Yesterday we highlighted that Goldman had closed out its long China trade in anticipation of reactionary measures to what the Beijing politburo decided to telegraph as high inflation (after all there is no such thing as Chinese "economic data": it is whatever the central committee agrees on). The news sparked a fresh wave of selling in the SHCOMP resulting in the biggest two-day selloff for the index in months. Today, Goldman pours more fuel on the fire, by raising its 2011 Chinese CPI expectations from 1.3% to 4.3%, which guarantees that the State Counsil will have to hike rates as it is obvious that the CNYUSD currency peg will not be removed as long as it is being used as a political scapegoat by Washington. Furthermore, ongoing insanity by the Fed guarantees that surging commodity prices will generate even more inflation in China, which in turn will eventually lead to higher prices in the US, leading to greater margin contractions, leading to more layoffs, leading to the need for what the Chairman will see as even more QE, thereby compounding the most virtuous cycle in the global economy that nobody talks about, as more and more money sloshes around the global system, and finds packets of least resistance. However that is a topic for Q1 2011.
In the meantime, here are the key factors that Goldman believes will lead to even higher inflation in China soon:
1. The food supply had a temporary shock due to natural disasters. Even though the drought in the spring did not result in major losses in grain production, the summer flood has destroyed the vegetable supply in a wide range of areas in August. Given there is little room for vegetable demand to shift to any substitutes in the short term, the supply shock has sent vegetable prices to new highs. Subsequently, the vegetable price inflation was further prolonged as it took longer for farmers to restore the land, grow and harvest another round of
vegetables in the fall.
2. The policy-induced growth slowdown was too uneven and brief to mitigate the inflationary pressures. Since the growth slowdown in 2Q2010 was induced by policy tightening focusing on the property sector and infrastructure investment (through tightened credit control on UDIC borrowing), the impact was concentrated in upstream industrial sectors, with little spillover to mid and downstream sectors or the service sector. In addition, business confidence was soon restored in the upstream sector, after seeing property construction activities continue to expand in almost full force (notwithstanding the residential property sales slowdown), and the National Development and Reform Commission (NDRC) loosened the investment policies in July (see China: Light at the end of the tunnel, Asia Economics Analyst 10/17, September 16, 2010). The bottom line is, compared to a more entrenched and widespread slowdown in a normal business cycle, the soft patch we saw in growth induced by policy tightening earlier this year had a smaller and shallower impact on the output gap and thus inflation afterwards.
3. We still find limited impact of labor cost increases on inflation. While many observers claim the deterioration in demographic structure have caused higher wage inflation to push up prices, we believe the productivity increase still offers a buffer to labor cost increase in the manufacturing sector so far (see Higher wages have not led to higher inflation and, so far, have not impaired China’s international Competitiveness, Asia Economic Analyst 10/15, August 5, 2010). The most recent industrial profit data also suggests labor compensation growth has not outpaced profit or output growth up until August 2010. However, we will continue to monitor the wage and productivity trends and their impact on inflation and present our findings in the future.
1. The CNY depreciated in trade-weighted terms. Despite the nominal appreciation against the USD since last June, the CNY has depreciated 7.2% in nominal effective exchange rate (NEER) terms on the back of broad USD weakness in July–October. Nonetheless, we believe the impact of the NEER depreciation is probably limited, given the small share of imports in the CPI basket.
2. In addition, commodity prices rose on the back of USD weakness and global demand stabilization. While part of the commodity price increases can be explained away by USD weakness, most of price changes have outpaced the USD decline and contributed to rising PPI inflation in China.
3. Quantitative easing has fueled expectation of rising capital inflows and higher inflation recently. Although the excess reserve ratio in the domestic banking system suggests the level of excess liquidity is perhaps still moderate in the monetary system (large banks’ excess reserve ratio was at 1.8% at the end of October, compared to close to 3% in 2007), the expectation of more hot money inflows to push up inflation have been on the rise, as the Fed’s quantitative easing plan was telegraphed and publicly announced in the past 2–3 months.
So once inflation starts to be pervasive, what monetary and fiscal measures does China have to combat the Fed's monetary insanity - a few, but all are futile.
Monetary policy measures: We see increasing probability for the monetary policy stance to be shifted from “moderately loose” to “stable” on the Central Economic Working Conference to be held in mid December.
- Reserve requirement ratio (RRR) hikes and other liquidity absorption measures: the monetary authority will likely rely on more RRR hikes and central bank note issuance to mop up the excess liquidity in the monetary system. In particular, if CPI inflation moves up further in November, which looks increasingly likely now given the ever-rising agricultural good wholesale prices in the past 1.5 weeks, the government will likely hike the RRR for one more time before the end of the year.
- Interest rate hikes: we maintain the view that the State Council will be more cautious in raising the policy interest rates, although real interest rates have been negative. We expect up to 3 hikes next year, each by 25 bp symmetrically in 1-year deposit and lending rates. We cannot rule out that the authorities may choose to frontload one rate hike into 4Q2010, if inflation surprised on the upside significantly in November. But we believe they will more likely choose to hike the RRR so as to avoid strengthening the expectation of a series of hikes that would attract capital inflows.
- Credit control: So far, the credit quota seems to be only loosely managed, which caused the surge in broad money supply in August–October. We expect the People’s Bank of China (PBOC) and the China Banking Regulatory Commission (CBRC) to collaborate and intensify the window guidance soon, as well as planning for a relatively conservative credit target for 2011. In contrast to a common belief that the 2011 target of newly increased loans should stay around Rmb7.5 trillion, we think the monetary authorities will likely try to reduce the target from the current-year level at least moderately to express a hawkish bias. Since the quota will be further adjusted down the road, policy makers’ decision (especially if publicly announced) will have a signaling impact in the near term.
- Exchange rate appreciation: While there is a good case to be made to appreciate the currency faster, especially given the broad USD weakness, we continue to expect policy makers to keep the pace of CNY/USD appreciation at approximately 6% per annum. This is because the Chinese government remains concerned about the consequence of exchange rate appreciation on external sector employment as well as hot money inflows.
Fiscal and investment policies: Although the government may maintain its “proactive” fiscal policy stance in 2011, we suspect it will slow down expenditure growth in the face of rising inflationary pressure. In particular, if the proposed budget fiscal deficits decline both in absolute levels and as a share of GDP, it will signal a shift in the actual stance of fiscal policy from expansionary to tightening. So far, fixed asset investment growth has remained firm, without significant overheating signs. However, should such evidence present itself, the government will likely move to curb lending as well as postponing approvals of investment projects.
Again, none of this will have any effect at curbing what is becoming the biggest Fed-blown emerging market bubble in history. And with China giving up on the plan to grow its domestic consumption strategy as exports once again rule the world, the Fed's plan of exporting inflation indefinitely will soon massively backfire.