The devastating earthquake is also bad for monetary policy

This has been a sad week for China, and it has certainly not been easy to watch on television the heartbreaking scenes of the effect of Monday’s earthquake. Sichuan is a heavily populated province, and many of my students have friends and family in the affected areas, so the disaster has hit us very hard. The fact that so many of the victims were schoolchildren makes it all the more horrifying. Bless China, as my student Gao Ming wrote me earlier today, a phrase many worried and dismayed students around campus have been repeating. Next week my friends and I will organize a concert to raise money for the earthquake victims. It’s not much, but everyone feels helpless and wants to do something to help, however small.

Unfortunately the earthquake and its corresponding devastation are almost certainly going to complicate matters horribly for the PBoC in its attempt to manage monetary policy and fight inflation. Already before and immediately after the earthquake the new numbers coming out were worrying. For example yesterday the authorities announced that new RMB lending for April amounted to RMB 464 billion, up substantially from March’s RMB 283 billion (Merrill says this is equal to 43.0% of their second quarter quota, while CSFB says it is 51.5%). The total new lending year to date is RMB 1.79 trillion, which is not much less than half of the RMB 3.6 trillion increase in loans for all of 2007. This year we were supposed to see a cap on loan growth equal to last year’s total increase in lending, so we are already at nearly half the full year’s new loan quota.

Banks have typically front-loaded their quarterly lending quota into the first month of each quarter, and this quarter seemed at first to be no different in that respect from other quarters. Had it not been for the earthquake I would have predicted that banks would certainly exceed their loan quota for the first half of the year, but not by nearly as much as the year-to-date figures imply. With the devastation wreaked by the earthquake, however, and the mounting anger and need for reconstruction accompanying the devastation, I am not so confident of that prediction. I suspect that the financial authorities are more likely to lean towards leniency on loan growth than to insist on strict maintenance of the caps.

They will also most likely be pretty lenient about money growth, even though the most recent numbers suggest they have already been too lenient. Besides the jump in lending we’ve seen a rebound in M2, which grew 16.9% year or year in April – according to Bloomberg the market was expecting an already high 16.2% increase. M1 is also up, by 19.1%. Both of these measures increased relative to March year-on-year figures. The China Daily quotes Fan Fangzhi, an economist with the Chinese Academy of Social Sciences, as saying “The statistics indicated that the Chinese economy is still challenged by excess liquidity and a rebound in credit growth.” I would find that hard to dispute.

Interestingly there has been a veritable battle in the press about which way to go. One article in China Daily yesterday proclaimed “Chinese economy still under liquidity pressure””and argued for more tightening, while an article by Xin Zhiming today is headlined: “Fears grow yuan lending may stoke inflation.” Both of these articles warned about excessively loose monetary policies and the inflation threat.

On the other hand yesterday’s China Daily also published an article titled “Price battle half-won,” which claims, rather optimistically I think, that the government’s “tightening” policy is working and must be maintained, although the author does acknowledge that it is ‘“far too early to claim victory in our battle against rising inflation.” Yes, I think I agree. It is far, far, far too early to declare that particular victory. Meanwhile an article today by Ma Hongman proclaims “Maintaining growth the only option,” in which he argues that while the causes of inflation in China are not under the control of policy-makers, “the three engines for economic growth – investment, consumption and trade – have all slowed down their forward pace”.

In short, the Chinese economy is seeing an overheating and a slowdown in different parts simultaneously, making it much more difficult to choose specific policy tools. Thus, it is advisable that the policymakers prepare themselves for the worst scenario in future when they fix economic policies.

The “worst scenario” mentioned above is stagflation, when inflation is combined with stagnation. The high inflation level is primarily caused by the elevated prices on the international market sneaking into China through its huge import volume. Since the domestic economic slowdown is also possible, it is hence not impossible for the country to witness a stagflation.

Although I too worry about the possibility of stagflation (and this is the first time I think I have seen the word used in the Chinese press about China) I think Ma is mistaken in seeing inflation as caused primarily by rising prices in the international market and so out of the control of local policy-makers. It seems to me that domestic monetary policy is clearly at the root of Chinese inflation, but his argument is an interesting new spin in the growth-versus-inflation debate – yes there is inflation, he acknowledges, but there is nothing we can do about it so let’s focus on growth.

The government is, however, very worried about the inflationary impact of the earthquake, and is taking steps to control the impact, but perhaps the wrong steps. According to Bloomberg:

China ordered authorities in earthquake-hit areas to step up price monitoring, to prevent “large-scale” increases and hoarding. Prices of food, fuel, medicine and drinking water will be closely monitored and local governments can take “intervention” measures, the National Development and Reform Commission said in a statement on its Web site late yesterday.

