies to revert to a mean, the mean itself is not static, but rather a moving and, in our opinion, a rising target. Hence, as far as mean reversion in commodity prices goes, we would say that history does not repeat, it rhymes. Rapid rises are likely to be followed by modest pullbacks; however, five years from today, prices are likely to be higher on average than they are today.
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Chinas liquidity legacy

Though there is clearly a changing interplay between the structural and cyclical drivers of inflation, China also has its very own legacy issue from the global financial crisis that is proving extremely difficult to control. Ultimately, the excess liquidity in the Chinese economy and it is enormous will contribute to either asset price inflation or goods price inflation, most probably both! Chinas broad money doubled in the last four years and reached CNY72 trn at the end of 2010, equivalent to 182% of nominal GDP. The PBoC is currently locking up more than onethird of total money supply through required reserves and central bank bills. However, the remaining two-thirds (or about 130% of GDP) still look disproportionally generous.
Why has China printed so much money and, more importantly, why does it continue to do so?
Recounting how China prints so much money is essentially the history of its impressive investment booms. Indeed, the three periods of sharp acceleration in money growth since 1990 has well coincided with the three big investment booms. The first one occurred in 1992~1993 after Deng Xiaopings southern tour. The second boom occurred in the lead up to and shortly after WTO ascension. The latest boom was the direct result of Beijings four-trillion yuan fiscal stimulus in 2009, a response to the global crisis. In each of the three investment cycles, money supply and domestic investment moved in lock step.
Investment and money supply, which comes first? The egg, the chicken or the frying pan?
100
China inflexible currency regime is taking monetary policy hostage

40
600 10
Investments' contribution to GDP growth (%) M2 (%yoy, RHS)
Y oY change in FX reserv es (USD bn) 500

CPI (% Y oY , RHS) 8 6
80
30
400
60
20 40
300 2 200 0
20
10
100
0 2001
-2
-4
0 0 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
2002
2003 2004
2005 2006
2007 2008
2009 2010
The state share of Chinese economy has declined over years, but the authorities are not getting any less efficient in ramping up credit growth. On the demand side, local governments are fully motivated to boost growth with grand city plan and mega infrastructural investments; on the supply side, the commercial banks are well rewarded with easy profits guaranteed by the regulated wide spread between deposit and lending rates. Risk is less of a concern, as the system seems to be working under the implicit assumption that all these projects are backed by the full-faith of the cash-rich central government. Hence, on a scale from one to ten, if the central government aims to achieve seven or eight, the results usually turn out to be ten. This explains why China is so prone to overshoot money growth. The still rigid currency regime is another mechanism in place that makes liquidity management PBoCs job more difficult than otherwise. Maintaining a targeted exchange rate has
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significantly curtailed Chinas scope for monetary policy, as the Mundell-Fleming trilemma would suggest, to address domestic inflation objectives. China has been running large trade surpluses and capital account surpluses for almost a decade, which implies appreciation pressures on the yuan. In order to keep its currency from appreciating too fast, the PBoC has been forced to print CNY20 trillion since 2001 to keep up with the demand for the yuan. The central bank has diligently sterilised 80% of such money. The quickening pace of FX reserve accumulation and the rising cost of sterilisation are posing huge challenges to liquidity management going forward. So in a nutshell, Chinas excessive money growth is a function of its own highly imbalanced growth model, which relies on cheap credit and competitive exchange rate to boost investments and exports. Hence, the inflation problem is also one of the symptoms of Chinas imbalance illness, and the right cure is probably not just cyclical monetary tightening like in a typical economic cycle.
A tough war against excessive liquidity
45 40 35 30 25 20 15 10 5 0 1999
% of nominal GDP Increases in Money Supply
China's own version of QE

Capital inflows to pose more challenges
o/w increases in FX reserves
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Has policy error contributed to inflation in this cycle?

