Wednesday, April 13, 2011

Mainland China Barreling Towards Stagflation

That's the gist of a Caixin Online report that says the People's Bank of China (PBoC) is making the same mistakes other central banks do: raising interest rates too slowly and by too little. According to Caixin, the PBoC rate should be at least 3% more than it is now.
China’s monetary-policy makers are too far behind the curve. Inflation is entering crisis territory, as consumer prices for many products and services rise at double-digit rates. Signs of panic have appeared along with hoarding which, when it spreads, could trigger a social crisis.

Yet something else is happening. By shifting capital to inefficient users against the backdrop of negative real interest rates, China’s economy is being pushed toward stagflation. Meanwhile, the public is afraid that the government wants to inflate away the value of their money.

What’s prevented a full-blown crisis so far is a belief that the yuan will appreciate. If not for this assumption, capital flight from China would be rampant.

To change course, policy tightening must shift away from credit rationing and toward market mechanisms. Moreover, the interest rate must be lifted out of the negative column: It should be raised at least three percentage points to allay public fears. These changes are needed as soon as possible.
Adding to inflationary woes is increased loans to inefficient state-owned enterprises, which do not damp inflation as much as private firms because they produce fewer goods per unit of money brought into the firm. Price controls, already being resorted to by the mainland Chinese government, won't work because they cut off profitabilty and encourage firms to cut costs that need to be borne. An example would be coal-fired plants and scrubbers.

Inflationary expectations are rising in part because savers have to endure negative real interest rates. Seeing one's savings eaten away by inflation does encourage one to buy goods to beat future price increases.

Unfortunately, a lot of municipal governments are debt-clogged. Raising rates might push them into bankruptcy. Needless to say, inflation benefits debtors whose loans carry a fixed rate.

The solution recommended by Caixin is the same one used by the United States in the 1980s: rising interest rates much more quickly than has been done in the past, but cushioning the blow with cuts in income-tax and capital-gains-tax rates. That'll encourage private business to pull the mainland Chinese economy out of a post-stagflation hole.

It's a hard-hitting report, which shows that maninland China is close to the same boat that the U.S. was in as of the 1970s. Oddly, though, high inflation has not coincided with a serious drop in growth as of yet. So, it's quite likely that the mainland Chinese authorities will ignore this report and others like it. The economy ain't broken yet, and central planners are as loath as anyone else to not fix what ain't broke. By their actions, the PRC central planners have shows a liking for the command approach rather than the market approach.

I should say that the above summary doesn't do full justice to the report itself, which can be read here.

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