Monday, December 20, 2010
Monday, December 13, 2010
Ramblings of a Portfolio Manager
Does Chinese Inflation Matter?
For over a year now we have been hearing in the press that the Chinese economy is in a bubble—that too much stimulus in the form of post-crisis Government-injected liquidity has generated scores of worthless, non-productive infrastructure projects, related speculation on real estate and a resulting runaway inflationary economy. The paradox is that many of those bright economists and money managers repeating this mantra also couch their warnings in “if you can believe the data.”
Are the Chinese, in fact, lying about growth and inflation (i.e. is it really lower than reported figures) or do they really have the makings of an overheated economy. And if their economy is overheating, should the People’s Bank of China be concerned along with, by proxy, the rest of the world? Let’s address the purported lack of candor for a second. The story goes that, though China reports an unemployment rate of just 4%, they are really only counting permanent labor in the big cities, and only short-term contracts in rural areas, and there is a big mismatch between skills needed and those available. Unemployment levels, therefore, are understated. As for GDP, the pundits’ favorite theory is that the Country’s growth is supported only by the sheer volume of money injected by the Central Bank and that it is all being funneled into worthless projects, which will contribute no productivity or return to GDP once completed—i.e. once the gas pedal is released, the car will stop —a Chinese Potemkin Village, to mix metaphors. Along with this axiom comes the assertion that the Chinese are just making up the GDP growth figures—that they are doing so not so much for the world’s benefit but to preserve domestic content. On this score there may be some theoretical basis (although not reality) for such allegations. Many economists believe China needs to sustain nearly an 8% GDP growth to keep full employment in the cities or risk many of the rural peasants who migrated there in search of a better life losing their jobs, thereby promoting internal strife. However, just releasing big numbers does not keep people in jobs. We have yet to see a reverse migration of workers back to the countryside nor have we seen any domestic unrest resulting from economic conditions (and believe us, even the Chinese State couldn’t hide that from the world). Doesn’t sound like overstated employment figures to us. As for the productivity of projects completed or in the works, there may be some truth behind the claims, yet the projects often cited (unoccupied apartment buildings, empty towns) are not necessarily ones that will be worthless in the future (unlike our own bridges to nowhere). They are more like bets on future growth and if the State really can engineer a soft landing to 8-9% annual growth, these projects will doubtless become productive and bear economic fruit in the near future. Finally, as of Friday, the Central Bank lifted bank reserve requirements by 50 basis points, the sixth such hike this year. And that is no lie. Central banks don’t just hike reserve requirements to bolster their own government’s “lies” about economic growth—not even in a well-controlled state like China. So there must be some truth the to GDP numbers we have been seeing.
But if the Chinese aren’t lying about their growth, employment and inflation figures, is there cause for concern? Over the weekend the Central Bank released their inflation data for November. Expectations were for 4.7% although the whisper number was for over 5%. The data came in at 5.1%. After Friday’s hike, the Chinese so-called benchmark interest rate stood at 5.56%. That would leave real interest rates at or near zero—what we are trying to engineer in the US and ordinarily a cause for inflationary concern in an economy already back up on its feet. But are rates really hovering at zero in China? No. A further look at Saturday’s inflation data casts a slightly different picture on the so called “overheated” nature of the Chinese economy. Ex-food, the actual inflation rate was only 1.9%--not far above that of our own lackluster economy. That means fully 63% or more (some peg it as high as 78%) of stated Chinese inflation comes solely from rising food prices, which have jumped 12% this year alone but are expected to moderate over the next twelve months. In the US inflation data is typically presented “ex food and energy” as these inputs tend to be volatile and are not considered “structural” components of a long-term inflation picture—certainly the Federal Reserve wouldn’t consider a domestic rate hike based on inflation data, over half of which was based on these non-structural inputs. Why should it be any different in China? In fact, China managed to produce year-over-year industrial output growth of 13.3%, a true indicator of economic health, with retail sales up 18.7%--important to the government’s effort to boost domestic consumption—all with a “core” rate just slightly higher than ours. Not bad in our opinion. In more fully developed economies, like the US, where there is much less “slack” in capacity utilization, employment or wages, such growth would already be producing significant inflation. In an emerging economy like China’s, where there is such slack, high growth can still occur with modest inflation. This is what we are seeing now.
