Richard Estes ‘New York Street Scene’

This blog was out ahead of the pack predicting inflation in China beginning this time last year for a multitude of reasons. Here’s a trip down memory lane:

Wednesday, June 10, 2009

Hyperinflation … in China?..

The China government is paying people in China to buy cars:

June 10 (Bloomberg) — Zhao Hang, who helped devise China’s auto-stimulus package, is facing demand from car buyers battling an unexpected consequence — two-month waiting lists.

“Eight friends have asked me to make calls or write notes to contacts to help speed purchases,” Zhao, president of the government-linked China Automotive Technology & Research Center said in an interview. “Given the world economic situation, demand for cars is surprisingly strong in China.”

Beijing drivers, used to leaving showrooms with new cars the same day, now have to wait about three weeks for a Hyundai Motor Co. Yuedong Elantra, China’s bestselling car, or as long as eight weeks for a Honda Motor Co. CR-V sport-utility vehicle. Carmakers failed to predict a 14 percent sales jump caused by an economic rebound, tax cuts and subsidies and are now trying to raise Chinese output even as they cut U.S. and European production on plunging sales.

I said:

The auto sales effort in China is classic Keynesian economic policy. The question is how this policy fits in with the ‘menage a trois’ of stimulus, the rise in energy costs and the likely relative revaluation of currencies. It seems likely rising energy costs derail similar stimulative efforts in the US. Any stimulative effects on China’s and USA’s economies are constrained by the yuan-dollar peg. Second, the China stimulus flies in the teeth of the Chinese savings habit, partly because saving is the only way for Chinese citizens to acquire goods and services; this runs alongside a long- standing cultural propensity to save. While the PBOC is unlikely to abandon the dollar peg until events force them to do so, they could cheat by printing more yuan. The outcome of the ‘Munchau Scenario’ is a decline in liquidity. Monetary authorities are working strenuously against this illiquidity outcome, including the Chinese, peg or no peg. This is why the Chinese government is paying people to buy cars.

I also said:

Conventional efforts to manage currency flows, savings rates and deleveraging tend to cancel each other out , at the same time ‘unintended consequence’ pitfalls multiply. Pegging the dollar/yuan makes one currency the proxy of the other. Inflation in China is held in check by deflation in the US. If the Chinese abandon the dollar peg currency inflation will manifest itself in China. Economic Undertow has long maintained the conventional wisdom that the yuan is underpriced is wrong. If the Chinese themselves felt the yuan was strong they would trade it and reap the benefits. It isn’t and they don’t.

Any upward revision of currency would be sort- lived; there are too many hasards to the government in out- and- out deflation: the Chinese are printing and they will print some more. There is little in the way of finance in China to ‘trap’ excess liquidity. With any increase in velocity, inflation leading to hyperinflation is not out of the question. Unlike America, there are few asset alternatives to the yuan in China. The Chinese’ savings are so much fiat scrap paper. Given enough Chinese stumulus savers’ hands will be forced; to spend now or lose everything. Once the savings emerge from tin cans buried in tens of millions of back yards, the race will be on.

Chinese hyper- inflation solves everyone’s problems. It removes Chinese savings ‘surplus’ and transfers it to the government, it inflates the value of dollar assets, inflating Chinese sovereign reserves at the same time. It balances current accounts. It takes pressure off the Euro and the Yen. The ‘people’ suffer, but who cares? The Chinese would rationalize that all wealth derives from the government rather than the people. They would execute a few malcontents, mop up excess yuan and pretend nothing at all had happened.

At the end the Chinese government would wind up much richer than when the crisis began. Is the Chinese government that cynical? You better believe it.

Keep in mind that much of China’ debts are non- indexed to inflation; there is much for elites to gain by high levels of inflation. Debts that savings represent are in the form of cash currency individually managed by amateurs who are easy to manipulate and susceptible to panic. China has experienced high rates of inflation recently. It is not something extraordinary in China. It is also a part of the current overheating of the economy.

The ‘vested interests’ in China are both powerful and have strong connections to the real estate bubble that is expanding across the Chinese landscape. It is hard to see Chinese apparatchiks voluntarily ruining themselves if an alternative was at hand.

Here’s Andy Xie:

In the early 1990s, inflation rose in China because production capacity was insufficient to meet investment demand. Investment rose due to rapid credit expansion. So an inflation tax subsidized capacity formation.