Is the PBoC slow in response? Yes and no.
Despite all sorts of signs of asset bubbles and economic overheating, rate hikes didnt kick off until after CPI inflation exceeded 3%. This cycle extends the tradition of being too late. All the rate cycles since 2000 lag inflation cycles in terms of timing or magnitude, or both. In 2004, interest rates were not moved at all, yet CPI inflation approached 6%. In 2007, interest rate started to normalize after CPI inflation rose above 3%. Because of the delay, the real deposit rate remained negative for 24 months and bottomed at -4.56%.
Chinas inflation and monetary tightening cycles
% CPI zero to peak RRR bottom to peak Interest Rate bottom to peak
In spite of this poor track record of rate decisions, we still think the PBoC has been trying quite hard to be a good central bank. After all, as a nonindependent central bank, the PBoC needs approval for each interest rate decision from the State Council. Among the policy tools at its disposal, the PBoC has much more say in
2003/04 2007/08 2009~11
5.3 7.9 5.1
1.5 8.5 4.5
0.25 1.89 1.00
decisions for required reserve ratios. Plotting the year-on-year change in this ratio against headline CPI and we note that its movement has followed the inflation cycles strikingly well since 2003. In each cycle, the central bank started hiking the RRR at the very
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beginning of the inflation run-up and didnt hesitate to drive it higher as inflation continued untamed.
Great tolerance for negative real interest rate
5 4 3 2 1 0 -1 -2 -3 -4 -5 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
RRR hikes are used proactively

1
Real Deposit Rate, % 24 months

16 months
7 6 5 4 3 2
10
0.9
Y oY change in RRR (%)

CPI (% Y oY , RHS) 8 6
13 months so far... 0.8

0.7 0.6 0.5 0.4 0.3 0.2 0.1 0
4
2 0
1
0 -1
-2
-3 2001
-2
-4 2011
2002
2003
2004
2005
2006
2007
2008
2009
2010
Source: CEIC, PBoC, SG Cross Asset Research
Between January 2010 and May 2011, the Peoples Bank of China has hiked the required reserve ratio eleven times, and the benchmark lending and deposit rates four times. But, the problem of inflation and asset bubbles remains. It seems this cycle is very difficult to contain with only monetary policies
The limitation of quantitative tools

The quantitative approach of monetary tightening is almost certainly reaching its limit. Between 2004 and 2010, the share of FX reserves sterilised by required reserves and open market operations declined from nearly 100% to around 80%, while the required reserve ratio was raised from 7% to 18%. Yet, Chinas current economic circumstance demands even more! In 2010, FX reserves accumulation contributed to 25% of the increases in broad money supply. And, that share was substantially higher in recent quarters at 48.5% in Q3 2010, 77% in Q4 2010, and 40% in Q1 2011. This suggested that a complete sterilisation needs a reserve ratio of 40%! Apparently, it is unrealistic and impractical to solely rely on quantitative tools to even tackle the flows. In other words, the PBoC hasnt yet started to deal with the existing huge money stock. China could continue its current approach of quantitative tightening, but not likely for much longer. Although the PBoC has made it clear that there is no limit to the level of the RRR, we think 25~30% is probably the practical maximum level for the RRR, given banks loan-todeposit ratio requirement at 75%. If the RRR is raised beyond that level, even the state-owned banks will have difficulty managing their day-to-day operations. Such level would cripple the fluidity of the entire banking system. Sterilisation is also not without cost to the PBoC. The interest rate paid by the PBoC on required reserves is at an all-time low of 1.62%, which is 50 bps higher than 3-year US Treasury bonds. Open market operations are even more costly to the PBoC, with the yield on 3 month note at 2.92% and that on 1 year bills at 3.31%. A more troubling thought is that it seems capital inflows are set to pour in going forward. There was no trade surplus in Q1, and so the USD300 bn addition to the already gargantuan stock of FX reserves was almost completely due to surpluses under the capital account. China
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is clearly caught up between necessary further steps in exchange regime liberalization and also necessary quantitative tightening. Chinas trade surpluses may decline as domestic demand continues to expand faster than external demand recovers. But, net income under the current account is likely to increase, and capital account surpluses are seen to widen when China opens up capital account and appreciate the yuan gradually. Hence, we think the pace of FX reserves accumulation would remain very concerning to the PBoC in near term.
The PBoC has sterilised 80% of the inflows
120 % of FX reserv es
Bank lending quota fails to contain credit growth

