May 2011

Why China Overheats
By John H. Makin
“Truck drivers at the Shanghai port of Baoshan are demanding relief from rising fuel costs in a rare industrial action that will reinforce government fears about the destabilizing impact of rising prices.” —Financial Times (April 23–24, 2011)

Despite efforts to rein it in, China’s inflation rate has reached a point where it is sparking social unrest. Chinese premier Wen Jiabao’s recent comment that inflation is a tiger that “once set free is very difficult to put back in its cage”1 aptly characterizes the current inflation in his country. The world’s second-largest economy faces some fundamental choices if it is to restore stability. China’s economy is overheating because for years capital has been flowing into the People’s Republic much faster than it has flowed out. Recently, capital inflows to China have accelerated so rapidly that even the usual measures to absorb the impact on growth of the money supply and spending have failed. Given the legal restrictions on nongovernment capital outflow, the only way China can slow the growth of excess liquidity and the upward pressure on inflation that has been building since last year is either to let the currency appreciate faster, raise interest rates more, or raise reserve requirements more. These steps would discourage banks from increasing lending and would slow the rush out of money into goods—the spike in spending—that is driving up prices. China could solve its inflation problem in a more fundamental way by allowing its residents to export capital—that is, to invest abroad. The fact that only the Chinese government is allowed to openly invest abroad—and is doing so at a rate that, while rising, is still too low to avoid
John H. Makin ( is a resident scholar at AEI.

accelerating liquidity growth and inflation— illustrates the growing need to allow its citizens to invest abroad on their own. The resulting mix of

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

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reaching a level of output that qualifies it as China’s actual inflation rate can also be inferred by the world’s second-largest economy. Of course. provided that it allow its citizens to develop diversified asset holdings abroad while encouraging growth of its financial sector. and invest” model that Rising Inflation Pressure proved so unsuccessful for Japan after its economic boom period in the 1970s and 1980s. experience.-2foreign investments would probably be an improvement over that of the government. While capital outflows from China might rise as wealth-storage facilities are developed inside the country. Flawed Stance on Wealth Accumulation On a more fundamental level. nominal year-over-year . an acceleration As Japanese citizens grew wealthier. Such increased burdens have already has a whole new set of problems from its recent tragic produced successful demands for sharp increases in China’s earthquake and related nuclear disaster. In March. in the Japanese stock market and even more vigorously in Moreover. insurance companies. In the late 1980s. having surpassed comparing nominal year-over-year GDP growth and real Japan’s gross domestic product (GDP) last year. China’s foreign exchange reserves grew The need to allow recycled household savings deposited in by another $197 billion. its financial sector failed to develop. inflation has accelerated while controls is growing of funds for the government to allocate economic growth has remained at a level inside Japan. During the first quarmade largely by government agencies that ter. which has tended to focus on US and European government bonds. minimum wage. and Japanese citizens The need to allow Chinese capital outflows unfettered by were discouraged from investing abroad.4 percent yearexport sector. As a result. powerhouse. there are suggestions that China may be Japanese real estate. Chinese estate bubble grew so large that the emperor’s palace in authorities reduced the weight of food in the country’s central Tokyo was said to be worth more than the state of index of consumer prices.9 percent in February. over-year rate in March. turing facilities. That move reduces reported California. Saving was very high. These Chinese food prices are also politically sensitive in view of are problems that persist to this day in Japan. including growth of more internationally oriented banks. The result of two double-digit increases in There are numerous parallels between Japan’s “work. since foodstuffs constitute one of the most Japan entered a lost decade that included wealth losses rapidly rising price categories in China and tend to equal to nearly three years of national income followed by account for most of the volatility in the inflation rate. and inflation. Japan’s financial outflows unfettered by China was unable to sterilize the positive sector developed far more slowly than its impact of money inflows (that is. growth. as their impact) on the growth of its money in China today. That said. pushing total Chinese capital Japan’s Postal Saving System and its shelreserve holdings over $3 trillion. especially those in the consumer goods rose to a 5. Rising inflation pressure resulting from bottled-up excess liquidity inside China would be relieved by allowing more capital outflows. Recently. neutralize foreign exchange production sector. Because tered banks. and (badly) invest” pattern and China’s experience over the past decade. and investment products like mutual funds. since nominal growth is the sum of real growth China need not repeat the Japanese bubble-bursting and the rate of inflation. by the 1980s they from 4. Inside Japan. so there was a huge supply supply. China’s reported inflation on passing month. persistent deflation and generally stagnant growth. the minimum wage and other wage increases in China is save. the bubble burst a year later. China’s real economy has become a to further exacerbate inflation. save. China is tracking what one might call the Asian “work. foreign competition and China’s great store of entrepreneurial talent would encourage growth of a financial sector in China on par with its sectors producing goods and nonfinancial services. They invested 3–4 percent that China says it desires. which sadly the increased burden on China’s lower-paid workers from higher food costs. This is the highest inflation looked for ways to store and enhance the wealth they were rate since July 2008 and is substantially above the level of accumulating as a result of their hard work. foreign exchange controls is growing more intense with investment-allocation decisions were each passing month. During those decades. The government agencies more intense with each high enough to be generating more favored investment in Japanese manufacinflation. the Japanese real underreporting its inflation rate.

