China’s government recently announced inflation hit a ten-year high of 6.5 percent in August. This increase in inflation is directly related to global trade imbalances, yet China is trying to control inflation without addressing that problem. That carries two consequences. First, it is doubtful this strategy can work, which likely augurs rising Chinese inflation. Second, the strategy aims to shift the onus of global trade adjustment on the U.S., which may come back to haunt China and the global economy.
China’s current inflation is a textbook case of prolonged under-valuation of a fixed exchange rate in tandem with export-led growth. As such, significant exchange rate revaluation should be a central element of its anti-inflation policy. However, instead of making such an adjustment China’s authorities are hoping to control inflation by exclusive reliance on tighter domestic monetary policy. It is doubtful this strategy can succeed because it leaves intact the inflationary impulse from China’s trade surplus and under-valued exchange rate.
One important contributing factor in China’s inflation is the rise in global commodity prices, including oil and base metals, which are now feeding through into prices. Food prices are also on the rise owing to increased global prices for wheat and corn. Furthermore, China has been hit by a virulent outbreak of swine flu that has decimated its hog population, driving up the price of pork, which is China’s favored meat.
In coastal areas, which have been the hub of China’s export-led growth, wages have started rising in response to rising living costs and in response to the gradual elimination of extreme surplus labor conditions.
Most importantly, China is beset by significant asset price inflation that borders on an asset price bubble. This asset price inflation is the product of massive expansion of the money supply caused by China’s trade surplus. Dollars earned by Chinese exporters have flowed back to China and been converted into local money by the central bank, which has bought dollars at the fixed exchange rate to prevent appreciation. Holders of these money balances have then bought stocks and real estate to gain higher returns and to protect against potential inflation. This has driven up real estate prices, triggering a massive construction boom that has in turn caused inflation.
The implication is clear. China is suffering from imported inflation caused by higher global commodity prices, domestic demand inflation caused by excess demand in export industries, and asset price inflation due to an increased money supply caused by China’s trade surplus.
The under-valued exchange rate is a key culprit since it contributes to excess demand in export sectors and it is also drives money supply increase via the trade surplus – which has hit new record highs in 2007. That suggests significant exchange rate revaluation should be a central component of China’s anti-inflation strategy. Moreover, revaluation would also diminish the impact of global commodity price inflation because commodities are priced in dollars so that a revaluation lowers their domestic price in renminbi.
Instead, China has chosen to rely exclusively on monetary tightening, raising interest rates and reserve requirements on bank deposits. This strategy is unlikely to work. First, there is already significant asset inflation and extensive debt-financed speculative investment, which means the monetary authorities are constrained from sufficiently meaningful tightening for fear of triggering a financial collapse.
Second, raising reserve requirements on bank deposits lowers the return on deposits and makes them less attractive. That provides an incentive for depositors to spend their money or invest elsewhere, which spurs more inflation.
Third, and most importantly, continuation of China’s under-valued exchange rate means continuing trade surpluses and large foreign direct investment inflows, which means further monetary expansion in China.
Putting the pieces together, the picture is one of rising Chinese inflation, and with that comes the risk of inflation-triggered social and political problems. In this regard it is worth recalling that the Tiananmen Square disturbances of May 1989 were in part caused by industrial worker unrest over erosion of living standards by inflation.
As for the global economy, China’s anti-inflation policy and continued refusal to adjust its exchange rate places the burden of trade imbalance adjustment squarely on the U.S. This adjustment will likely happen via recession and there are signs that process may already be underway. This is a sub-optimal approach, which is bad for all.
Copyright Thomas I. Palley
If the Chinese revalued their currency abruptly the price of their export products in US dollars would go up and that is likely to push inflation rates up in the US and rest of the world. This could force the Fed to raise interest rates in response to higher inflation. Thus I believe the best strategy for China and the US would be for China to revalue the RMB slowly over time (which happens to be exactly what they are doing). Apart from that I agree 100% with your comments Mr Palley.
I think this post has an interesting point. The exploration of the Chinese problem with inflation reflects the United States own problem with its currency. I see how many of the Chinese solutions to inflation mirror actions taken by the Fed with an emphasis on monetary tightening and altering interest rates. I think if you compared how each of the economies has handled the problem, you could draw a convincing parallel. I realize that this is probably your specialty and by no means my own, and I respect your credentials. However, I want to know more about how one economy affects the other specifically. You explain that the Chinese strategy is to “shift the onus of global trade adjustment on the U.S.†What exactly is the process by which the Chinese do this? How do the differences in situations effect the implications of the policies taken by each respective government? How do the problems surrounding the Chinese economy directly affect the U.S. economy?