China must tackle its bubble trouble
Andy Xie says China's wave of inflation reflects its misguided attempt to invest its way out of a slowdown, thus taxing households when it should be strengthening them to boost consumption
China is experiencing another wave of inflation. From bottled water to bread, prices are surging. The statistics may not fully reflect the situation. Over the past decade, China has transformed from the lowest-priced economy in the world to one of the highest-priced. Nothing symbolises the transformation better than busy customs officials trying to stop travelling Chinese from hauling food items and toilet paper back across the border.
From 1998 to 2003, China experienced deflation following a bout of inflation, driven by overcapacity and a labour surplus. China shifted into inflation in 2004 due to rising commodity prices and the end of the labour surplus.
But the inflation today is different.
Inflation, not growth, is the destabilising force in China. It could trigger a wage-price spiral
First, overcapacity is still a problem; in fact, it became worse after the 2008 crisis as China's attempt to stimulate the economy vastly increased capacity while a weak global economy kept demand weak. This is why the producer price index has experienced a long period of decline.
Furthermore, commodity prices are now declining. But despite these reasons, prices are rising because local governments have developed an elaborate machinery to collect money between production and consumption.
China's inflation is largely a tax on the household sector to fund the government sector. The main purpose is to extend the investment cycle.
In the East Asian export and investment development model, the two go together. When exports slow due to weak demand or competition, investment must slow, too. Otherwise, there would be a big balance of payments deficit, leading to a financial crisis.
This was what South Korea faced in 1997. China's day of reckoning should have been in 2008. The global financial crisis exposed the weakness of credit-fuelled Western demand for Chinese goods. But, instead of slowing investment to match the slower exports, China accelerated investment with its stimulus to maintain the GDP growth rate.
Investment rose to about 50 per cent of gross domestic product, 10 percentage points higher than in 2008. Rising local government debt and inflation funded the investment surge. As the local government debt becomes difficult to increase, the funding burden is increasingly shifting to inflation. The latest bout of inflation should be understood in this context.
Japan and Korea saw their investment rise above 40 per cent of GDP briefly. China's investment has been above that level for over a decade. The simple maths is that a higher ratio for investment means a lower ratio for consumption. But the former leads to more capacity. With consumption held down, exports could absorb the capacity. But as the global economy remains sluggish, there is no demand other than investment itself to absorb the capacity. China's growth model has become a capacity bubble. To absorb excess capacity, China creates investment demand that leads to even more overcapacity.
Bread costs more in China than in most places. But China's five-star hotels offer some of the lowest rates in the world. The contrast reflects China's growth model: taxing the household sector through inflation to fund investment. Necessities like foodstuffs and toilet paper can be taxed more than five-star hotels.
China's inflation dynamic reflects the government's monopoly power in maximising prices. The money supply defines the limits of inflation. For example, China's money supply is rising at about 15 per cent this year. The real growth rate is, at best, half as much. The difference is probably absorbed by inflation.
Inflation, not growth, is the destabilising force in China. The current high rate of inflation could trigger a vicious wage-price spiral, as China is facing a labour shortage. The spiral would make the exchange rate policy unsustainable.
China's financial stability depends on expectations of a stable or rising renminbi against the dollar. If inflation leads to expectations of a devaluation, a financial collapse is likely. Hence, China has to slow growth of the money supply.
Japan experienced a price bubble two decades ago; South Korea and Southeast Asia, 15 years ago. The bubble deflated in Japan after a long period of deflation, while a "maxi-devaluation", a large reduction in the currency's value over a period of time, followed in Southeast Asia and Korea. China's adjustment would be similar to Japan's. The more inflation China has now, the more deflation later.
Local governments have been trying everything to raise financing to sustain existing investment projects. But, banks are pushing risky loans off their books to the shadow banking system. Local government funding costs are rising as a result. With rising interest rates, China's investment bubble will burst, probably in a matter of months, not years.
If China sticks to a stable exchange rate policy, which I expect, prices will go down. China suffered high prices in the early 1990s. By sticking to a stable exchange rate policy, it took five years of deflation to make China cheap again. In this current period of inflation, prices are more out of line with international levels. The coming bout of deflation needs to be severe enough to correct the misalignment.
Unlike Japan, China can expect another growth cycle. The current level of household consumption is one-tenth of the level in advanced economies. It is logical, therefore, for China to shift income away from government to households to support consumption, which would gradually absorb the overcapacity.
The collapse of the land bubble is a necessary part of the adjustment. It will decrease government revenue and increase the purchasing power of household income.
When the property bubble crashes in China, it will be a new beginning, not the end, of China's growth. The US experienced the 1930s before its rise to become the world's dominant economy. The same thing will probably happen to China.
