Inflation No Real Threat to Chinese Market: Buy on Weakness

Includes: CAF, CHN, FXI, PGJ
by: Enzio von Pfeil

Are you selling your China shares on all of the "tightening" talk in China? We just published a piece querying the wisdom of buying Wall Street just because the Fed Funds are being cut. Equally, we'll be investment iconoclasts and query just how pervasively China actually can tighten...

1. Cost-push inflation

In Econ 101, we are taught that there are two types of inflation:

  • cost-push [CP], and
  • demand-pull

The later is the one that Central Banks can steer. Within the framework of The Economic Clock™, if an excess supply of money creates an excess demand for goods, up goes DP inflation. So the Central Bank converts the excess demand for goods into an excess supply of goods by creating an excess demand for money.

This is not what China - or indeed the world - is experiencing this time around. No, we are fully back to cost-push inflation. Some of you older readers will remember the oil-spike 70s. That is when the term, CP Inflation was introduced, albeit not for the first time.

This September, Chinese consumer prices rose by an annual 6.2%. This is all due to higher input prices:

  • steel prices have reached record highs;
  • prices are rising in coal, oil, cement and glass
  • in September, wheat prices jumped by an annual 11%, and pork prices rose by 62%

2. Can Beijing "tighten"?

Understandably, Beijing is worried that the spill-over effects of higher input prices into higher product prices will fan social unrest and thus public discontent. Indeed, just this Thursday, the National Development and Reform Commission [NDRC], China's top economic planning agency, raised prices of petrol, diesel and other fuels by 10%. In short, energy inflation is gathering steam.

It could be argued that CP inflation is picking up: after all, in 3Q07, real GDP rose by an annual 11.5%. This was a little slower than the 2Q figure of 11.8% - but it is still 43% faster than Beijing's "wish" rate of 8%.

So the government wants to cool growth. In particular, Beijing wants to limit investment in capital goods, exports, and in energy-intensive sectors like steel.

But beyond this, Beijing can do precious little. The Talmud teaches us that we see things as we are - not as they are. Applied here, this means that those economists and strategists observing China from a Western perspective expect "tightening" to work. In other words, they expect the Central Bank to tighten. Because creating such an excess demand for money whacks demand and thus markets, these Western strategists then logically conclude that the market should be sold.

Step in a Westerner with Eastern eyesight! Hayek and thus Popper taught me to scrutinize the assumptions of an argument before even studying the logic of the argument itself. The logic of the "Western" view - that Central Bank tightening actually works - assumes that:

  • China has a functioning, market-based banking system through which Central Bank policy moves are transmitted efficiently into the market, and
  • Beijing is in charge.

Nobody believes that China's banking system runs smoothly and commercially.

And many of us believe, along with Kenneth Lieberthal, that China is not governable: "the sky is high and the emperor is far away" means that what Beijing decrees is not followed pervasively at a provincial, township or even local level.

The upshot: don't believe - and certainly don't act on - tightening talk!

3. How to Make Money Off This Idea

1. Always talk with your financial adviser first!
2. Once Wall Street cracks, sentiment will drive China and thus Hong Kong down further. Buy ETFs on weakness - once the dust has settled.
3. Buy energy stocks: "the beat must go on" in order to create 10 million jobs a year in order to stem social unrest.