Page 2 of
2 China's inflation carries long-term
risks By Pieter
Bottelier
estate or shares. An
appreciating exchange rate and higher interest
rates add relatively little to the large profits
that can be earned in bullish asset markets.
The experience with previous inflationary
cycles in China confirms that negative real
deposit rates can be harmful to the financial
system by driving financial intermediation
underground [8] and by increasing the liquidity of
M2, which facilitates inflation. It is in China's
interest to raise deposit rates to make them
positive in real terms.
Since current CPI
inflation in China is primarily driven by
exogenous and temporary domestic supply-side
factors, an
attractive alternative to
nominal deposit rate increases would be to index
them to current inflation, as was done during the
inflation cycles of the late 1980s and early
1990s. Indexation would avoid the need to lower
nominal rates when inflation begins to fall.
Risk of asset price bubbles Another
potentially dangerous risk to China's economic
stability, the bubble on China’s stock market
fueled by excess liquidity in the hands of the
public and enterprises, has subsided, in part
because of government intervention. Between
October 2007 and the middle of April 2008, the
Shanghai Composite Index fell by almost 50%. A new
bubble may develop, of course, but it is likely
that the government will again intervene should
that happen.
The risk of a national
housing price bubble, as developed in the United
States from 2002, seems remote in China. There may
be local bubbles, but at the national level
average urban housing prices have been rising more
slowly than personal incomes, making houses on
average more affordable. In some large cities,
such as Shenzhen in Guangdong province, housing
prices have actually been falling for some time.
China's government makes effective use of
markets for development, but it is definitely not
guilty of "market fundamentalism" [9]. It believes
that the state is responsible for controlling
potentially dangerous asset price bubbles. Both
the national and local governments have intervened
with various administrative measures to deflate
local real estate price bubbles [10]. The national
government intervened in the share price bubble
that developed in 2006 and 2007 by: (1) increasing
transaction costs though a raise in the stamp
duty, (2) increasing the supply of tradable shares
in state enterprises, (3) raising the ceiling on
amounts that can be invested abroad, and (4)
high-level public warnings against price bubbles.
It must be expected, however, that
controlling asset prices bubbles will become more
difficult in China as the economic system
liberalizes and the direct influence of the state
on economic processes shrinks.
Looking at
China's development since the start of Deng
Xiaoping's reforms in the late 1970s, it is
remarkable how modest inflation has actually been
on average, especially in light of the super fast
growth of money supply relative to GDP for most of
that period.
The ratio of M2 money supply
to gross domestic product (M2/GDP) rose from about
0.59 to over 1.6, one of the highest such ratios
in the world. This clearly reflects two things:
China's high savings rate and the scarcity of
alternative assets available for investment.
For most of the reform period, Chinese
households were essentially limited to domestic
bank accounts for the investment of their savings.
From around 2004 China's M2/GDP ratio appears to
have leveled off at a little over 1.6. The main
explanation for the rapid increase in M2 with
surprisingly low inflation on average is the
gradual monetization of China's economy, including
the monetization of state subsidies for housing,
energy, consumer goods and many services.
This monetization process has yielded
significant unplanned financial benefits for
China’s government in the form of seigniorage [11]
- the nearest thing to free money. As most
subsidies have now been monetized, while credit
cards and electronic payments systems reduce the
need for transaction money, China’s exceptionally
high M2/GDP ratio may be expected to fall in the
years ahead.
This, combined with the
development of domestic capital markets and
gradual relaxation of restrictions on private
capital outflows, should reduce excess liquidity
in the economy and make it easier to control
inflation. Since China's transition from plan to
market is incomplete, effective inflation control
in China requires not only appropriate short-term
monetary policy, but also long-term institutional
development aimed at developing domestic capital
markets, freeing interest rates, liberalizing the
capital account and making the exchange rate
regime more flexible.
Notes: 1.
China calculates its monthly CPI (and other price
indices) as the percentage change over the same
period 12 months earlier, not the preceding month
as is the practice in most countries. Similarly,
China's quarterly CPI is calculated as the change
over the same quarter one year earlier. This often
leads to confusion when international comparisons
are made. For example, China's CPI of 8.3% for
March actually represents a price decline of 2.4%
relative to February. 2. Economic "overheating"
refers to a situation where demand exceeds supply
in many sectors of the economy
simultaneously. 3. The government's estimate of
GDP growth in 2007 was adjusted from 11.4 to 11.9%
in April 2008. 4. Defined here as total bank
deposits minus loans outstanding, minus minimum
reserve requirement at the central bank. 5. The
sharp price increases for rice, oil and other
internationally traded commodities in recent
months may also reflect the effects of speculation
related to excess liquidity in pockets of the
international financial system. 6. The terms
liquid and liquidity refer to the ease with which
the market value of an asset can be converted into
cash or to the supply of liquid funds in the
economy, depending on the context. 7. For
example, the producer price index for industrial
products jumped 8% in March after having been low
and stable for many months. In addition, in some
parts of the manufacturing sector wages are rising
faster than productivity, which increases unit
labor costs. 8. For obvious reasons, there are
no official statistics on underground financial
intermediation in China, but anecdotal evidence
suggests that it has become a very important
factor in certain parts of the country in recent
years. 9. The term is sometimes used to refer
to a blind faith or ideological belief in the
power of markets to correct their own
excesses. 10. For example, when it became
concerned that local real estate prices were
rising too fast, the Shanghai municipal government
intervened by raising the minimum down payment on
new mortgages and by requiring that first
mortgages were fully paid off before second
mortgages could be applied for. 11. Seigniorage
is the difference between the nominal value of new
money printed (or coined) and the cost of printing
(or minting).
Pieter Bottelier
is a senior adjunct professor at The Johns Hopkins
University's School of Advanced International
Studies (SAIS). Prior to this, he served at the
World Bank from 1970-1998 and was the chief of the
World Bank's resident mission in Beijing from
1993-1997.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