So, back to the question, what will the Chinese do with their benchmark rate and should we be concerned? Reviewing the components of Chinese inflation, if taming the “stated” inflation rate is the policy goal, raising rates will do little to make a dent. People don’t buy food based on interest rates either here or in China—which is why our Fed tends to factor out that part of our inflation data when considering its next move. And, perhaps, that is why we have seen the PBC wait so long to hike the benchmark rate even in the face of very high stated rates of inflation. However, the Chinese Central Bank has a deeper objective in its rate policy and that is reigning in real estate speculation. There, as it does here, rates do matter and the hope is that the Central Bank wont kill the golden goose while aiming at an entirely different target. Will it do so? As the theory goes, if a bunch of educated PhDs here in the states have difficulty engineering a soft landing in an economy whose metrics are well understood, how can a bunch of ex-communists accomplish that in a wild west version? Well, let’s not forget that for better or worse, most of the economists and analysts manning the PBC were educated in the West—in the finest graduate schools, no less. So what we can expect to see in Chinese economic policy probably wont be much different from what a western Keynesian or monetarist would espouse. That’s not to say they will get it right (as certainly economists here seldom do) but let’s not assume they will just be shooting from the hip either. There are lots of tools to accomplish their objective, short of raising interest rates (as we have seen with the reserve rate hike, for example). In our opinion, there most likely will be rate hikes to come in China but they will be modest, measured and well telegraphed. And the PBC will put forward other programs to slow real estate speculation, as they already have. That’s a page from our own Federal Reserve’s manual, something the Chinese have long studied. And if we are right and food inflation moderates, perhaps the cycle of tightening might be much shorter than most forecasters expect. That would be good news for the world economy and, of course, the world’s equity markets.
For over a year now we have been hearing in the press that the Chinese economy is in a bubble—that too much stimulus in the form of post-crisis Government-injected liquidity has generated scores of worthless, non-productive infrastructure projects, related speculation on real estate and a resulting runaway inflationary economy. The paradox is that many of those bright economists and money managers repeating this mantra also couch their warnings in “if you can believe the data.”
Are the Chinese, in fact, lying about growth and inflation (i.e. is it really lower than reported figures) or do they really have the makings of an overheated economy. And if their economy is overheating, should the People’s Bank of China be concerned along with, by proxy, the rest of the world? Let’s address the purported lack of candor for a second. The story goes that, though China reports an unemployment rate of just 4%, they are really only counting permanent labor in the big cities, and only short-term contracts in rural areas, and there is a big mismatch between skills needed and those available. Unemployment levels, therefore, are understated. As for GDP, the pundits’ favorite theory is that the Country’s growth is supported only by the sheer volume of money injected by the Central Bank and that it is all being funneled into worthless projects, which will contribute no productivity or return to GDP once completed—i.e. once the gas pedal is released, the car will stop —a Chinese Potemkin Village, to mix metaphors. Along with this axiom comes the assertion that the Chinese are just making up the GDP growth figures—that they are doing so not so much for the world’s benefit but to preserve domestic content. On this score there may be some theoretical basis (although not reality) for such allegations. Many economists believe China needs to sustain nearly an 8% GDP growth to keep full employment in the cities or risk many of the rural peasants who migrated there in search of a better life losing their jobs, thereby promoting internal strife. However, just releasing big numbers does not keep people in jobs. We have yet to see a reverse migration of workers back to the countryside nor have we seen any domestic unrest resulting from economic conditions (and believe us, even the Chinese State couldn’t hide that from the world). Doesn’t sound like overstated employment figures to us. As for the productivity of projects completed or in the works, there may be some truth behind the claims, yet the projects often cited (unoccupied apartment buildings, empty towns) are not necessarily ones that will be worthless in the future (unlike our own bridges to nowhere). They are more like bets on future growth and if the State really can engineer a soft landing to 8-9% annual growth, these projects will doubtless become productive and bear economic fruit in the near future. Finally, as of Friday, the Central Bank lifted bank reserve requirements by 50 basis points, the sixth such hike this year. And that is no lie. Central banks don’t just hike reserve requirements to bolster their own government’s “lies” about economic growth—not even in a well-controlled state like China. So there must be some truth the to GDP numbers we have been seeing.
