Most PBoC watchers have always believed that the PBoC has been among the most vocal supporters of a stronger currency, and has argued in the past that an appreciating RMB is the best way to fight inflation. Yesterday, however, Zhou Xiaochuan, governor of the PBoC, surprised a number of people at his NPC-related press conference. He said, among other things, that “faster currency appreciation helps to rein in inflation, but not a lot. To curb inflation, we will rely more on domestic policies. ?There is no need to use exchange-rate reforms as a way to fight inflation.”
A lot of commentators are reading this as meaning that currency appreciation is losing its appeal as a way of attacking inflation (The Wall Street Journal Asia headline was “China‘s Zhou Says Strong Currency May Not Be Best Way to Fight Inflation”), while raising minimum reserve requirements and hiking interest rate will be used more aggressively. I am not sure I agree, since Zhou also commented on the difficulty or using interest rates as a tool, and admitted that the recent aggressive rate cuts in the United States are restricting his agency’s ability in raising the cost of capital. He also said “We have to consider and measure the impact of interest rate changes on domestic demand,” which doesn’t sound like he is expecting to raise the deposit rates by a whole lot.
Zhou may have meant what he said about the currency, but it is also possible that he was just trying to talk down hot money inflows by downplaying the prospects of large appreciation gains. Actually I think Zhou is partly right about the limited efficacy of RMB appreciation in the fight against inflation, but not perhaps for the reasons he means. Looking at the rate of appreciation of the RMB and the CPI inflation numbers, it is hard to draw the conclusion that an increasing appreciation rate has reduced inflation.
In part this shouldn’t be a surprise since there are inevitably going to be lags between the currency and its impact on domestic inflation, especially if you believe, as I do, that the inflationary pressures have been accumulating for many years and have only just emerged. On the other hand it isn’t much easier to see the inflation-reducing impact of raising interest rates or minimum reserve requirements. None of the policy measures have worked – that is the big problem facing the authorities.
If Chinese inflation is a monetary problem, which I think it is, I it seems clear to me that the only way to reduce inflationary pressures is to reduce monetary growth, and that means of course reducing the net capital and current account inflows into China. A more rapid rise of the RMB is not only unlikely to reduce those inflows (at least until the RMB is much more expensive than it is now), but on the contrary it will actually increase net inflows by encouraging hot money faster than it reduces the trade surplus (and anyway so far the trade surplus hasn’t declined). This is what seems to be happening, and a recent report by Bloomberg, that “China will increase (QFII) quotas for overseas investments in yuan-denominated stocks and bonds this year,” seems unnecessarily to complicate things, unless they are hoping that it will boost the stock market.
The contradictory relationship between the currency regime and currency inflows forces the authorities back into the policy gridlock I have discussed so many times before. China must adjust the RMB to regain control of its careening monetary policy, but the very process of adjustment is likely to make things much worse before they can get better, and it is not clear to me that China has room for things to get much worse. That is why I think ultimately they must be forced into a much more abrupt currency adjustment.
And they are certainly going to have to do something about inflation. During Premier Wen’s speech he announced that the inflation target for 2008 will be 4.8%, equal to 2007’s CPI inflation (the 2007 target of course was under 3%). I haven’t found a single person, Chinese or foreign, who doesn’t believe that this target is more about reining in expectations and letting the Chinese people know that the government is fighting inflation than it is a serious forecast. Everyone I have spoken to thinks inflation will come in much higher for 2008, and there are some pessimists (including me) who expect it to average above 7%, perhaps well above 7%.
So far, of course, the pessimists are right. I have mentioned in previous posts that CPI inflation for February is widely expected to come in at no less than 7.8% and perhaps even exceed 8% (we will know Tuesday – January CPI inflation was 7.1%). A very interesting report by my friend Paul Cavey at Australian investment bank Macquarie is a whole lot grimmer. He writes:
Inflation definitely is a big worry. According to the Ministry of Agriculture’s wholesale price index, food prices were about 30% higher than in the same month a year earlier. This index tends to be quite a good predictor of food CPI, suggesting overall inflation in China could make double-digits in February. Statistical quirks could bring the published number lower, but it is still likely to be high enough to be scary.
Paul also argues, based on China’s two previous bouts with inflation in the late 1980s and the early mid 1990s, that the policy responses are going to less vigorous than we might have expected because “Contrary to the popular perception of a Communist Party seeing inflation as a life or death issue for the regime, Beijing’s response to inflation has usually been late and indecisive. The reason of course is that as much as the government is worried about the social consequences of rising prices, it is also concerned about the dissatisfaction that an inflation-tackling slowdown would cause.”
Unemployment, in other words, will trump inflation as a cause of concern. Of course we might get both. Premier Wen predicted that GDP growth for 2008 will be 8%. That might seem shockingly low after the last year’s GDP growth of 11.4%, but remember that most years (including last year) the government projects next year’s GDP growth at 8%. This is not really a target but a base case. In fact I would define 8% growth as stagnation, since for me stagnation in the Chinese context means GDP growth that isn’t great enough to prevent a rise in urban unemployment. On this topic Xinxin Li at Observatory Group has some useful reminders:
The 8% GDP growth rate is only a bottom line growth rate, and the real target of Beijing’s policymakers is around 10%. Note that Wen also announced an annual target of new urban job creation at 10mn. That won’t happen without stronger economic growth. (Forget the unemployment rate target of 4.5%, as the real number could be much higher, too.) In the past three years, China created 9.7 million, 11.8 million and 12.0 million new urban jobs respectively, but its annual GDP growth was steadily high at 9.9%, 11.1% and 11.4%. In other words, 10% is viewed as a minimum growth rate for Beijing to reach its employment target.
If China can’t keep its GDP growth rate above 10%, it will have great difficulty in maintaining the necessary employment growth, and with unemployment rising among the young (and among university graduates) there is a lot of pressure to keep growth effervescent. China’s conundrum is that it has too many economic policy objectives not only which are contradictory but also for which they seem to have no very efficient tools. Last year around this time Premier Wen shocked everyone by saying that the Chinese was on a clearly unsustainable path. One year later the country is still racing, faster than ever, down the same path.
Leaving China briefly and turning to the rest of the world I saw the following in today’s Financial Times:
Capital flows to emerging markets reached record levels last year as investors fled the US and other developed economies in search of higher yields and faster rates of economic growth, the Institute of International Finance said on Thursday. The IIF said total flows to emerging markets reached an estimated $782.4bn in 2007, a sharp rise from $568.2bn in 2006 and $521bn in 2005.
I am not surprised that during this time of developed-world crisis so much money is flowing to emerging markets. There is plenty of risk-loving liquidity looking for a home (see Brad Setser’s latest blog entry), and I do not believe we are at the end of the latest globalization cycle, in which rising international trade and investment flows and the always coincident “next stage” in the industrial revolution are always underpinned by a sharp rise in global liquidity.
Still, the developing-country financial historian in me finds this worrisome. In the past, massive capital flows into developing countries with their weak financial systems and inverted balance sheets often created serious imbalances in sovereign and banking capital structures. These were only resolved by financial crises that were often deep and long lasting. The “lost decade” of the 1980s was merely the most recent such period.