16
PBoC bills & notes
14 12
Required reserv es
100
Total social financing (credit supply) CNY trn

others stock market
80
60 40 20
10
8 6
corporate debt
acceptance bills trust loans
4
2 0
bank lending in FX
bank lending in CNY
0 2001
-2
2002 2003 2004 2005 2006 2007 2008 2009 2010
2004 2005 2006 2007 2008 2009 2010
Rate hikes have to step up, but now is not a good time
China needs to raise interest rates. The regulated benchmark deposit and lending rates in China is just too low. The ten-year average real deposit and lending rate between 2001 and 2010 was merely 0.8% and 2%, respectively, nearly 3% lower than other Asian economies and developed countries. From a cyclical perspective, China could not achieve a proper normalization in monetary conditions without lifting interest rates much higher. In an environment of abundant liquidity, a negative deposit rate would continue to encourage households and corporate to look for more profitable investments, thus fuelling asset bubbles. Price caps so far have created a whack-amole game between speculators and the government as liquidity shifts from one asset class to another. As property tightening intensified in the past 12 months, we have seen bubbles emerged or emerging in various markets, spreading from equity market, domestic commodity market, a number of storable food items, arts, and even Chateau Lafite Rothschild Wine. From a structural view point, suppressed interest rates lie at the heart of excessive money supply and economic imbalance. As the chart below shows that there is a fairly good correlation between the relative size of money stock and the relative level of lending rates. If we view nominal GDP growth rate as a macro gauge of average economic return in a certain economy, the spread between this growth rate and the interest rate should be a logical measure of the appropriateness of the interest level in this economy. China has a substantially lower average interest rate relative to its nominal GDP growth compared to major emerging and developed economies, and it also has one of the largest money stock (% of GDP). Low deposit rates mean that households are implicitly subsidizing investments, making some inefficient projects financially viable. This distorted price signal compromises the efficiency level of capital allocation and the entire economy. Together with Chinas political structure, more capital gets channelled to less efficient state-related enterprises, and more efficient private players get squeezed and crowded out. Over time, the overall productivity growth will be affected. Initially, generous money growth mostly drives up domestic demand (investment
27 May 2011 25
F179665
Inflation Themes
and consumption), creating positive output gap. As profitable physical investment projects runs out, the excessive money will be increasingly channelled to fuel asset bubbles and general inflation. The danger is stagflation. This cycle resembles this scenario more than any previous cycle, with less overheated economy but same elevated inflation.
Suppressed interest rates encourage efficient borrowing
250 Broad Money % of GDP, 2010
But interest rate hikes invite capital inflows

300 China 1y r benchmark lending rate - HK best lending rate (bps) HK's f inancial institutions' claims on Chinese corporate (%y oy , RHS) 160 120 80 40 0
TW
200
200
CHINA
150 JN KR EU AU US NZ ID UK SI TH IN 50 PH MX Nominal GDP growth - Lending rate 2001-10 av erage, % 2 4 6 8 10 12
100
MY
VN
0 -100
100
-40
-80
-200
-300
-120 -160
0
-6 -4 -2 0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
China should boost the cost of capital not only for the sake of cyclical inflation problem, but in order to address economic imbalance as well. And so interest rate hikes should continue and should continue even after inflation peaks out in this cycle. Otherwise, excessive money growth and inflation will be a recurring issue and haunt Chinese policy makers over and over again in the coming decade. But, it is not a very good time for sizable interest rate hikes, due to the problem of capital inflows. The combination of four benchmark interest rate hikes and less credit supply has driven market interest rates 30~60% higher. More and more Chinese companies are tapping international bond markets and Hong Kongs banking system for funding, so that they can circumvent the mainlands lending curbs and higher interest rates altogether. According to Dealogic, China corporate have borrowed USD12.2 bn from international investors so far this year, more than five times the amount raised during the same time last year. Based on current trajectories, it shouldnt take much longer to break the full-year record of USD15.8 bn set in 2010. In addition, Hong Kongs commercial banks total outstanding loans to Chinas non-financial corporate doubled between January 2010 and January 2011. This upsurge even caught the attention of the Hong Kong Monetary Authority, the citys de facto central bank, who issued a warning about potential liquidity risks associated with such lending. Therefore, interest rate hikes seem to offset some of the efforts of the quantitative tightening. Besides, as the yields on central bills, the cost of sterilisation needs to move up with benchmark interest rates, rate hikes also makes open market operation more costly. The PBoC is faced with a big dilemma with very small leeway in its choice of monetary policy tool.
The right cures: fiscal tightening and a new currency regime

