Tuesday, July 8, 2008

China's economy and the battle with inflation

Michael Pettis, professor at Peking University's Guanghua School of Management and author of the excellent blog China Financial Markets, weighs in on the falling Chinese stock market. The SSE Composite index is off 40 percent YTD and represents the worst performing stock market globally. At this point valuations seem to be compelling for some but not for Mr. Pettis who sees a recovery in the markets possible for other interesting reasons. In his opinion Chinese authorities are beginning to shy away from inflation as their major concern leaning now more towards supporting growth.

As recently as March and April preventing inflation was the number one policy task and one of Premier Wen’s “two prevents” (preventing overheating was the other), but now it is just “one of the major tasks”. Fighting an economic slowdown seems to have taken priority.

This apparent shift away from inflation is a particular concern because it downplays the potential of hot money inflows to destabilize China's economy. According to Mr. Pettis this could very well lead to a crisis. His main point over the last couple of month is to suggest to the authorities to implement a one off revaluation of the yuan to put a halt to speculative money inflows, although he is worried that this "least bad" policy is coming at a heavy cost.

I have never been an inflation hawk and I do agree that sometime a little bit of inflation is very far from being the end of the world, but as regular readers of my blog know, I think in the last few years China has been sitting on explosive and potentially very destabilizing money inflows, with the attendant money creation, and so I suspect that China does not really have “a little bit” of inflation as one of its policy options. I think that, like the US in the early 1970s, in China we’ve had our delightful monetary party with all the attendant good things, but the party is nearly over and it is going to be very hard to keep the lid on inflation over the next few months and years. I think by the end of this year it will get much worse.

Perhaps it is not unreasonable for stocks to be trading at crisis valuations. On the one hand there is a potential economic slowdown that could depress earnings sharply. On the other hand, a policy shift to combat this potential slowdown risks an even greater undermining of national balance sheets which, when combined with the huge money creation and the increasing role of very pro-cyclical hot money in that money creation, could very well lead to a crisis.

Ambrose Evans-Pritchard, a writer for The Daily Telegraph, blows into a similar horn and warns of rising oil prices, wage inflation and sagging exports posing a triple threat to China's economy.

Foreign reserves have reached $1.8 trillion, playing havoc with the money supply. Declared inflation is just 7.7pc, but that does not begin to capture the scale of repressed prices, from fuel to fertilisers. "There is a lot more bottled-up inflation in this economy than meets they eye," says Stephen Green, from Standard Chartered.

Inflation merely steals growth from the future. It defers monetary tightening until matters get out of hand, which is where we are now. Vietnam has already blown up at 30pc. India is on the cusp at 11pc, so is Indonesia (11pc), the Philippines (11pc), Thailand (9pc) - leaving aside the double-digit Gulf.

click to enlarge

source: Shanghai seems to discount the fight against inflation

By Michael Pettis
source: Oil price shock means China is at risk of blowing up

By Ambrose Evans-Pritchard, The Daily Telegraph

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