This morning, China released its economic figures for March (and the year’s 1st Quarter). Consumer inflation, or CPI, hit a new high of 5.1% year-on-year, up from 4.9% in February. Producer inflation (PPI), hit 7.3%, up from February’s 7.2%. China’s M1 measure of money supply (cash and checking accounts) grew by 15% year-on-year in March, while M2 (which also includes savings accounts) grew by 16.6% — both of these numbers down from the roughly 20% year-on-year rates of money expansion that prevailed throughout 2010, but still strongly outpacing real GDP growth. Speaking of which, China’s GDP grew by 9.7% in the 1st Quarter, higher than most analysts expected.
As regular readers of this blog will know, I’ve been predicting (and warning) that China would be facing a strong run-up in inflation since early last year, when CPI stood at 1.5%. I watched and commented as China’s money supply continued to grow and CPI climbed steadily upwards through 2010. When CPI passed 3% in the late spring and early summer, most analysts — particularly the i-bank economists — focused on temporary disruptions in food supplies and argued that inflation would peak in the summer and start declining in the Fall. I argued that monetary expansion, not supply shocks, were the primary driver, and that – given the fact that China’s money supply had surged more than 50% of the past two years — the real question wasn’t why we were seeing rising inflation, but why we weren’t seeing even more inflation sooner. In a Bloomberg op-ed published in October, when the latest CPI numbers stood at 3.6%, I outlined my analysis of the situation and argued that inflation would rise, not fall. By November, CPI passed 5% for the first time this cycle. When it dipped back to 4.6% in December, I warned on NPR that it was “too early to declare victory over inflation,” and that China would likely see a resurgence in the months ahead.
Over the past year, I’ve been hitting away at several consistent themes regarding inflation in China:
FIRST, the main driver of inflation in China is monetary expansion, not temporary food shortages due to weather, logistics, etc. The fixation by many analysts on the latter — focusing on supply shocks and ignoring the bigger monetary story — has led them to consistently underestimate or discount China’s inflationary trend. The real story is that, over the past two years, China’s money supply has exploded by over 50%, as a way of boosting GDP through a massive lending binge. One of the contributing factors to this story is China’s maintenance of its exchange rate peg with the dollar, which requires China to continually inject more and more domestic currency into its economy in order to accumulate excess dollars as reserves.
SECOND, CPI captures only part of the inflation story. Most of the new money that has been created in China went into an investment boom, not a consumption boom. The result was asset inflation: dramatically rising prices in real estate, commodities, gold, artwork, jade, and other tangible forms of savings. This asset inflation — which in many cases feels like a get-rich boom — is actually masking the true extent of the inflationary pressures at work in China’s economy.
THIRD, price controls won’t work. Over the past few weeks, the Chinese government has leaned heavily on both foreign and domestic companies not to raise prices. The NDRC, China’s top planning body, stopped Unilever from going forward with a planned 15% price hike. The result is a squeeze on profit margins, as companies paying higher prices for wages and raw materials are unable to pass those increases along to their customers. That’s a recipe for pent-up problems, not a solution to the real dynamics driving inflation. The solution is to get China’s money supply back under control.
FOURTH, high GDP growth is not “good news” that offsets high inflation figures. In fact, China’s obsession with high GDP growth is part of the problem. Last year, well over half of GDP growth was due to investment in fixed assets, much of it fuelled by cheap money and easy credit — the same policies fueling inflation. These turbo-charged growth rates only measure the sheer amount of money being invested, not whether those investments are good or bad, or what the return will be. Stupendous rates of GDP growth due to overinvestment or misallocated investment will end up being more of a curse than a blessing. The real challenge for China isn’t racking up ever higher GDP figures, but putting its economy on a more sustainable footing going forward, even if that means “lower” rates of growth.
In conclusion, I want to post the following chart, which I came across in Red Capitalism, a recently published book written by Carl Walter and Fraser Howie, both of whom have extensive experience working in China’s banking sector. It shows what happened in the 1980s in China, after a remarkably similar explosion in lending. In 1984, lending grew by 33% — the same rate as in 2009. It persisted for two more years at 31% (compared to more modest 20% in 2010). About a year after the lending boom began, China saw a run-up in inflation, peaking first at 8.8%, then rising to 18.5% in 1988. Many people credit the sharp rise in inflation as a contributing factor in sparking the Tiananmen protests in 1989.
I’m not going to claim any identical parallels. China’s economy and its banking system have changed significantly from the 1980s — for one thing, there was no private real estate market at that time. Lending increased at a higher rate for a longer period of time. So let’s grant that, in many ways, the dynamics are quite different. But the basic story — a huge lending boom followed by a big run-up in inflation — is still remarkably striking, when you consider what’s unfolding today. If nothing else, it demonstrates why China’s money and inflation numbers matter, and are worth keeping a close eye on.