Therefore, this cycle of inflation and excessive liquidity will be very difficult to contain with only monetary policies. Monetary policy tightening could effectively squeeze small medium enterprises and cause some growth deceleration, but as long as the insatiate demand for investment and credit is not properly addressed, inflation would be a recurring issue.
26
27 May 2011
F179665
Inflation Themes
Another important implication is that the monetary policies are basically taken hostage by inflows, and the inflexible yuan is the root cause. Beijing has now accepted that it is the current exchange rate mechanism that is proving to be problematic from a liquidity perspective. In order to sterilise inflows, the balance sheet of the PBoC has swelled to nearly CNY27trn, equivalent to 65% of Chinas GDP and 50% bigger than Feds total assets, while Chinas economy is only one-third of the US. FX reserves account for 85% of total assets. On the liability side, financial institutions reserves and central banks own bills account for 53% and 16%, respectively. If FX reserves add USD200~300 bn every quarter, which has been the pace since Q3 2010, the PBoC will be forced to print CNY1.1~1.8 trn in high-power money every quarter and CNY4.4~7.2 trn in a year. This alone would contribute 6~10 ppt to M2 money growth. The accumulation not only makes the management of FX reserves even more onerous, but also adds immense amount of inflationary pressures to already concerning trend. No wonder the PBoC Governor Zhou Xiaochuan recently admitted candidly that the excessively rapid accumulation of Chinas FX reserves was already beyond [any] necessary and reasonable level. This path will be more and more damaging to the Chinese economy. The most likely outcome for China seems to be a combination of nominal appreciation as well as inflation. But in addition to long-term structural productivity growth pressures, China appears to be trapped in the perfect storm of inflationary pressures. Given the potential for social and political disruption from high inflation, as we have seen, most famously in the 1987-88 inflation episode and the culmination of that unrest at Tiananmen Square, Beijing may be in the process of rethinking the inflation-appreciation trade-off. Thus, yuan nominal appreciation may be closer at hand, and stronger than expected. This policy stalemate leaves China with no other option but to finally reform the exchange rate mechanism. We believe that the reform would centre on a new exchange rate mechanism that aims to allow currency appreciation whilst deterring some of the damaging and, now, unmanageable speculative inflows. The daily trading band would be widened to allow the CNY to move more significantly on an intra-day and intra-week basis to introduce more volatility. Sporadic large adjustments in the fixing (either way) could be employed as a further tool against speculation. Though such volatility seems to be anathema to the mantra of exchange rate gradualism, the fact that the yuan is being rapidly adopted as an invoicing currency for intra-emerging market trade will reduce the stress on Chinese exporters and importers of the rise in USD volatility. It is notable that China has recently launched yuan options trading in the interbank market. This indicates preparedness for rising exchange rate volatility and more effective hedging against that. In the near term, persistent expectations for more yuan appreciations may only lead to more capital inflows. However, without currency reform China will remain trapped in disruptive liquidity-driven cycles. Conventional and highly constrained policy tools have reached their use-by-date. A reformed exchange rate mechanism is a qualitatively superior policy tool that will much better address Chinas current policy stalemate. Once again, history provides a useful benchmark. In its industrialisation period, Japan
allowed the real effective exchange rate to appreciate by nearly 50% over the first decade of
27 May 2011 27
F179665
Inflation Themes
rapid growth and this kept inflation stable at just over 6% during this period. The OPEC oil shocks complicate analysis after this period. In contrast, South Korea ran with a persistenly weak currency policy and paid the consequences of this with inflation averaging nearly 15% during its first decade of rapid growth.
Relative performance of inflation
35 30 25 20
140
Relative exchange rate performance

