Here in China things don’t ever seem to slow down. Last week the inflation numbers for May came in.  At 3.1% year on year, inflation was slightly higher than expected.  Here is what an article in Saturday’s People’s Daily had to say:

Inflation in China edged higher in May, exceeding the official target of 3 percent for the year, amid some initial signs that the world’s major developing economy’s investment has slowed.

The National Bureau of Statistics reported Friday that consumer prices in May rose jumped 3.1 percent from a year earlier, accelerating from April’s 2.8 percent rate. To make things worse, producer price index, a major gauge of inflation at the gate of manufacturers, soared a staggering 7.1 percent.

The rapid industrial product price rises are expected to be transmitted to consumer inflation in a couple of months, analysts say.  Higher inflation in recent months has stoked concerns that Beijing might hike interest rates to cool economy overheating that surged to 11.9 percent in the first three months.

3.1% CPI inflation, if that number isn’t understated, isn’t really a lot to worry about although 7.1% PPI inflation is much more problematic.  Much of the price increase was in food prices, so of course inflation is worse for lower-income households than for higher income.  This means that real income growth is likely to be understated for the rich and overstated for the poor.  Aside from the social implications, it also has consumptions effects – the poor typically consume a greater share of their income than the rich.

As I see it there are two concerns with these inflation numbers.  The first, concern, much noted, including implicitly in the People’s Daily article, is not so much the level of inflation but the trend.  We have seen rising inflation all year, and although part of this may reflect a low base last year, if it continues rising it will create real problems for monetary policy-making.

Declining cost of capital

The second, and related concern, is the impact of inflation on real interest rates – for me a much bigger problem.  As I have said many times before, rebalancing in the Chinese context requires that household consumption rise as a share of GDP.  This will only happen I think if household income (or wealth) rises as a share of national GDP.  Except for a transfer of state assets to the household sector – in effect a kind of privatization – it seems to me that an increase in the household income share requires that wages rise more quickly than they have in the past, that the currency revalues, and perhaps most importantly, that real interest rates rise.

So has this happened? So far we seem to be seeing some upward pressure on wages, although my friend Logan Wright at Medley Advisors told me yesterday that he is not sure upward wage pressures are likely to remain in place for too long.  I won’t go into his reasoning, but I would add anyway that upward wage pressures are likely to be pro-cyclical.  In other words we cannot count on them to drive growth since they are as much likely to be a consequence of growth as an engine of growth.

The currency, too, has been rising in trade-weighted terms this year, although this is not as good for rebalancing as it might at first seem.  The rise in the RMB against the euro does not mean that Chinese demand for European goods is rising so much as European demand for foreign goods is collapsing.  In other words, the appreciation of the RMB against the euro is not contributing to global rebalancing so much as reacting to a sudden and sharp increase in the global imbalances.  For all the rise in the RMB, the global imbalance ex-Europe is worse, not better, and its impact must be absorbed by someone – and it is not just China that doesn’t want any part of it.

Against the two positives of rising wages and appreciating currency, real interest rates are declining.  Measured against CPI inflation, real deposit rates in the banking system are already clearly negative, and measured against PPI inflation almost all loans made by banks are at negative real lending rates.

Surge in exports

In other words the cost of capital for China’s already too-capital-intensive and overinvesting economy is declining, and so worsening the domestic imbalances, and all but assuring that China’s trade surplus excluding Europe will surge (and maybe even including Europe it will still rise).  In fact one of the least surprising of the “surprises” of recent months was China’s May trade figures.  Here is what an article on Thursday in the South China Morning Post says:

Mainland’s exports rose 48.5 per cent in May from a year earlier and imports were up 48.3 per cent, the General Administration of Customs said on Thursday, giving the country a trade surplus of US$19.53 billion, up from just US$1.7 billion in April.  The median forecast of 32 economists polled by Reuters was for exports to rise 32 per cent and imports to climb 45 per cent, with a projected trade surplus of US$8.8 billion.

Sources said on Wednesday that export growth was up about 50 per cent from a year ago, giving a boost to global financial markets as investors expressed relief that the country’s fast growing economy did not appear to be juddering to a sharp halt.

Some surprise, although I should add that I have a worrying feeling that the subsequent applause by the global stock markets may have got it exactly backwards.  Net exports had to surge after the temporary contraction earlier this year, and in fact if you exclude the impact of commodity stockpiling, which overstates outflows due to consumption imports and understates outflows due to investment, China’s trade surplus would have probably been much higher.  It is being artificially reduced by commodity stockpiling, which of course must be reversed at some point in the future.  I expect that Chinese net exports will continue very strong this year, perhaps even taking into account the effect of the European crisis, which should be excluded from the number.  And of course I expect US net imports, and with it US unemployment, will surge to politically unacceptable levels throughout this year and next, thanks in large part the European crisis and the unwillingness of anyone else to absorb it.

