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Tricky route to a soft landing
China’s rise in inflation shows that problems with its growth rate are becoming acute, says Andrew Smithers
hina causes a great deal of justified worry. It is very large, grows rapidly and pursues a disruptive exchange rate policy. Its growth poses a problem if it continues and another if it falters. Its currency intervention also threatens trouble in two different ways. Keeping China’s real exchange rate below its equilibrium level inhibits the much needed rebalancing of the world economy but adjustment through inflation is also a major threat. Developed world governments run massive fiscal deficits, with those of the UK and US exceeding 10 per cent of GDP. These must come down and, since adjustments from the household sector will be difficult, it will be vital for economies such as the UK and US to increase their net exports and so achieve a big improvement in their current account deficits. This in turn requires decent growth in China, a huge potential consumer of developed world output. Given the size of China’s economy, below-trend growth there is incompatible with a sustained recovery for the UK or the US. Unfortunately, however, while the developed world must rely on China’s continued growth, that same growth poses a problem for the developing world because it pushes up the prices of food and raw materials. In the developed world, demand for food and goods does not increase much with rising living standards, as the bulk of the extra demand is for services. In the developing world, demand for food and raw materials rises strongly as people become better off. China’s policy of pegging its exchange rate, so that the renminbi rises only slowly
12 June 2011 www.financialworld.co.uk
in nominal terms, has added to the difficulty of achieving a smooth adjustment. It has produced an undervalued exchange rate, with the result that China’s foreign exchange reserves have risen rapidly. As Chinese currency is used to buy dollars, domestic liquidity rises naturally with the intervention. To prevent the growth in money from causing inflation, it has to be “sterilised”. This can be done by issuing government bonds to mop up the liquidity or by increasing the banks’ reserve requirements with the central bank. Lacking a large bond market, the method used has
Once inflation picks up in the way it has in China, it is difficult to bring it back down
had to be increased reserve requirements. Until a short time ago this was successful in keeping inflation at bay. The recent and worrying pick-up in inflation would probably have hit the economy three years ago if inflationary pressures had not been halted by the drop in world demand. There are problems with any form of sterilisation and the use of increased bank reserve requirements seems to be increasingly failing as a way to prevent inflation. Despite the rise in reserve ratios, liquidity appears to be leaking into the economy. One problem is that banks are neither allowed nor able to pay much interest on deposits when they have such large
reserve ratios. This means that depositors with banks have poor returns at times when investment in assets, particularly houses, has been giving high ones. Depositors have, therefore, a strong encouragement to use their money to buy assets. The liquidity produced by the foreign exchange intervention then leaks out, going into asset-buying rather than being deposited with the banks. With asset prices leading the way, consumer price inflation follows, as the wealth induced by rising asset prices seeks an outlet in consumption. Relative inflation is one way of adjusting the real exchange rate but it is a very risky one. In March, China’s inflation hit 5.4 per cent, compared with 2.7 per cent in the US. The renminbi has also risen by 4.4 per cent against the dollar over the past year. This combination of a rise in the nominal exchange rate and a manageable difference between the inflation rates of the two countries is the ideal way to adjust because it makes US output steadily more price-competitive compared with Chinese output. But once inflation starts to pick up in the way China’s has, it is difficult to bring it back down again. Expectations of inflation rise as prices accelerate and make their own contribution to a further rise in inflation through workers wanting increased wages and producers demanding higher prices. China is busy tightening its monetary policy but, as the rate is now over 5 per cent, it will be tricky to bring it down without cutting growth to below trend. As I have pointed out, this will probably render sustained recovery in the UK and US even more difficult. A soft landing for China is possible but a hard one is at least as likely. The current tightening could produce a sharp fall in domestic demand. If it does not, a further rise in inflation could occur, which would only delay matters as an even more stringent cut in credit would then be needed. Either way, there would be a disruptive impact on world trade. Getting the balance right for a soft landing will be tricky. Economies usually adjust well to mild changes but find sharp ones disruptive. China needs a much higher real exchange rate than it has today. This can only be achieved by some combination of relatively high inflation in China,
