“Inflation is always and everywhere a monetary phenomenon.” Milton Friedman’s eternal quote must be ringing around the corridors of power in Beijing, after official statistics showed a surge in inflation to 6.9% in November, the highest level recorded recently. Notably, it is not only food but also other items in the basket that are pushing up prices in China, which in the context of industrial overcapacity in most sectors, is saying something. The problem of inflation is more serious than corruption, according to a survey of young Chinese leaders.
While some factors such as a government-mandated increases in diesel prices helped to push up CPI in November, the overall trend of money supply staying out of control is unmistakable. Look at the diesel story for example: the government mandated a price increase in order to reduce demand, a strategy that seems to have failed completely, going by anecdotal evidence from Chinese refiners.
The fault lines go back to another piece of data from China for November, namely surging export surpluses, which hit US$26 billion for the month, another record. A simple way of understanding the picture is to follow the dollars, putting yourself in the shoes of an average manufacturer of widgets in Shenzhen.
Say this seller of widgets makes a profit of $1 per widget sold at $100 each (this is a common manufacturing margin in southern China), total sales of $1 billion for the month would equate to a profit of $10 million. The moment the money comes in, the People’s Bank of China, or central bank, would provide him with about 7.5 billion yuan (US$1.017,000,000) or so (assuming some degree of forward selling), of which around 75 million yuan would represent the manufacturer’s profits for the month. The other money would be used to repay bank loans, pay for raw materials, electricity, employees and all the good stuff.
Of these, say for example that the money going towards raw materials is around 500 million yuan, and that for wages is 300 million yuan. In any normal economy, the 75 million yuan profit margin (900 million yuan for the year) would represent the new addition of money to the economy, which would contribute to inflation. Not so in China, as we see below.
Typically over a period of a few months, the manufacturer would have set aside a large pool of money, say around 1 billion yuan because as the Chinese currency appreciates against the US dollar, his local income decreases. This 1 billion yuan is used to speculate on assets like shares and property, with the income used to supplement the 75 million yuan that is earned every month for selling widgets. Used on shares listed in Shenzhen this year, the 1 billion yuan would have returned more than five times as much, which is obviously an exceedingly large sum that adds to the country’s surging demand for assets. Keep that as say 5 billion yuan in the bank for the year, over and above the 900 million yuan from manufacturing profits for the year.
Remember the 300 million yuan for wages: that money now is also going towards property and shares, as employees find their monthly wages are not enough to pay for the rising costs of groceries, fuel and rents, as well as all the other good stuff in life, like a Ferrari or two. That money fully deployed in stocks this year would have made 1.5 billion yuan, but lets not get greedy and call it 500 million yuan in profits for the employee crowd.
Then there is the matter of the 500 million yuan for raw materials, which is where the government thinks it exerts the greatest price controls. Well, that may be so for certain products but in many cases southern Chinese manufacturers claim that their suppliers squeeze them on prices by levying additional charges, as they themselves attempt to combat inflation. In any event, the suppliers have to use existing liquidity to invest in shares and property, which this year would have garnered them good returns of say 1 billion yuan.
As I wrote in a recent article (What’ s Chinese for Ponzi? Asia Times Online, November 10, 2007), the sheer weight of money chasing the stock and property markets, combined with economic growth engendered by rising export surpluses, has allowed companies to prosper with new stock listings. Money made in the stock markets comes back to the consumption of pork (now every day rather than for Chinese New Year as some middle-aged Chinese remember it), cars (try driving in Shanghai) and other consumables. All this supports a new economy of goods made in China for domestic consumption only, albeit at steadily rising prices.
Most important to all this is the circular nature of the story – as consumption of various goods increase, the need to earn more through risky investments also increases. This produces an asset bubble that inflates with every rise in food and other prices across China.
The role of banks
Salient in all of the above is of course the small matter of the PBoC not knowing any of the characters involved above – the manufacturer, his employees or his suppliers. All that work gets done by the commercial banks, which interact with these folks. These banks obviously need to make more money than what government yields in China offer, so they are happy to make available various forms of lending to the public, including the lucrative area of unsecured lending such as credit cards. Anecdotal evidence shows that some investors are paying for their stock market accounts with credit cards, in an eerie throwback to what we saw during the dot-com bubble in the US at the end of the ’90s.
Additionally, banks are also happy to extend lending to both the supplier and the manufacturer from above, as they build new offices for their expanding business empires – it is another matter that building new headquarters is one of the easiest ways of entering the commercial property market.
As the central bank attempts to mop up excess liquidity, it sells bonds to the banks, but takes the cash so received and makes it available for overnight liquidity to the same banks. In the context of the amounts described above, increased reserve requirements would only mop up around 50 million to 100 million yuan of the 7.5 billion yuan (received when the goods are sold in the United States) that is circulated, leaving all the rest available for banks to lend. More importantly, the profits made on stock markets – which we counted as 6.5 billion yuan above, would count as excess money in circulation, which hasn’t been drained.
This is why the PBoC circulars on reserves are greeted with some degree of derision by investors in China, as the amounts involved pale in significance to what helps to bump up liquidity every month.
At the risk of oversimplification, the heart of the matter is the original $1 billion in widget exports. If China were to revalue its currency, it is quite likely that sales would decline, perhaps to $750 million, with concurrent declines in wages. It is to avoid any decline in wages that the Chinese government attempts to keep the yuan steady. However, in so doing, it has unleashed a massive asset price bubble that feeds domestic inflation.
Any revaluation would increase the purchasing power of today’s rich Chinese. They would follow the Japanese in becoming the world’s most visible tourists and also increase consumption of goods produced locally. The twin forces of consumption and tourism would probably more than offset the economic decline caused by lower exports.
Failing this recognition of reality, Chinese authorities can turn to the Buddha, as I recommended in a recent piece ( Ben, beef and the Buddha Asia Times Online, October 13, 2007). More time spent on teaching the people of China to reflect on a life without conspicuous consumption may help authorities fight the inflation battle more equitably. Somehow though I don’t quite expect the strategy to be successful.