Why do I keep insisting on excluding Europe in judging the process of Chinese rebalancing?  Because, as I discuss in an earlier entry, what happens in China in relation to Europe is not part of global rebalancing so much as a reaction to the European-induced exacerbation in global trade imbalances.  The impact of the European crisis will be to make all non-European trade balances much worse regardless of what happens domestically in China, Japan and the US.  So policies – in Beijing or elsewhere – aimed at protecting the domestic trade account from the effect of the European crisis can only work to the extent that some other country can be forced into absorbing the full cost.

Where is the inflation?

Still, for all the outsized trade surpluses and limited currency appreciation, over the past several years inflation in China has been fairly moderate, even though credit and high-powered money have been expanding at a breakneck pace.  Why haven’t we seen more inflation in China?  China has seen very sharp productivity growth in the tradable goods sector, and according to the standard economic model, any country experiencing very rapid productivity growth in the tradable goods sector will see a rise in the real value of its exchange rate.

This can occur in two ways.  One way is for the nominal exchange rate to rise.  In a market in which the central bank does not intervene, the nominal currency would rise automatically as demand for renminbi exceeds demand for dollars.  In an intervened market, in response to surging reserves the central bank would simply re-peg at increasingly higher rates (although central banks are often very late when it comes to revaluing their currencies).

If the nominal exchange rate doesn’t rise, the resulting net current account inflows should cause excess domestic monetary expansion, which means, ultimately, that domestic prices must rise.  This is just another name for inflation.  A country that runs large and persistent trade surpluses and a pegged exchange rate should gradually see an erosion of those trade surpluses as rising domestic prices increase the external price of that country’s exports.

For the past decade, the rapid growth in Chinese productivity has far exceeded that of its trade partners, and has also far exceeded the growth in domestic wages.  The natural result should have been a gradual but strong appreciation of the renminbi.  But the level of the renminbi is set by the People’s Bank of China, and its total appreciation in the past decade has been much less than the relative growth in productivity – and I am ignoring other factors that should have put even more upward pressure on the currency, like low interest rates, subsidized capital and real estate, and socialized credit risk.  As a result China has seen a surge in its trade surplus.  As a share of global GDP China’s recent trade surpluses (roughly 0.6-0.7% of global GDP) are easily the highest recorded in the last 100 years.

This is all the more striking when you consider that the two previous record holders, the US in the late 1920s (with a trade surplus equal roughly to 0.4% of global GDP) and Japan in the late 1980s (0.5% of global GDP), were relatively much larger economies.  The US represented more than 30% of global GDP in the late 1920s, and Japan represented 15% of global GDP in the late 1980s.  By contrast China represents only 8% of global GDP today.

The huge resulting current account inflows, reinforced by net capital account inflows as foreign money poured into China to take advantage of cheap assets and subsidized costs, forced an expansion in domestic money supply far beyond the needs of the Chinese economy.  Normally, such rapid money growth should have pushed China into an inflationary spiral, which would have then forced a rebalancing of the Chinese economy away from excess reliance on a trade surplus.  Remember that rebalancing in China primarily means that household consumption must rise as a share of GDP, and this can occur in both good ways (a surge in consumption) or bad ways (a sharp drop in GDP growth).  Spiraling inflation would probably force GDP growth to drop relative to consumption.

Financial repression

But this inflation didn’t happen.  There have periods of inflation in China in recent years, and even a brief inflationary scare in 2007 and 2008, but on average inflation has been far less than what was needed to revalue the currency sufficiently.

So what happened?  Why has inflation been muted – as it has by the way in other countries that followed the so-called Asian growth model, including most importantly Japan in the past several decades?

Two months ago University of Chicago economist, Robert Aliber, came to speak at my central banking seminar at the Guanghua School of Peking University.  In a fascinating discussion he explained that in fact there was another possible resolution of the imbalances caused by relatively rapid productivity growth in the tradable goods sector.

He pointed out that if the nominal exchange rate is not allowed to rise, policymakers can still contain inflation by what economists call financial repression, made possible by their control over the banking system in countries where banks completely dominate the financial system.  In the Chinese context, financial repression exists because the vast bulk of Chinese savings is in the form of bank deposits, and the deposit rate is set at extremely low levels.

