China: Stagflation Revisited

In my January 17 posting I wondered whether China might experience stagflation in the near future. In my piece I defined the stagnation part of stagflation a little differently than its normal definition. Specifically:

In China a “stagnant” economy is not one in that is recession. It is one in which employment growth fails to keep up with the growth of the labor population, which when I first came to China six years ago everyone assumed to be GDP growth below 7%. Given the much higher growth we have seen in recent years and the still-upward pressure on unemployment, especially among university graduates, I suspect that the minimum level of GDP growth is probably much higher

I agree that the idea of stagflation in China seemed at the time a little farfetched given the country’s rocketing economic growth, and I received quite a few comments saying exactly that. Still, it seemed to me that there was a real possibility that frantic efforts to cool the domestic economy, if they didn’t involve serious measures to constrain monetary growth (which, for me, is another way of saying adjusting the currency regime to cut net inflows sharply), could very easily lead to a sharp slowdown with absolutely no slowdown in money growth and so no slowdown in inflation.

I noted in particular a comment by John Tamny, at Investors.com, in which he claims that in the US “empirical evidence suggests that economic slowdowns correlate far more with rising, rather than falling, prices.” This is because, he argues, inflation is monetary, and not necessarily affected by changes in aggregate demand.

Since much of the tightening focus here in China is in the form of loan caps, administrative measures, and a more rapid appreciation of the currency, and the last of these simply means more hot money inflows and so more monetary expansion, one could make a very plausible case that the tightening can cause an economic contraction while having no impact on inflation, which would continue to rise. Stagflation is not only possible, but in certain fairly plausible scenarios it is very likely.

Given my musings I found it very interesting that, according to today’s China Daily, a prominent Chinese economist is now making a similar warning. According to China Daily:

While combating inflation and excess liquidity, the nation's financial regulator should also be wary of possible stagflation, the Shanghai Securities News quoted a noted economist as saying on April 20.

Speaking at a financial expert forum in Beijing, Tang Shuangning, chairman of the China Everbright Group and also a well-known economist, said the nation faces the threat of both inflation and stagflation. It is justifiable and necessary to adopt a tightening monetary policy in order to prevent the economy from going too fast, but monetary policy alone or improper use of it could cause a dilemma.

In order to address the problem, he suggests the government increase agricultural investment to secure food supply and stable prices. Therefore, it is necessary to combine monetary tools with other means such as credit and fiscal policies to support rural production.

I am not sure we have the same outlook. It seems to me that what he is saying is a variation on an argument I hear a great deal. China can sharply curtail monetary growth and make up for the resulting drop in demand by rapid fiscal expansion – and I think he suggests fiscal expansion directed at the agriculture sector.

I don’t completely agree. I would argue that China actually needs to be a little careful about assuming that it has unconstrained use of fiscally expansion measures. Why? After all since Chinese government debt is low (around 20% of GDP, I think) and the fiscal deficit is also low (below 1% of GDP), isn’t there plenty of room for fiscal expansion?

I am not sure there is. I think the ability to play the fiscal card is a likely to lot more constrained than we might think, for at least three reasons.

1. I think government debt is a lot higher than the headline numbers. There is almost certainly a lot of government-guaranteed municipal and provincial debt that is not recorded. A few years ago a Chinese economist estimated that this kind of debt might add up to 10% of GDP. I have no idea how much there really is and if his estimate would change today, but as someone with a lot of experience in developing countries I can only suggest that during a contraction these numbers always turn out to be much higher than originally expected. In addition there are a lot of bonds on the balance sheet of the large banks issued by the AMCs. This debt is guaranteed by the MoF but the non-performing loans the AMCs purchased in exchange for the bonds are almost certainly worth no more than a quarter of the value of the bonds. That means that the AMC’s are bankrupt and their obligations should also be included as government debt.

2. In a contraction these numbers are likely to rise as contingent liabilities suddenly surge. Specifically I expect that non-performing loans in the banking system are much higher than the official numbers (no big surprise here – nearly everybody pretty much thinks the same) and in case of a contraction they are likely to rise significantly. I was told by a friend of mine who worked on the Japanese banking crisis that in 1990 the Japanese government had almost no debt. By 2000, after ten years of cleaning up the banking system, its debt significantly exceeded 100% of GDP. I haven’t verified these numbers but my only aim is to make the non-controversial point that in a serious contraction we might see an explosion of contingent liabilities. In fact we almost certainly will.