220
Consumer Price Index

200 180
Real Effective Exchange Rate

China (2000) Japan (1960) Korea (1970)
Korea (1970)
160
15
120 100
10
5 0 -5
80
60 40 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
9 10 11 12 13 14 15 16 17 18 19 20
Like South Korea, but not to the same extent, China has run a self advantagous exchange rate policy allowing the currency to initially depreciate in real terms immediately after world trade organisation ascension to rapidly facilitate the creation of its highly competitive export sector. Over the past five years, however, the real effective exchange rate has appreciated byu nearly 20%. Again, this is mirrored in the inflation profile, with inflation on a steady rising trend during the soft currency period, and inflation only falling after the exchange rate appreciated in real terms.
Now or never? What will Chinas new exchange rate regime look like?
Chinas present case and the historical example of South Korea and Japan decades earlier clearly indicate the important linkage between the exchange rate policy chosen and inflation. Japan, which allowed its currency to appreciate the most in real effective terms recorded the most benign inflation. South Korea, which kept its currency artificially low, had persistently high inflation. China is now at the point where, as we outline above, its conventional policy tools are reaching their limits. They have one policy tool which we believe has not been used effectively enough to date the exchange rate. There are many things counter-intuitive about the behaviour of the Yuan. We often hear that the yuan is held steady during periods of international uncertainty, but have a look at when the pace of yuan was the fastest. As hot-money became either more risk-adverse, or indeed dried up, at the beginning of the financial crisis in 2007-08, this was the period when China chose to accelerate the exchange rate at the fastest pace in its post-float history. When hot money is abundant, on the other hand, China dramatically slows the pace of Yuan appreciation. This is a handy tool for deflecting, if not punishing, speculators, but it can wreak havoc with the inflation profile for an economy that is a price-taker in its import markets. With the required reserve ratio and lending rates reaching their practical limits, and therefore becoming constrained policy tools, it would be an extremely risky policy to continue to run such a speed-variant exchange rate policy.
28 27 May 2011
Indeed, such a policy could introduce even
F179665
Inflation Themes
greater volatility into Chinas inflation profile. Moreover, the faster pace of yuan appreciation is certain to attract speculative capital inflows. Unfortunately for China, a fast pace of yuan appreciation may help contain the domestic inflation problem, however, it only exacerbated the domestic liquidity problem.
What would the new CNY regime look like?
CNY/USD
8.5
7.5
Two-way movement in wider band
6.5
6 2004
2005
2006
2007
2008
2009
2010
2011
For this reason, we believe one of the key elements of any exchange rate reform is the inherent ability for Chinas exchange rate mandarins to be able to punish and ultimately dissuade speculators. As Chinas usual policy tools, lending rates and the RRR, reach their effectiveness limit later this year, we expect China to undertake exchange rate reform, or a partial further liberalisation of the exchange rate determination mechanism, to facilitate the use of the yuan as a more effective policy tool to tackle inflation. That reform will involve an initial 5% positive revaluation and a widening of the fluctuation bands. This will give the currency mandarins the ability to engineer significant two-way moves in the currency that will ultimately dissuade speculation and hence thwart the problem of liquidity attraction that a simple yuan appreciation policy would invite. The times they are achangin in China and there is one remnant of the policy toolbox that is looking quite dated: the exchange rate. It is time for China to more proactively use the exchange rate as an inflation fighting tool, however a reform of the yuan determination mechanism is necessary for that. We expect that reform to occur in the fourth quarter of this year.
27 May 2011
29
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Inflation Themes
What next?
As a simple thought-exercise, think back to last year and what your forecasts for activity and inflation were in 2011? Like us, you have probably found activity has evolved as expected. Inflation, on the other hand, appears to be universally stronger than even some of the most bearish commentators were forecasting.
Global inflation dynamics are a-changin too

There are complex interplays at work that are likely to pan out over years, if not decades. Though it would be a brave forecast to suggest that the great moderation was in fact reversing, it certainly appears that something more profound is occurring than it having simply ended. The strongly uni-directional pressures on the global demand and supply curve that were a feature of recent decades of globalisation were arrested by the global financial crisis. Some of these pressures have been halted whilst others are, in fact, reversing. The ascension of China to the WTO in 2001 was perhaps the most profound development in economics in recent decades as it caused a massive boost to the global labour supply whilst constraining wages growth in the developed economies. In short, the economic ascension of China, as the peak of all that was considered benign in globalisation, flattened the global Phillips Curve to such an extent that the output-inflation trade-off for the developed economies had skewed to such an extent that much higher output could be tolerated without generating inflation.
New pressures on global supply and demand as old pressures reverse
Price
Demand
Supply Tighter Capital Supply
Asian Consumers Finite Commodities Commodity Demand Protectionism Deleveraging
Climate change
Big government Policy Regime Ageing populations

New Technologies
Deregulation
The major consequence of Chinas policy response to the global financial crisis is that it is now engineering an outward shift in the global demand curve. Is there any reason to believe that the outward shift China engineers in the demand curve will be any less profound than the supply curve shift it engineered a decade ago? We still find the global supply curve to be relatively inelastic. It is thus a most unfortunate paradox that the very policies China will use to rebalance its economy to more sustainable growth will ultimately export inflation to the rest of the world.
30 27 May 2011
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Inflation Themes
ECONOMICS
Global Head of Economics Michala Marcussen (44) 20 7676 7813
michala.marcussen@sgcib.com
Euro area Klaus Baader (44) 20 7676 7609
klaus.baader@sgcib.com
James Nixon (44) 20 7676 7385
james.nixon@sgcib.com
Vladimir Pillonca (44) 20 7676 7863
vladimir.pillonca@sgcib.com
Michel Martinez (33) 1 42 13 34 21
michel.martinez@sgcib.com
United Kingdom Brian Hilliard (44) 20 7676 7165