This has the effect of transferring large amounts of income away from net savers, which for the most part consists of Chinese households, and in favor of net users of capital.  Net users, of course, consist primarily of large, capital intensive businesses, real estate developers, infrastructure investors and local and central governments, including the People’s Bank of China, the largest net borrower of renminbi in China.  Net savers are forced into subsidizing net users, in other words.

The consequence is that monetary growth is channeled not into household demand but rather into the production of more goods, and the inflationary impact of monetary expansion is muted.  Financial repression is an alternative to currency appreciation or inflation.

The cost of low interest rates

But according to Aliber’s model, financial repression has a cost.  It leads to overinvestment, asset bubbles, and rising excess capacity.  By keeping the cost of capital in China very low – perhaps as much as 5-8% below a rate that would impose a fair distribution of the benefits of economic growth between savers and users of capital – it results in a surge in investment which, allied with large-scale socialization of credit risk, can lead at first to a rapid increase in economically viable investment but ultimately, if left unchecked, results in capital continuing to pour into investment long after its returns are uneconomical.

I think it is pretty clear that during the last few years, and perhaps even longer, we have migrated into a state where the correctly valued costs of Chinese investment in infrastructure, real estate development, manufacturing capacity, and government spending, exceed the economic benefits.  In fact on Sunday Beijing announced measures aimed at what may be among the worst offenders.  According to an article in Market News:

China’s State Council, the cabinet, has ordered local governments to stop borrowing using financing vehicles that rely solely on government fiscal revenue for their income, and to shut down those financing vehicles as soon as possible.  The State Council said its policy announcement at the weekend is aimed at “effectively guarding against fiscal and financial risks.” Cumulative debt levels of local government financing vehicles have expanded too rapidly and local governments have in many cases illegally guaranteed the debt of those vehicles, resulting in ever-rising debt risks.

The economic impact of the government’s move to rein in local government borrowing is unclear. Spurred on by the central government’s edict last year to expand lending to boost growth, banks lent lavishly to local governments to finance local development projects.

No official figures have been published on total Chinese government debt from the central, provincial and local governments.  However, Victor Shih, assistant professor of political science at Northwestern University in the United States, has estimated total debt at about CNY3.9 trillion by 2011, or approximately 96% of GDP.

…The State Council also forbid local governments from using their fiscal revenues to guarantee any more debt through financing vehicles.  The cabinet said banks are not allowed to provide loans to any local government vehicles that can’t generate stable cash flows to repay their debts.  The State Council ordered local governments to report their progress on cleaning up their debt vehicles by December 31, 2010.

Non-economic lending

Xinhua’s article on Monday was a little more circumspect:

China’s State Council, the Cabinet, ordered local governments on Sunday to better manage investment agencies amid concern that their borrowings, estimated at hundreds of billions of yuan, could cause problems for Chinese banks.  It also directed banks to control lending to these agencies by targeting loans at specific projects and monitoring how the credit is used.

Chinese banks have escaped the mortgage-related turmoil that hit Western financial institutions and triggered the global economic downturn, but analysts warn that a lending boom driven by government stimulus spending could leave lenders with a mountain of bad loans.

…The State Council statement said some banks and financial organs had poor risk awareness while investment agencies lacked adequate credit management.  Local governments, it said, had also broken rules.  They are not allowed to use state-owned assets or government revenue to offer guarantees, directly or indirectly, for the investment agencies.

These investment agencies or debt vehicles, which seem to account for a large portion of the recent fiscal and credit expansion, have become notorious for the quality of their investing, but since these debt vehicles were created precisely to generate the level, if not the type, of growth that Beijing required, it is not clear how easy it will be to enforce the new ban. It is going to be hard to generate rapid growth without leaving on the credit spigot.  This kind of thing is one of the expected consequences of financial repression.

More importantly, China’s financial repression is also at the heart of the imbalance in the Chinese economy.  By transferring large amounts of wealth from the household sector to net borrowers (perhaps as much as 5-10% of GDP annually, as I explain in an earlier entry), it creates the large growth differential between national GDP and household income that is at the root of China’s very high savings and very low consumption levels.

I should add that if much of this investment is non-economic, as I believe it is, this will exacerbate even further the differential.  Why?  Because the total economic cost of the investment (which must include the real debt forgiveness implied by excessively low interest rates), and which will be borne over the future as the cost are amortized in the form of debt repayment, exceeds the total economic value of the investment (which must include externalities), which will accrue upfront.  This means that we get more investment-driven growth today and less consumption-driven growth tomorrow.

China is faced with a difficult policy choice.  It can maintain an undervalued exchange rate, it can run the risk of inflation, or it can increase the domestic costs of financial repression.  How Beijing balances these separate forces will determine the pace and form of its necessary rebalancing.