Yiping Huang from Barclays Capital has been producing a multi-part research series on the Chinese economy. The fifth part is on Chinese inflation. Not surprisingly and actually quite rightly, Huang states that inflation has been understated by 1-2 percentage point at its peak. That would put inflation at roughly 8.5% instead of 6.5% in July 2011.
Parts of this note are a regurgitation of Huang’s earlier academic work (which can be found here) on the determinants of Chinese inflation in the short-run:
The Huang-Wang-Hua study carried out detailed analyses of China’s monthly data for 1998-2009. The co-integration analysis of the year/year data, for instance, gave the following results:
CPI = −0.073 + 0.358Eliqudity + 0.132Ogap + 0.223Phouse + 0.041PStock
Where CPI is the inflation rate, Eliquidity a measure of excess liquidity, Ogap the output gap, Phouse is housing prices, and Pstock stock prices. All estimated coefficients are statistically significant at a 1% significance level.
Without going further into detail of the statistical analyses (interested readers may refer to the original paper), we summarise the main findings of the Huang-Wang-Hua paper. Findings from two sets of examinations (based on y/y and m/m data) are generally consistent with each other. According to the estimated long-run equilibrium relation based y/y data, a 1% increase in excess liquidity, housing prices, stock prices and exports would, respectively, lead to increase in CPI of 0.35pp, 0.22pp, 0.04pp and 0.13pp. Statistical tests also confirm that excess liquidity, exports, housing prices and stock prices Granger cause inflation in the short run.
We found similar short-run causation relations for the m/m growth data. The direct effects of real interest rates and real effective exchange rates on inflation are complicated. These two policy instruments in general do not Granger cause inflation, although the real interest rate was found to cause inflation at a 10% significance level, in the case of m/m data. Surprisingly, evidence of CPI Granger causing changes in real interest rates was much stronger statistically.
But such results should be interpreted with caution. Since the authorities still pay a lot of attention to the quantity variables of monetary policy (ie, bank loans and money supply), the price variables (ie, interest and exchange rates) could become non-binding. Therefore, it is possible that liquidity measures are still more effective for controlling inflation in China. But we should not assume that interest and exchange rates are not effective. These two tools do affect housing prices while interest rate changes alone can affect stock prices. And the direction of property and stock prices can have a big spillover impact on inflation. But the findings also suggest that further reforms of the monetary policy system are necessary.
The impulse response analyses find that shocks to excess liquidity, output gap, exports, housing prices and stock prices have positive accumulated effects on CPI. Interestingly, most responses occur within the first five months and gradually disappear after 10 months. While both housing and stock prices have generally positive impacts on inflation, the monthly trajectories are more complicated with negative effects in some months. Overall, according to structural variance decomposition, the output gap and excess liquidity have the largest effects on inflation while housing prices have the smallest effect.
How should we interpret these analytical results? Our key takeaway is that excess liquidity, overcapacity and expectations provide an interesting framework for thinking about China’s inflation problem:
This is a simplistic but useful version of the analytical framework. For instance, we may apply it to gauge the near-term future of Chinese inflation. The excess liquidity measure fell recently (Figure 16) and the overcapacity problem may have intensified (Figure 17). These moves imply that, if current trends continue, inflation pressure should moderate. However, if domestic and external growth remains stable and monetary policies become more accommodative, inflation could easily surprise on the upside.
Defining the expectation variable is somewhat more difficult. Inflation expectations can rise if food prices increase, or wages grow, or the Fed adopts another round of QE policy. Since 2010, the PBoC has focused on managing expectations as a method of controlling inflation pressure. This can be done through statements or pre-emptive policy moves.
How about the long-run? His analysis, interestingly, is rather close to the consensus in believing that China will enter “a period of relatively high structural inflation”:
First, after more than 30 years of rapid economic growth, the Chinese economy is gradually stretching the resource constraints. For instance, for several years the Chinese demand has pushed up international iron ore prices by 70-100% a year. Similar changes could be seen in other areas such as oil, copper and even gold. In fact, some analysts question if the world has enough resources to
support continued expansion of the Chinese economy. At a minimum, however, the increasing constraints of resource supply are likely to turn into inflation pressures in China.Second, demographic changes point to higher labour costs ahead. Despite the question of whether or not China has started to see labour shortage problems, rapid wage growth is apparently evident across the country. This could be strong evidence that rural China is running out of surplus labour. In addition, after enjoying decades of the so-called demographic dividend (rising proportion of labour force in total population), the dependency ratio already started to rise from 2011 and total labour force would begin to decline from 2016.
Third, the removal of factor market distortions also means rising higher cost pressure going forward. In China: Beyond the miracle: Part 1 – China’s next transition, we argued that repressed cost of production, through policy distortions in capital, land, energy and other resource markets, was a key form of subsidy to enterprises. Now the government has started to remove these distortions in an effort to improve resource efficiency and rebalance economic structure. This was evidenced by the recent adjustment of petrol prices, despite a slowing economy and still high inflation. According to our estimations, these distortions were equivalent to 8% of GDP in 2008. Removal of these distortions could lead to a significant rise in production costs. For instance, electricity prices for industrial users in China are already higher than those in the US.
Finally, monetary policy conditions have been relatively loose, both at home and abroad. China started its massive monetary policy easing from the end of 2008. The amount of new credit doubled to CNY10trn in 2009 from CNY5trn in 2008. After a brief period of tightening in early 2011, monetary policy easing started again from the second half of 2011. Similarly, other central banks implemented very loose monetary policies during the global financial crisis and have maintained these conditions in the following years. Such easy money is bound to eventually translate into inflationary pressures.