brian.hilliard@sgcib.com
Scandinavia / Switzerland Anatoli Annenkov (44) 20 7762 4676

anatoli.annenkov@sgcib.com
Poland Jaroslaw Janecki (48) 22 528 41 62

jaroslaw.janecki@sgcib.com
Americas Aneta Markowska (1) 212 278 66 53

aneta.markowska@sgcib.com
Alejandro Cuadrado (1) 212 278 73 13

alejandro.cuadrado@sgcib.com
Rudy Narvas (1) 212 278 76 62

rudy.narvas@sgcib.com
Brian Jones (1) 212 278 69 55 brian.jones@sgcib.com
Asia Pacific Glenn Maguire (852) 2166 5438

glenn.maguire@sgcib.com
Takuji Okubo (81) 355 49 5560

takuji.okubo@sgcib.com
Wei Yao (852) 2166 5437

wei.yao@sgcib.com
Joseph Lau (852) 2166 5441

joseph.lau@sgcib.com
Research Associates Lydia Boussour David Tam
Martin Rose Samuel Slama
Mehreen Khan Alexandre Donna
Ramzi Berrima
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China Domino

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27 May 2011

China Economist Wei Yao (852) 2166 5437

Senior Asia Economist Joseph Lau (852) 2166 5441

Research Associate David Tam (852) 2166 5436

A new domino theory.

inflation in recent years by pushing up prices of energy

The first domino. Chinese inflation

Inflation is above, and will move further above, trend

Source: CEIC, SG Cross Asset Research

Changing drivers of inflation in China

Needs to be better controlled.

From mahjong to dominos

Been preceded by a significant acceleration in money supply growth.

Source: CEIC, SG Cross Asset Research/Economics

Early days: Chinas three cyclical inflation waves.

Cycle 1: 1987-89. China comes perilously close to hyperinflation.

Cycle 2: 1993-94. Deng Xiaoping overstimulates the economy.

Chinas unusual deflation episode: 1998-2001.

110 105 100 95 90 85 80 75 70 65 60 Mar-1995 Mar-1999 Mar-2003 Mar-2007 Mar-2011

Source: SG Cross Asset Research

Cycle 3: 2003-04. The first inkling of structural inflation

Cycle 4: 2007-08. Food demonstrates its weight

Source: SG Cross Asset Research

Cycle 5: 2010-??. China enters a new inflation paradigm

This current price cycle is different from 2007-08

Narrower dispersion indicates broader-based inflation

CH CPI: Headline CH CPI: Food CH CPI: Energy CH CPI: Housing

Why the fifth cycle is different?

160 140 120 100 80 60 40 20

China CPI 2001=100

Source: CEIC, SG Cross Asset Research/Economics

Wage rises have stayed ahead of food costs

5 10 15 20 Months into the inflation upcycle

Source: CEIC, SG Cross Asset Research

Source: CEIC, SG Cross Asset Research

140 135 130 125 120 115 110 105 100 95

CPI price level, rebased at starting m onth to 100

Food CPI level Urban income level Rural income level

Labour demand exceeds supply

Minimum wage growth increasingly faster than CPI

CPI Year Average %

Shanghani & Beijing - Avg growth in Minimum Wage %

Source: SG Cross Asset Research

Not even China can escape Friedmans monetarist dogma.

SGs model of Chinese inflation key inputs

%, yoy CPI Headline Inflation Expectations (lagged by 1Q, RHS)

10 CPI Headline CNY NEER (lagged by 3Q, RHS, reverse scale)

The arrival of structural inflation!

China is urbanising at a faster pace than previously thought.

Pace of urbanisation and real wages growth

Chinas Lewis turning points: one down and one to go

Nom inal Wage Growth, % YoY

Urban Lewis Turning Point Rural Lewis Turning Point

Source: CEIC, SG Cross Asset Research

Is Chinas move to structural inflation really that unique?

Relative performance of inflation during high growth periods

Consumer Price Index

China (2000) Japan (1960)

Source: SG Cross Asset Research

Relative performance of wages during high growth period

Relative urbanisation during high growth periods

Real Wage Index

50 40 Korea (1965) China (2000)