China's Devastating Earthquake: Bad For Monetary Policy, Too

This has been a sad week for China, and it has certainly not been easy to watch on television the heartbreaking scenes of the effect of Monday’s earthquake. Sichuan is a heavily populated province, and many of my students have friends and family in the affected areas, so the disaster has hit us very hard. The fact that so many of the victims were schoolchildren makes it all the more horrifying. Bless China, as my student Gao Ming wrote me earlier today, a phrase many worried and dismayed students around campus have been repeating. Next week my friends and I will organize a concert to raise money for the earthquake victims. It’s not much, but everyone feels helpless and wants to do something to help, however small.

Unfortunately the earthquake and its corresponding devastation are almost certainly going to complicate matters horribly for the PBoC in its attempt to manage monetary policy and fight inflation. Already before and immediately after the earthquake the new numbers coming out were worrying. For example yesterday the authorities announced that new RMB lending for April amounted to RMB 464 billion, up substantially from March’s RMB 283 billion (Merrill says this is equal to 43.0% of their second quarter quota, while CSFB says it is 51.5%). The total new lending year to date is RMB 1.79 trillion, which is not much less than half of the RMB 3.6 trillion increase in loans for all of 2007. This year we were supposed to see a cap on loan growth equal to last year’s total increase in lending, so we are already at nearly half the full year’s new loan quota.

Banks have typically front-loaded their quarterly lending quota into the first month of each quarter, and this quarter seemed at first to be no different in that respect from other quarters. Had it not been for the earthquake I would have predicted that banks would certainly exceed their loan quota for the first half of the year, but not by nearly as much as the year-to-date figures imply. With the devastation wreaked by the earthquake, however, and the mounting anger and need for reconstruction accompanying the devastation, I am not so confident of that prediction. I suspect that the financial authorities are more likely to lean towards leniency on loan growth than to insist on strict maintenance of the caps.

They will also most likely be pretty lenient about money growth, even though the most recent numbers suggest they have already been too lenient. Besides the jump in lending we’ve seen a rebound in M2, which grew 16.9% year or year in April – according to Bloomberg the market was expecting an already high 16.2% increase. M1 is also up, by 19.1%. Both of these measures increased relative to March year-on-year figures. The China Daily quotes Fan Fangzhi, an economist with the Chinese Academy of Social Sciences, as saying "The statistics indicated that the Chinese economy is still challenged by excess liquidity and a rebound in credit growth." I would find that hard to dispute.

Interestingly there has been a veritable battle in the press about which way to go. One article in China Daily yesterday proclaimed “Chinese economy still under liquidity pressure” and argued for more tightening, while an article by Xin Zhiming today is headlined: “Fears grow yuan lending may stoke inflation.” Both of these articles warned about excessively loose monetary policies and the inflation threat.

On the other hand yesterday’s China Daily also published an article titled “Price battle half-won,” which claims, rather optimistically I think, that the government’s “tightening” policy is working and must be maintained, although the author does acknowledge that it is “far too early to claim victory in our battle against rising inflation.” Yes, I think I agree. It is far, far, far too early to declare that particular victory. Meanwhile an article today by Ma Hongman proclaims “Maintaining growth the only option,” and he argues that while the causes of inflation in China are not under the control of policy-makers, “the three engines for economic growth - investment, consumption and trade - have all slowed down their forward pace”.

In short, the Chinese economy is seeing an overheating and a slowdown in different parts simultaneously, making it much more difficult to choose specific policy tools. Thus, it is advisable that the policymakers prepare themselves for the worst scenario in future when they fix economic policies.

The "worst scenario" mentioned above is stagflation, when inflation is combined with stagnation. The high inflation level is primarily caused by the elevated prices on the international market sneaking into China through its huge import volume. Since the domestic economic slowdown is also possible, it is hence not impossible for the country to witness a stagflation.

Although I too worry about the possibility of stagflation (and this is the first time I think I have seen the word used in the Chinese press about China) I think Ma is mistaken in seeing inflation as caused primarily by rising prices in the international market and so out of the control of local policy-makers. It seems to me that domestic monetary policy is clearly at the root of Chinese inflation, but his argument is an interesting new spin in the growth-versus-inflation debate – yes there is inflation, he acknowledges, but there is nothing we can do about it so let’s focus on growth.

The government is, however, very worried about the inflationary impact of the earthquake, and is taking steps to control the impact, but perhaps the wrong steps. According to Bloomberg:

China ordered authorities in earthquake-hit areas to step up price monitoring, to prevent “large-scale” increases and hoarding. Prices of food, fuel, medicine and drinking water will be closely monitored and local governments can take “intervention” measures, the National Development and Reform Commission said in a statement on its Web site late yesterday.

Clearly the earthquake in Sichuan will not only impact agricultural production and the ability to deliver products to the market, but its reconstruction will fuel a boom in demand for energy, materials, and a wide variety of related goods and services. Recognition of the impact of the earthquake both on loosening monetary policy and on increasing the demand for a variety of goods seems to have powered the stock market today. It closed up 2.73% today, driven by smelters and banks.

The government’s automatic response to this potential surge in demand is to clamp down even tighter on price increases, but this cannot possibly have any but the most adverse effect. After all it is one thing to freeze prices in order to drive out inflationary expectations, but the earthquake has caused a real increase in demand and a real decrease in supply – and the stock market immediately recognized that fact. How can price freezes possibly eliminate the disequilibrium?

In fact yesterday’s China Daily had a very long article on the difficulty of maintaining existing price freezes. The article is called “To raise oil prices or not, that is the question” and starts out very bluntly with: “Diesel sold out. This notice can be seen at many gas stations in the country.” It explores both the difficulty of keeping prices at current levels – shortages and an increasing fiscal subsidy – and the difficulty of letting prices rise – the inflationary impact. People like me of course will point out that price freezes simply convert inflation from one kind, the kind that’s measured in CPI, to another, the kind that shows up as shortages and higher taxes, but the idea that China does not have monetary inflation, simply a temporary food-supply problem, has become so ingrained in policy, even though fewer and fewer people believe it, that its impact will stay with us for a while.

Comments

[darkduck]

good article. But can you analyse the reason of inflation: why do you think it is not a temporary inflation caused by shortage of food? You say it is monetary policy that causes the inflation; but why in stock market we can not see the money supply? Where are these loans?

[sharpe_mind]

Not only does it complicate things, but from the bureacratic point of view it's likely to make the policy stance even more accomodative, and less likely to act.

[M. Pettis]

Darkduck, I discuss the reasons why I think China's food inflation in several of my blog entries, many of which are included in Seeking Alpha. The loans show up in a variety of laces, including fixed asset investment.

[Xi WAN]

For me, the freeze of price would simply transfer the high price to down stream products because of shortage of it, except for two cases: 1, the price of down stream products is freezed too or 2, there is no down stream products.

Of course this argument is based on the assumption that there is no substitute goods. Otherwise the price of substitue goods will be drove up.

[paultaut]

A good article for a change, but monetary policy can only dampen inflation if it dampens demand.

Demand will accelerate dramatically in the wake of the quake. Chinese authorities throughout the nation will look the other way and any economist voicing contrary opinions will be either silenced or shunted somewhere.

There will be no contrary opinions, Solidarity will be the theme throughout the nation and imports of everything will be subsidized by the Government if not purchased outright.

China will show the world what a united Chinese people can do...