Why China should not fear the bogeyman of inflation

Who’s afraid of inflation? It seems like China is, judging by recent rebuttals from Beijing ruling out further massive policy stimulus along the lines of 2008, spoiling the chances of another major monetary push. Yet the risk of higher inflation is the last thing Beijing should be worried about right now.

The world economy is still moving in the wake of a deflationary hangover, and global demand-pull and cost-push price pressures remain subdued. Meanwhile, China’s inflation outlook looks benign. Beijing needs the courage of its convictions, to throw caution to the wind and ease monetary conditions to prevent growth slowing further.

China’s economy is slowing from a quick canter to a crawl. A major reason why China’s growth rate will extend its decline from around 6.5 per cent this year, possibly towards 5 per cent next year, is simply because Beijing’s growth policies are not up to the job. Thanks to the deteriorating global outlook, China should be stepping up monetary and fiscal stimulus, but the country’s economic planners are falling behind the curve. Policy is squeezed from two directions.

In real terms, inflation-adjusted central government spending is only expanding at an underlying 4.7 per cent annual rate, while 12-month M2 money supply growth is limping along at a lacklustre 5.5 per cent rate above inflation. This is barely enough to support this year’s modest growth objective, let alone encourage hopes for future improvement. China’s monetary balance sheet is in stasis, with total assets held by the People’s Bank of China unchanged from a year ago in nominal terms and down 2.6 per cent in real terms. This is no “fire and fury” response to domestic slowdown.

The only major area where China’s authorities have run an open-door policy for faster growth has been the dramatic devaluation of the renminbi exchange rate, which has fallen by as much as 10 per cent versus the US dollar this year. In normal circumstances, this would have given China’s export sector a major boost, but not after the damaging trade rift with America. Despite signs of a potential truce between China and America at last weekend’s G20 meeting, the jury is still out on what it means for the future.

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Despite the yuan’s drop this year, there have been few adverse consequences for inflation. China’s producer price inflation rate is still relatively modest at 3.3 per cent, headline consumer price rises are only 2.5 per cent up from a year ago, while core inflation remains subdued at 1.8 per cent. From an inflation standpoint, there is nothing stopping another major monetary push, with lower interest rates, additional cuts in banks’ reserve ratios and faster credit expansion to help speed things along.

Obstacles may be blocking the way but they are not show-stoppers. Beijing is worried that giving way to easier monetary policy could give misleading signals to foreign exchange markets, possibly flashing a green light to currency bears to hit China’s renminbi even harder. Global ratings agencies have also sounded concerns that a credit downgrade could be on the cards if Beijing fails to rein in China’s domestic credit boom adequately. Given the weaker growth outlook, Beijing needs to bite the bullet as soon as possible.

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China may find an unlikely ally in the shape of US Federal Reserve chair Jerome Powell, who softened his line last week by hinting that US interest rates may soon be close to “neutral”. If US interest rates are nearing their peak, it may give China’s authorities an opportunity to cut rates again. China’s solid inflation-adjusted prime lending rates still provide enough scope to ease again without too much of a dent in exchange rate perceptions. Another half-a-percentage-point cut could easily be absorbed by markets without much ado.

China’s consumers might not favour rises in the cost of living, but even higher inflation would be better than slower growth, weaker job opportunities and more factory lay-offs. Right now, China’s inflation outlook is benign and Beijing needs more ambitious pro-growth policies in place to get better traction.

David Brown is the chief executive of New View Economics