4 percent. The difference. the PBOC governor. Yearbecome so rapid that they have exceeded the central over-year GDP growth in March. Since last September. as already noted. the rate of return on Investment Corporation (CIC). China’s first steps toward expandcontrol inflation. when the renminbi was kept at a rigid . has decided to allow more currency appreciation to Somewhat ironically.) A broader growth was reported at 18. has official 5. (See the February 2011 Economic Outlook for furthe coming year. suggested None of the other economic data released in mid-April that China reduce its foreign exchange reserves because covering the month of March suggested any slowdown in they exceed the level that the country requires. and the head of expected.7 percent. respectively. 8. in 2011. That said. On tion rate is subtracted from the 3. Of course. is the rising role as a medium of exchange and unit of account in implied inflation rate. and a suggestion that the China underreported inflation of 5. While such movement is modest. which means the renminbi will appreciate faster. one that is substantially above the lending and borrowing activities outside China. Industrial production and prevent the dollar from weakening against the renminbi investment indices were reported to be higher than adds liquidity for the Chinese economy.5 percent. has attempted to lower inflation pressure by Taking Inflation Seriously rapidly increasing the reserve ratio required of banks and by increasing one-year lending rates. to neutralize their 9.4 percent. This China’s rapidly overheating economy. dollars—to expectation of 16. is considering additional investments abroad. the actual behavior of are striking. revisions to the data that China may be more growth of liquidity that is exacerbatseries have pushed down reported growth in ing Chinese inflation. up from Febexpanding global role for its currency while simultaneously ruary’s 15. China’s sovereign wealth deposits is still less than negative 2 percent once the inflafund. Retail sales rose 17. one of the more inclusive measures of underreporting its renminbi were made fully convertible. April 19. while real growth was international role for the Chinese currency. to achieve that outcome is for China to buy less foreign while prices for units in newly constructed residential exchange.-3from liberalizing controls on the currency. to moderate inflation cent. effect allowing free capital outflows.1 percent. a favorite vehicle of China’s central bank has now suggested that reserve wealth storage for Chinese investors unable to invest accumulation needs to slow or be reversed. Right after the report in mid-April of accelerating inflation.7 percent. Residential investment. Further. Here again. 9. even above the already-high expectation of impact on liquidity growth and inflation inside China. buildings in major cities continued to rise. at least against the dollar. appreciated by about 4 percent against the US dollar. including a reported at 9. boosted the demand for renminbi purOne of the major drivers of faster inflation is accelerated growth in money There are suggestions chases from China. early in April the PBOC increased oneimportant issues: allowing more appreciation of the year lending and deposit rates to 6.4 percent.25 perrenminbi. helping control its own inflation rate. China’s central bank. the renminbi has ing the international role of its currency. the People’s Bank of China (PBOC).6 percent year-over-year. the tenth increase in the captured by a change in the official Chinese tone on two past year. rose at a year-over-year rate of over 33 percent. also above the The act of buying foreign exchange—that is. too. the reported growth rate of M2 climbed China would satisfy conditions for an to 16.4 percent rate.4 percent. inflation rate.7 percent. The only way abroad. These results Alongside Zhou’s comments.5 percent. The result has been even more capital inflows to China and and credit. Even given that. Zhou Xiaochuan. even based on probably pressure inside China. the renminbi. if the M2. with have intensified the already-rising inflation pressure inside markets expecting another 3 percent appreciation over China. in money supply. that is. it ther discussion of the internationalization of the renminbi represents a change in policy from the period that ended and potential benefits for China and the global economy last summer. particularly in view of policy efforts to slow the the renminbi against the dollar has suggested that China flow of funds into real estate. despite aggressive unusual admission by the head of the central bank is a tightening moves in the form of the boosts in reserve clear indication that capital inflows to China have requirements and interest rates by the PBOC. was bank’s ability to sterilize them. the PBOC boosted the The intensity of the rising inflation pressure in China and reserve requirement ratio for major financial institutions to the rising official concern associated with it is perhaps best an unprecedented 20.3 percent and 3.25 percent deposit rate.