COMMENT & ANALYSIS
compared with the developed economies, and a higher nominal exchange rate. As either rapid inflation in China or a rapid rise in the nominal exchange rate would be risky, the ideal is a sustained period over which the nominal exchange rate rises at around 5-10 per cent a year and Chinese inflation is stable at about 4 per cent. The real exchange rate between the dollar and renminbi is influenced by the gap between Chinese and US inflation rather than just the level of Chinese inflation. A very low level of US inflation is thus desirable, with zero better than 2 per cent. This is particularly the case because in China rapid growth means that it has a naturally rising real exchange rate – the so-called Balassa-Samuelson effect. The need to adjust the real renminbi/ dollar exchange rate is not therefore a one-off move to cope with the current undervaluation of the Chinese currency, but a requirement that will continue so long as China is catching up with the developed world. In addition to these difficult issues of adjustment, the scale of China’s investment raises problems. Rapidly growing economies invest a lot and, as investment is more volatile than consumption, this means rapid growth is naturally less stable than a slower rate. Investment is more volatile than consumption because decisions to cut capital spending do not have the same direct and negative impact on living standards as decisions to cut consumption. They can, however, have an
Growth Rate Japan 1950 - 1973 China 1978 - 2009 US 1950 - 1973 9.30% 9.90% 3.93%
Investment Ratios Volatility 30% 38% 20% 0.02 0.04 0.02
even greater indirect impact on living standards because of their knock-on impact on wages and employment. This factor on its own would render the growth of developing economies more volatile than those of mature economies. Experience, however, suggests that there can be, but need not be, an important offsetting factor. In 1950, the US GDP per head was five times that of Japan, but there was rapid convergence. Over the next two decades, until the oil crisis, Japan grew at 9.3 per cent per annum in real terms and invested 30 per cent of its GDP, while the US grew at 4 per cent, so that by 1973 US living standards were only 1.4 times higher than Japanese ones. Thereafter, until the crash of 1989, Japan continued to grow more rapidly than the US but the difference narrowed substantially. It is, however, only from around 1978 that China has been on a rapid growth path, although it started with living standards half those of Japan in 1950. China’s long-term growth rate can thus remain very high for many years before it slows as living standards converge. As the table above shows, Japan and China have been similar in their growth rates during these catch-up periods and have had similar investment ratios. The table above shows, however, that while Japan’s GDP growth from 1950 to 1973 was no more volatile than that of the US, China’s from 1978 to 2009 has been twice as volatile. (This relatively high volatility also applies if all three countries are compared from 1978 to 2009.) The relative lack of volatility shown by Japan from 1959 to 1973 suggests that there was some compen-
sating factor to offset the natural volatility of investment, a factor absent in China. Investment is planned on the basis of expectations of demand. These will regularly prove wrong but, in rapidly growing economies, the rapid rise in domestic
Lack of a soft landing will make it harder to achieve a sustained recovery in the US and UK
demand means that such errors will produce only very short periods of excess capacity. But while this could reasonably account for Japan’s experience from 1950 to 1973, the same damping process does not seem to have applied to China. One reason is probably that China is three times more dependent on exports than Japan and mistakes made in investing for exports are not bailed out as quickly by rising demand as those dependent on the domestic market. Another possibility is that China’s policy of pegging its nominal exchange rate has created large imbalances in domestic investment because of the way that speculation in assets, particularly housing, has been encouraged as a result of exchange rate intervention. China faces difficult problems both with its rate of growth and with imbalances in the constituents of that growth. The rise in inflation shows that these problems are moving from the chronic to the acute stage. There is, therefore, a sizeable risk that China will not have a soft landing and this will increase the difficulty of achieving a sustained recovery in the UK and US. Andrew Smithers is chairman of Smithers & Co Ltd
www.financialworld.co.uk June 2011 13
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