Containing Stagflation Risk

謝國忠

Summary

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The central government has embarked on monetary tightening. The main tool is credit rationing. The efficiency of capital allocation is declining. This is compounding the trend of declining capital efficiency in the past few years. China's growth potential is declining as a result. The surging inflation reflects the tightening speed limit on growth rate.

Even though interest rate has been raised a few times, the aggregate amount is still small. China's nominal GDP has been rising at 20%, with much of it inflation. a rate hike of 25 bps hardly makes a dent in the level of negative real interest rate. Hence, inflation expectation remains high and rising.

The combination of shifting capital to inefficient users and negative real interest rate are pushing China's economy towards stagflation. To change the course, the tightening needs (1) to shift away from credit rationing and towards market mechanism and (2) to eliminate negative real interest rate as soon as possible.

Monetary policy is too behind the curve

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The PBoC just raised interest rate by 25 bps, the fourth rate hike in the tightening cycle. Still, China's monetary policy is too far behind the curve. China's nominal GDP has been rising at 20% per annum, with much of it inflation. The magnitude of negative real interest rate is big. Raising interest rate by 25 bps hardly makes a debt in it.

Inflation is entering crisis territory. Consumer prices are rising at double digit rate in so many products and services. The inflation expectation is very high and rising. There are signs that inflation panic is spreading. Hoarding is already visible from time to time. When it becomes widespread, a social crisis is likely.

China's interest rate should be three percentage points higher at minimum to allay the people's fear that the government is interested in inflating away the value of money. The pace of rate hike is too small to calm such fear. What's stopping a full blown crisis is the belief that Rmb would appreciate. Otherwise, capital flight would be rampant, making devaluation possible.

Psychological warfare cannot cure inflation

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Too many in China believe in the power of psychological warfare. Inflation is not a psychological phenomenon. It is a monetary phenomenon. Excessive money supply leads to inflation. To contain inflation is to contain money supply to growth rate in line with production. Even when psychological warfare succeeds, i.e., making people believe the false picture of no inflation, its impact won't last. No one has succeeded in fooling people all the time.

Indeed, psychological warfare can backfire. When people realize that they have been fooled, they may not believe anything. Hence, when inflation really cools, they may not believe it. This would require monetary tightening to overshoot to calm the people's fear. Interest rate overshooting always triggers a recession. It is not a desirable outcome.

Administrative power won't cure inflation either

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The worship of administrative power is pervasive in China. When it comes to inflation fighting, many think that the government could force businesses and merchants not to increase prices. There have been recent examples in that regard.

Forcing businesses not to increase prices can only have a temporary effect. When input costs are rising at 20-30% per annum, no business can remain viable without raising price. When the government pressures a business not to raise price, it has to stop production or raises price in a different manner. For example, shrinking portion or repackaging old products as new and with new pieces would achieve the same effect as raising prices.

No matter how powerful government is, it is not more powerful than the market.

In the case of state owned enterprises, subsidy can slow price increase. For example, China's thermal power plants are virtually all losing money. They survive by covering their losses with loans. It is just shifting the burden of inflation to banks. Such tactic has many side effects. Burning low quality coal or not scrubbing sulfur from coal becomes pervasive. The resulting pollution can lead to a public health crisis. While the administrative approach may keep the headline inflation number lower a bit, is it good for the country?

Credit rationing decreases efficiency

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Credit rationing has returned with a vengeance. Most private companies cannot get credit from banks at all. They are turning to gray market for financing at interest rate often above 20%. Many, if not most, cannot serve at such high financing cost. Most such borrowers think that the current situation is temporary. However, if inflation persists and the credit tightening approach remains the same, bankruptcy will spread in the private sector.

China's capital allocation has become more and more biased towards SOE's in recent years. Banks have been lending to underperforming SoEs because they are government owned. The stock markets in Hong Kong and Shanghai have been raising funds mostly for SoEs. Local governments have been raising massive amounts of money through land sales and taxes on property purchases. Hence, government expenditure has risen as a share of GDP.

Government and SoE expenditure may have reached half of GDP. This is by far the highest in the world. The high government revenues in Europe are for redistribution. Such expenditure in China is quite small. History shows that the government or SoE expenditure has low efficiency. There are widespread evidences that the government and SoE expenditures are very low in efficiency. Image projects are sprouting like bamboo shoots in Spring across China.

One byproduct of low efficiency is inflation. When money is spent on low productivity activity, there won't be products or services to absorb the money. Hence, it becomes inflation.

The credit rationing is worsening the situation. While the public sector continues to waste money and adds to inflation, the efficient small and medium sized enterprises are being starved to death. The overall level of efficiency in China is possibly declining.