After several years of rapid investment, production capacity was no longer a bottleneck. Deflation tied to a labor surplus became a dominant force in the economy. China then joined the World Trade Organization, which made the deflationary force a magnet for multinationals looking to relocate. China’s low-cost labor was a big attraction.

China experienced double-digit GDP growth and low inflation as manufacturing soared. This ideal equilibrium – combining high growth and low inflation – was first broken when prices for commodities, especially oil, started to rise. China’s demand growth eventually tipped the supply-demand balance in the oil market and triggered price increases from an average US$ 20 per barrel to about US$ 80 today. Prices rose across the board to accommodate higher oil prices, since interest rates were kept low in most major economies.

I have little doubt that the latest changes for China’s labor market are even more inflationary. Over the past decade, the share of China’s labor income in the economy has fallen dramatically. Today, it’s probably below 40 percent. But over the next 10 years, I think labor’s income share will rise significantly, probably up to 60 percent. Odds are that this normalization for labor income will lead to annual inflation of 5 percent or more.

But the current interest rate structure is not right for an inflationary environment; it was only appropriate for a deflationary environment. Now, a transition to higher interest rates is necessary to prevent a crisis.

Maintaining the current interest rate structure will accelerate inflation as real interest rates turn negative. This process can feed on itself and trigger a crisis. So the sooner China raises interest rates, the better. I think an interest rate that’s right for the future could be 5 percentage points higher than today’s level.

Nevertheless, the government has been reluctant to raise interest rates. This hesitancy reflects transition difficulties. High on the list of hurdles are local governments and state-owned enterprises – the most powerful interest groups in China. Both could oppose higher interest rates, delaying the transition.

In the low interest rate environment, the nation’s money supply grew rapidly, inflating prices for assets such as property, which local governments rely upon for revenues. Low interest rates also caused state-owned enterprises to increase leverage. If interest rates normalize today, the property market could decline 50 percent, hurting the fiscal position of local governments. And enterprises, whose average leverage ratio is probably around 100 percent, could see their profits wiped out if interest rates rise 5 percentage points.

Because interest rates will only be allowed to rise slowly, and reluctantly, economic forces will push China’s inflation rates higher than they could be if rates were allowed to rise rapidly. It’s hard to guess how high prices could climb, since tough-to-forecast oil prices play an important role. Yet oil prices are likely heading higher in coming years. China’s inflation rate could spike in double-digit territory.

One possible scenario is that inflation rises above 10 percent in 2012, leading to social tension that overwhelms resistance to higher interest rates. And as interest rates climb in chunks, as they did in the early 1990s, property prices would fall dramatically, probably by more than 50 percent.

Yikes! China has painted itself into the same corner as the rest of the industrialized world! It cannot raise interest rates to battle real inflation (as opposed to an oil- price driven illusion of inflation) without causing a property and banking crash. At the same time, leaving interest rates low will allow inflation to ramp upward.

The 50% price drop real estate scenario is scary; the US property drop so far has been around 20% although some areas have fallen farther.

I can’t see the Chinese have any choice but to print, to stimulate and to pour more funds into the economy. The wage component of the ‘wage-price spiral’ is now taking form. Workers @ Chinese factories are forming impromptu unions and striking. Unlike past periods when labor unrest appeared and the government has reacted with brute force, the labor forces are now winning. The government will react by cheating … and silently inflating away the value of the increased pay checks.

Here are some more articles referring to China inflation:

Also …

Here’s an article and a nice chart: (Go to article to see the chart)

The Chinese yuan revision is a wild- card. China is held hostage by its increasing fuel consumption that it now satisfies with dollars it holds in reserve. Revising the yuan upward against the dollar would seek to export Chinese inflation to the US in the form of higher- priced Chinese goods.

Whether this is realistic or not depends on the particular goods as American consumers are over-extended and not able to spend wildly as they once did. Higher prices will destroy demand as the increased cost of crude has destroyed demand and for the same reason. Attempting a harder currency than the current oil- pegged dollar is a way to crash the property bubble and for what reason?

To support the dollar which does not need any help?

As I pointed out last year, any yuan appreciation will likely be short- lived as Chinese administrators use what time is left to break the infernal peg between dollar and crude that will ruin them in turn after the ruination of American business.

They appear to be taking their chances with inflation. It’s going to be interesting …