3. Finally, I am skeptical about the stability of the current fiscal deficit. Aside from the fact that there may be a lot fiscal spending occurring indirectly and off-balance-sheet (a former student of mine from Tsinghua University who works for an SOE in another province assures me that this is the case, although he gave me no specific examples, so I am not sure), I believe that both fiscal expenditures and fiscal revenues have grown very quickly in recent years. I need to check the numbers (and I will at some point) but I have been told by another professor here that the biggest reason for rapidly rising fiscal revenues has been corporate taxes (because the recent surge in corporate profits). If this is true, a sharp contraction might automatically cause the fiscal deficit to surge even without additional spending, since corporate profits would almost certainly drop sharply and, with them, corporate taxes.

At any rate the China Daily article is headlined “Preventing Stagflation is also important.” It certainly is. I am delighted that this debate is occurring, and I suspect that it is very much in the minds of the folks at the PBoC and the more-monetarist-oriented think tanks.

I noted two other interesting pieces today. Xinhua reports that the authorities are announcing new measures to crack down on “profiteers.” They say:

China’s oil regulators are ready to launch a nationwide crackdown on wholesalers who sell to illegal filling stations and dealers in the wake of supply shortages…

…Illegal dealers and filling stations are believed to have aggravated the situation by hoarding oil and jacking up prices to drivers wanting to avoid the long queues at licensed stations.

Aside from the obvious point that shortages are a common consequence of price controls, it is clear that an inflation purist would insist that the long queues, from which people are willing to pay money to escape, are a form of reduction in the quality of good or service that is as much a component of inflation as higher prices, and so headline inflation is being disguised as waiting time. Real inflation is higher than the official numbers, and Chinese motorists are paying this higher cost, but it is not showing up correctly in CPI.

The second additional interesting piece today is also from Xinhua. It notes that according to Zhang Wei, a “senior official” from the China Council for the Promotion of Foreign Trade, China’s combined direct investments abroad amounted to $92.05 billion by the end of 2007. Not a big number, but I think it is growing fast, and I suspect that the PBoC would like to see it grow much faster.

Comments

[city]

disclosure

[city]

I like to remind readers here; Mr Petti worked for Bear Stearns and also he is working in a State Chinese Communist run school at the moment. Details please visit seekingalpha.com/autho...

China has many problems on its own; but it's very ironic the red communists do not mind Mr Petti (who is paid salary by the Chinese communist run school) being so critical of everything in China even the air he breathes every day.

[city]

All Mr Petti's pupils and seeking alpha readers here; the story about Mr Petti just does not add up! According to Mr Petti's views (you can read all his articles about China on this site ; strangely he only wrote about China), everything in China is in crisis even the air is filthy so why he is making a living there; getting paid from the red Communist school; why not go back to Wall street to work for Bear Stearns ? Bear Stearns is not dead yet.

It is time for Mr Petti and his loyal pupils to disclose his relationship with the red Chinese government now!!! And all readers on this site should also make such a demand; otherwise it's an insult to the intelligence of all seekingalpha readers!

[city]

seekingalpha site is a free and fair site! otherwise you are fooling all your readers!

[nickgogert]

city. city. Its time to come home. city have you been pestering mr. Petti? Be a good boy citi and read your marx and propoganda lessons. Citi, you know mr. petti is only expressing his thoughts. now leave him alone. It is a free internet after all.

[nickgogert]

Sorry mr. petti. I don't know what gets into city. Too much sugar is his cereal in the morning. He used to be such a good little fellow.

[J.D]

I wonder what NPLs would look like given a slowing Chinese economy plus a big writedown in SOE crossholdings through a stock market declines. The NPL issue was basically "resolved" through government writeoffs and loan expansion, so the numbers could look pretty grim if the economy goes south. Has there really been enough corporate and financial sector reform to avoid a repeat? Possibly not.

Even so, this issue won't return suddenly but it could be a major trend for a medium/longer term slowdown (given a scenario where, say, the Chinese economy has massively over-invested and essentially hits a wall - akin to the US subprime in some respects).

Given that major companies including financial institutions remain government owned, NPLs should be viewed as potential government debt.