Stagflation risk is rising

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Declining capital efficiency and persistent negative real interest rate lead to stagflation. Stagflation eventually leads to currency devaluation. No emerging economy has avoided a major crisis after currency devaluation.

Local governments cannot survive positive real interest rate because their debts are three times revenue. Some governments have debts 5-10 times revenues. Their hope for survival rests with selling land at high price. With positive real interest rate the land price bubble is likely to burst. Hence, there is a powerful force to keep interest rate low.

State owned enterprises are in similar shape. While they reported Rmb 2 trillion in profit last year, they were still cash flow negative. The SoE sector has not been cash positive ever. The negative cash flow has become worse in recent years. Accounting profit is always difficult to understand. It is doubly so in China. When the vast SoE sector is so cash flow negative and so levered, one worries about its financial health. When real interest rate turns positive, many of the sector's problems may get exposed. Hence, the SoEs really want to keep interest rate low.

The force is with credit rationing and negative real interest rate. If the combination persist, stagflation is inevitable. If stagflation is a stable equilibrium for a few years, many would love it. It effectively wipes debts away for those who are incapable of repaying. But, when debtors see their debts cut, savers see their savings wiped away. One cannot expect savers not to respond. This is why stagflation is never a stable equilibrium. Social instability inevitably sets in during stagflation.

For an emerging economy serious stagflation always leads to devaluation, which always triggers a financial crisis. China has vast foreign exchange reserves and capital control. Devaluation risk is still low. But, one should not ignore such risk. China's money supply is about four times the foreign exchange reserves. Further, there is a massive amount of credit creation outside of the official system. The trust sector, for example, is effectively in arbitraging regulated interest rates. Its risk profile and thin capitalization pose a risk to financial stability. And it is vast. The effective money supply may be significantly larger. When the expectation shifts, the pressure on the exchange rate could be intense.

Changing tightening speed and mix

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China needs to move away from credit rationing to interest rate for controlling money supply. Each interest rate hike should double to 50 bps at minimum to signal a new approach. The level of interest rate should be increased by three percentage points as soon as possible.

To move away from credit rationing, lending rates should be liberalized further. For example, the band for lending rate flexibility around the official rate can be widened further. At present, banks charge fees to increase effective lending rate. It is not transparent and inefficient.

Rebalancing is the way forward

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Imbalance is no longer just a macro issue. It is affecting micro efficiency. It is in turn leading to the macro consequence of inflation. China's economic difficulties are due to the problems in the system. Unless the root cause is addressed, the economic difficulties cannot be resolved.

The root cause of China's problem is the rising and inefficient public sector expenditure. The system is biased towards giving growth in income to the public sector. As the public demand for funding exceeds what the economy can bear, money printing becomes inevitable.

The tools for shifting money to the public sector are high taxes and high property prices. Unless both are reduced, economic rebalancing is merely talk. China must cut taxes to signal a new approach to economic growth. The top personal income tax rate should be cut to 25% as soon as possible. And VAT should be reduced to 12%.

China's growth model is suppressing the middle class especially hard. A successful white collar cannot afford an average property in tier 1 city after working for ten years. No other country is like that. Suppressing the growth of middle class is not in the country's interest. Social stability in a modern society depends on a large and content middle class.

Many local governments have come out with property price targets. The policies seem to limit price appreciation. They ignore the current unaffordable levels. The system seems to have become incapable of addressing people's fundamental concerns. Average property price per square meter in a city should be less than two months of average wage after tax. This is already a high level by international standards. It already takes into consideration of the high investment cost for building cities from scratch. The current price level is two to three times of that. Such high price can only be sustained by speculative demand. This is why property sales have collapsed after implementing sales restrictions to multiple property or non-resident buyers. Unless local governments recognize the reality, China's economy is likely to experience a hard landing.

Removing negative real interest rate is not only necessary for containing inflation. It is vital to shifting growth model to household expenditure from government expenditure and speculation. When savers are losing wealth to inflation, they are unlikely to be strong consumers. Instead, they may become speculators to recoup the losses, trapping the economy in an inflation and speculation cycle.

Conclusion

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China's economic difficulties are all interlinked and cannot be addressed separately. The root cause is the political economy that gives public expenditure the leading role in driving economic growth. Hence, the fundamental solution must limit the government's means to raise funds. Containing inflation and bubbles must be viewed in that context.

The current growth model is pushing the economy towards stagflation. One consequence of stagflation is currency devaluation risk. Devaluation is likely to trigger a financial crisis like what the US has experienced. China's system is not robust enough to remain stable in such a crisis. The urgency for fundamental economic reforms is easy for everyone to see.

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