Redstate

No End In Sight

By blackhedd Posted in China | Economy | foreign exchange | inflation | Olympics | yuan — Comments (16) / Email this page » / Leave a comment »

Several worrisome trends in the Chinese economy that have been in place for nearly a year and a half are charging ahead with no end in sight. Here’s a news story about it.

In a word: inflation. China simply has too much money, and not enough economy. That’s putting tremendous strain on the government, which controls the economy tightly. And it’s opening up big questions about whether the country can continue its historically-unprecedented rate of change.

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The sheer numbers here are astounding. China now holds nearly $1.7 trillion in foreign reserves. It was only the beginning of last year that we were all remarking that they had reached a trillion.

We don’t really know how big China’s economy is. They say it’s around $3 trillion, making them the world’s fourth-largest. It’s far more likely to be around 6 or 7 trillion, making them number two. Let’s say it’s the latter. For them to be sitting on $1.7 trillion in foreign exchange would be like us holding close to $4 trillion worth of yen and euros, in cash. It’s just crazy.

Where does all of that foreign exchange come from? Well, when you and the Europeans buy stuff from China, their exporters receive dollars and euros. The People’s Bank of China (their central bank) requires all exporters to turn over their foreign-currency revenues in exchange for yuan. (Chinese people aren’t permitted to hold foreign-currency balances.)

Just as it does with oil-based economies, all of this trade-based inflow generates inflationary pressure. China exacerbates the problem by artificially undervaluing the yuan, which is allowed to change its value relative to the US dollar in tiny increments every day. This morning, the yuan is trading at just under 7 to the dollar, up from nearly 7.5 about a year ago. But the dollar has been falling against the euro, which accelerates the yuan’s undervaluation against the euro. China’s trade deficit with the Eurozone is about the size of ours. In fact, it may now be bigger.

So broad measures of inflation in China are showing prices about 8.5% higher than a year ago. Some food and grain prices are nearly 50% higher than a year ago. That’s not a typo.

What have they been doing to cool their economy down?

They raised policy interest rates half a dozen times last year. Their benchmark is a one-year rate that now stands at 7.47%. (No one has ever explained to me why China always makes their interest rates a multiple of 9 basis points. Maybe 9 is a lucky-money number.) A similar-dated US Treasury security yields a bit more than two percent. I couldn’t tell you whether the Chinese benchmark rate is actually a government-bill rate, an interbank lending rate, or a prime rate.

Still, what about raising lending rates further, as a way to reduce inflation? There are limits to that, because it tends to attract foreign capital looking for the highest yield on any given day, adjusted for exchange-rate risk.

These speculative yield-seeking inflows are called “hot money,” and they deeply frighten the Chinese. Hot money can and will change direction overnight, and an economy which comes to depend on it can crash when it decides to go somewhere else. This effect (originating in Thailand) was what caused the Asian Flu financial crisis of 1997, which devastated the economies once known as the “Four Tigers,” but barely scraped China. They still remember the lesson.

So they’ve refrained from raising rates so far this year, and they’ve slowed down the rate at which the yuan appreciates against other currencies. That leaves then with increasing bank-reserve requirements as a policy tool.

And they just raised them again, to 16.5%. (Comparable reserve requirements in the US and Europe range anywhere from 8% or less to around 10%, depending on the type of institution.) People are saying that China’s bank reserve-requirement will hit 19% by year-end. This has the effect of freezing money out of the economy, since it can’t be loaned out.

With a strategy like that, you expect that the bankers will start howling because their profits will fall. But Chinese bank profits are as strong as ever, which implies that the increased reserve-requirements aren’t really cooling the economy down.

They’re also putting money into what is probably the world’s largest sovereign wealth fund (SWF). This is a vehicle for sterilizing capital inflows by investing them in other countries under government control. To my knowledge, China’s SWF now has about $400 billion, which is about the same size as their holdings of US Treasury bonds.

China could go out and plow a trillion dollars or more into assets all around the world. But here, they would quickly run into political limits. It would be awfully hard to contain the ruckus if they suddenly start buying up public equity here in the US.

China is rapidly becoming a society full of very wealthy people. But they have an income-inequality problem that is vastly worse than the one we have. And the environmental degradation throughout the country is rapidly becoming a world-class crisis, as industrial development proceeds at all costs.

China is on an unsustainable path. Inflation simply can’t keep going at its current pace without causing some major disruptions.

The problem is that Chinese society is very fragile. Inflation is causing economic distress now, as China’s non-wealthy people find it harder and harder to buy food and fuel (prices of both are controlled, which of course results in shortages). And their attempts to cool inflation, if successful, will result in different stresses, possibly including a major spike in unemployment as investments go bad all over the country.

China’s society is controlled from the top down. They don’t have reserves of economic strength embedded at all levels of society like we do. By coming as far as they have in such a short time, they may find that an economic slump will put a lot more stress on social cohesion among their elites than they can easily handle.

On the other hand, if they don’t get a grip on inflation, they might end up with another Tiananmen Square.

-Francis Cianfrocca (“blackhedd”)