[J.D]

I wonder what NPLs would look like given a slowing Chinese economy plus a big writedown in SOE crossholdings through a stock market declines. The NPL issue was basically "resolved" through government writeoffs and loan expansion, so the numbers could look pretty grim if the economy goes south. Has there really been enough corporate and financial sector reform to avoid a repeat? Possibly not.

Even so, this issue won't return suddenly but it could be a major trend for a medium/longer term slowdown (given a scenario where, say, the Chinese economy has massively over-invested and essentially hits a wall - akin to the US subprime in some respects).

Given that major companies including financial institutions remain government owned, NPLs should be viewed as potential government debt.

[huangthomas]

In my mind, NPL is a public debt and in the end the central government has to pay, because borrowers are government agencies. If banks are private, commercial banks, then I'll worry about the NPL.

[M. Pettis]

JD and Huangthomas, you are both correct. Much of the improvment in the NPL ratios occurred for two reasons. First NPLs were transferred to the state-created AMCs, for which the AMCs exchanged bonds at 100% and 50% of face. Since the collection rate on NPLs is only around 20%, the AMC's, whose obligations are guaranteed by the Ministry of Finace, are heavily under water, and their debt should appear as government debt (it doesn't).

Second, loans expanded so rapidly in the past 3-4 years that the NPL/Total Loans ratio automatically improved, but the improvement isn't meaningful unless we can be sure that none of the new loans go bad. That is probably too much to hope for. Huangthomas is right in saying NPLs are effectively government debt. My friends in the PBoC are very aware of that and very worried by it.

[M. Pettis]

Thank you for saving me the response, TR, and nice to see you on this site too. People in the MoF are also aware of the potential for a sudden explosion of contingent liabilities. An IABD book published March 2007 discusses the role of contingent liabilities in financial crises. It is a very interesting issue and a problem well worth pondering.

Thank you Nickgogerty, but anyone who blogs regularly, even on topics as unsexy as central banking, attracts all kinds of stalkers and loonies -- it is the icing that makes us feel a little kinship with the big Hollywood stars, and allows us to feel important. By the way most people at Peking University would be surprised to hear that this is a state communist school. I remember meeting far more communists when I studied at Columbia. At any rate I think I am far better versed in Marx than any of my students are.

[sharpe_mind]

Mr. Pettis, always find your analysis interesting. It seems like yuan appreciation has slowed significantly lately, and there's some talk that China might reconsider allowing yuan gains because it fuels hot money inflows and hurts exports. At the same time, Stephen Roach today is coming out saying China needs to hike by at least 100 basis points to address inflation. Given persistantly negative real rates and a reluctance to either let the currency appreciate or hike rates (as both fuel inflows, though it is pretty clear already even at currency CNY rates that yuan interest rates will be higher than USD rates for the foreseeable future) how do you see the situation playing out?

It seems like China is basically praying that the inflation situation goes away, with "temporary" price controls and other band aids such as export curbs (or high taxes in the case of fertilizer). A number of economists predict inflation will come off in the second half of the year due to base effects, but this theory's timeline continues to be pushed further out as inflation continues to be stronger than expected. I am skeptical of it especially given the broadening out of inflation pressures, the inflation in the pipeline due to price controls and the continued rise of PPI, and negative real rates. Could anything finally force China to move?

[M. Pettis]

SharpeMind I think you are right to be skeptical. I have written often about China's inflation and why I think it is a monetary problem, not a food problem. I also do not think it is going to decline in the second half of the year. I expect that by May, year on year inflation will exceed 10% and it will stay at that level or rise further. The key is monetary expansion, which will continue until they address the currency problem. About fifteen months ago I argued that they would inexorably move to a maxi-revaluation as all other options failed, and I think by now this view is widely accepted. The big question is: when will they do it? before the Olympics and risk the uncertainty? or after, and be forced to take four or five more months of out-of-control money growth? Hard to say.

[sharpe_mind]

One thing that is a bit puzzling, given the monetary angle for interpreting China's inflation- why is it that back in 2004, when China also had a rise in inflation, a cheap currency, and negative real rates was it able to contain that inflationary outbreak? That experience was also due to inflation primarily in food, yet non-food inflation stayed well contained and CPI managed to come down significantly.

[sharpe_mind]

Looking through the data, the best explanation I can come up with was that at the time bank lending and money supply growth were well below what they've been running at now (at the time the banks were dealing with a large number of NPLs and getting recapitalized I believe). In contrast, M2 has been running in the mid-teens for nearly three years now. Any thoughts?