There are growing indications of covert capital outflows—engineered by underreporting of export receipts or overreporting of outlays on imports—seeking investment opportunities outside China’s overpriced real estate sector and negative real interest rates. that has caused Japan so much pain. 2011. they respond in ways that push up inflation even more rapidly. it begets more inflation. these are suboptimal ways to store wealth outside China. the CIC is making the decision about what foreign assets to buy instead of Chinese private investors—who. The pressure for Chinese overheating is likely to continue. China’s economy shows every sign of continuing to overheat. China’s Overheating May Continue Despite currency appreciation. Households. the Chinese have been more present in upscale art auctions over the past year and have become aggressive purchasers of fine wines and Ferraris. driven by consideration of profit. While it may be politically expedient to delay adequate tightening measures to contain China’s rising inflation pressure. has said that Chinese statistics. and hints of further foreign investment by the CIC. save. Still. There is a serious problem with delaying the implementation of policies strict enough to curb China’s accelerating pace of inflation. It may be that the delay in efforts to slow China’s inflation and risk a hard landing is due to a desire to avoid instability immediately before the transfer of leadership inside China that will occur in 2012. Li Keqiang. As inflation rises. China. anticipating higher prices for products. However. railway freight. The CIC receives its capital from China’s rapidly growing pool of foreign exchange reserves. entrepreneurial spirit.-4exchange rate against the dollar. Just as significant is a hint from the chairman of the CIC that it is considering more investment overseas. If the CIC uses its foreign exchange allocation to invest abroad. a Chinese hard landing would be very damaging to a global economy that is facing headwinds while recovering only at a modest pace. Of course. has outgrown its financial system. invest” pattern. China’s next premier. it would be unwise. the Chinese authorities have been hesitant to move aggressively enough to contain accelerating inflation. Such a new set of policies would enable China to avoid the “work. bid more aggressively for raw materials. . and credit growth. fearing higher prices. and high saving rate. are “man-made” and intended “for reference only. such candor as Li’s suggests that Chinese statistics may become less reliable over the coming year. which would tend to mitigate the upward pressure on the renminbi. which offers too little in the way of wealth-storage facilities for residents who are rapidly adding to their wealth with their hard work. culminating in investment bubbles. might make better choices about where to invest. all of which are rising strongly. 2011. This concern may account for some of the efforts to manipulate data to make inflation and money growth appear less intense than they are. note to clients. which are in turn a result of rising currency intervention. Evidence of accelerated moves toward more inflation and spending is contained in the latest data reports discussed above. China’s wealthy are becoming increasingly restive as they seek alternative ways to store wealth outside China. Experience shows that once households and firms see signs of accelerating inflation coupled with an official hesitancy to rein it in. Meanwhile. In effect. aggressive tightening that could precipitate a hard landing for the Chinese economy—is an outcome whereby bad economics also produces a bad political situation. Apparently Zhou’s statement about excessive Chinese foreign exchange reserves reflects an intention to allow faster renminbi appreciation to counter rising inflation rates that threaten to destabilize China. The result—a need for belated. Producers. begin to accelerate purchases and resort to hoarding storable commodities and goods whose prices are expected to keep rising. April 25. 2. especially GDP statistics. but China’s strict controls on capital outflows tend to make such steps necessary. China and the world economy would both benefit from more diversified Chinese investment and reduced imbalances. it needs to buy dollars or euros. If the CIC wants to buy assets in the United States or Europe. This remarkably candid comment along with some doubts about possible biases in recently revised Chinese statistics was reported by Logan Wright and Daniel Sternoff of Medley Global Advisors in an April 14.”2 He prefers to look at real Notes 1. as the world’s second-largest economy. It would be far better to let Chinese investors export capital and to encourage more rapid development of the financial sector. The new generation of Chinese leadership should seriously consider an expanded global role for its currency and its financial sector. higher interest rates. Further. numbers for activity like electrical consumption. Financial Times. higher reserve requirements. that is the equivalent of official capital outflows from China.

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