Clearly the earthquake in Sichuan will not only impact agricultural production and the ability to deliver products to the market, but its reconstruction will fuel a boom in demand for energy, materials, and a wide variety of related goods and services. Recognition of the impact of the earthquake both on loosening monetary policy and on increasing the demand for a variety of goods seems to have powered the stock market today. It closed up 2.73% today, driven by smelters and banks.

The government’s automatic response to this potential surge in demand is to clamp down even tighter on price increases, but this cannot possibly have any but the most adverse effect. After all it is one thing to freeze prices in order to drive out inflationary expectations, but the earthquake has caused a real increase in demand and a real decrease in supply – and the stock market immediately recognized that fact. How can price freezes possibly eliminate the disequilibrium?

In fact yesterday’s China Daily had a very long article on the difficulty of maintaining existing price freezes. The article is called “To raise oil prices or not, that is the question” and starts out very bluntly with: “Diesel sold out. This notice can be seen at many gas stations in the country.” It explores both the difficulty of keeping prices at current levels – shortages and an increasing fiscal subsidy – and the difficulty of letting prices rise – the inflationary impact. People like me of course will point out that price freezes simply convert inflation from one kind, the kind that’s measured in CPI, to another, the kind that shows up as shortages and higher taxes, but the idea that China does not have monetary inflation, simply a temporary food-supply problem, has become so ingrained in policy, even though fewer and fewer people believe it, that its impact will stay with us for a while.

3 Responses to "The devastating earthquake is also bad for monetary policy"

  1. CHEN jiyao   May 16, 2008 at 1:47 pm

    Hmm, China is already very vulnerable at this point; but the bright side is that those external shocks might facilitate a revolutionary change in the policy choice of the CCP. those shocks will make relying exclusively on tightening monetary policy even less able to bear fruit, thus paving the way for further exchange rate regime reform to come in. Those natural disasters are bad because innocent people died while still they had positive lights because this substantially increased the social cost of the government’s choosing ‘a stable exchange rate regime’ and ‘using monetary policies to tackle an inflation which a one-off revolutionary is better at addressing’. Still, my deepest compassion to the victims. ‘Although I too worry about the possibility of stagflation (and this is the first time I think I have seen the word used in the Chinese press about China) I think Ma is mistaken in seeing inflation as caused primarily by rising prices in the international market and so out of the control of local policy-makers. It seems to me that domestic monetary policy is clearly at the root of Chinese inflation, but his argument is an interesting new spin in the growth-versus-inflation debate – yes there is inflation, he acknowledges, but there is nothing we can do about it so let’s focus on growth.’ Yes, I agree with that. China’s inflation I argue is a necessary outcome of the following: Gap between too much savings and too little consumption in association with the government’s FDI and export-inviting strategy resulted in the current and capital account surplus leading to a growing foreign reserve and expectation on RMB rise. This leads to the slow-appreciation of the Chinese government as it both has to revaluate and fears a radical movement. The slow-appreciation is a cause of loose monetary policies, loose monetary policies is a cause of today’s inflation. So it is either to change the gap between savings and consumption, or Using a Radical one-time-off Revaluation, risking the consequences, but ultimately tackles the inflation and speculative activities. But at this moment, I am very curious about the true reasons why the government has been reluctant to talk about the genuine origin of today’s inflation and instead kept beating around the bush by citing international factors such as rising oil prices( of course, this should be factored into the inflation, but still not the fundamental root). But the government does acknowledge that the best way to get rid of the growing trade surplus is to encourage domestic consumption, one does touch upon the root cause. But I figure the reason why the government talked less about it is probably because they do not want to invite challenges towards their FDI and export-led growth paradigm. I think the CCP authority already realized that the CPI surge is not simply a product of temporary market distortion; The bureau of statistics recently posted articles about their findings and it was enshrined in their statement that other major factors are believed to contribute to this inflationary disturbance.( before i remember Xiefuzhan kept stressing the dominant role of Pork supply shortage in this CPI rise).

  2. Victor   May 16, 2008 at 6:40 pm

    Hi Michael, I agree that the earthquake will make constraining inflation even more challenging. It turns out that there were two loopholes in the credit quota: the policy banks and foreign exchange loans. In a note written by Stephen Green at Standard Chartered recently, he shows some evidence that a portion of the large increase in fx loans in first quarter is being recycled back into the fx reserve. Also, if you look at loan growth in 1Q, you see declines everywhere except for the policy banks. I think you will see policy banks continue to make loans in 2Q

  3. Michael Pettis   May 17, 2008 at 2:07 am

    Victor, I saw Green’s piece yesterday and like you noted the big policy bank loophole, which they seem to have exploited quite aggressively. If we could also figure out loan growth in the informal banking sector, which from (very) anecdotal evidence seems to be quite strong, we would have a much better sense of how tight these loan caps really are.Chen Jiyao, I agree that consensus seems slowly to be shifting but rhetoric is still about supply and international causes of the inflation and not domestic monetary causes. I suspect that will be the case until the consensus has fully changed.