But if the Chinese aren’t lying about their growth, employment and inflation figures, is there cause for concern? Over the weekend the Central Bank released their inflation data for November. Expectations were for 4.7% although the whisper number was for over 5%. The data came in at 5.1%. After Friday’s hike, the Chinese so-called benchmark interest rate stood at 5.56%. That would leave real interest rates at or near zero—what we are trying to engineer in the US and ordinarily a cause for inflationary concern in an economy already back up on its feet. But are rates really hovering at zero in China? No. A further look at Saturday’s inflation data casts a slightly different picture on the so called “overheated” nature of the Chinese economy. Ex-food, the actual inflation rate was only 1.9%--not far above that of our own lackluster economy. That means fully 63% or more (some peg it as high as 78%) of stated Chinese inflation comes solely from rising food prices, which have jumped 12% this year alone but are expected to moderate over the next twelve months. In the US inflation data is typically presented “ex food and energy” as these inputs tend to be volatile and are not considered “structural” components of a long-term inflation picture—certainly the Federal Reserve wouldn’t consider a domestic rate hike based on inflation data, over half of which was based on these non-structural inputs. Why should it be any different in China? In fact, China managed to produce year-over-year industrial output growth of 13.3%, a true indicator of economic health, with retail sales up 18.7%--important to the government’s effort to boost domestic consumption—all with a “core” rate just slightly higher than ours. Not bad in our opinion. In more fully developed economies, like the US, where there is much less “slack” in capacity utilization, employment or wages, such growth would already be producing significant inflation. In an emerging economy like China’s, where there is such slack, high growth can still occur with modest inflation. This is what we are seeing now.
So, back to the question, what will the Chinese do with their benchmark rate and should we be concerned? Reviewing the components of Chinese inflation, if taming the “stated” inflation rate is the policy goal, raising rates will do little to make a dent. People don’t buy food based on interest rates either here or in China—which is why our Fed tends to factor out that part of our inflation data when considering its next move. And, perhaps, that is why we have seen the PBC wait so long to hike the benchmark rate even in the face of very high stated rates of inflation. However, the Chinese Central Bank has a deeper objective in its rate policy and that is reigning in real estate speculation. There, as it does here, rates do matter and the hope is that the Central Bank wont kill the golden goose while aiming at an entirely different target. Will it do so? As the theory goes, if a bunch of educated PhDs here in the states have difficulty engineering a soft landing in an economy whose metrics are well understood, how can a bunch of ex-communists accomplish that in a wild west version? Well, let’s not forget that for better or worse, most of the economists and analysts manning the PBC were educated in the West—in the finest graduate schools, no less. So what we can expect to see in Chinese economic policy probably wont be much different from what a western Keynesian or monetarist would espouse. That’s not to say they will get it right (as certainly economists here seldom do) but let’s not assume they will just be shooting from the hip either. There are lots of tools to accomplish their objective, short of raising interest rates (as we have seen with the reserve rate hike, for example). In our opinion, there most likely will be rate hikes to come in China but they will be modest, measured and well telegraphed. And the PBC will put forward other programs to slow real estate speculation, as they already have. That’s a page from our own Federal Reserve’s manual, something the Chinese have long studied. And if we are right and food inflation moderates, perhaps the cycle of tightening might be much shorter than most forecasters expect. That would be good news for the world economy and, of course, the world’s equity markets.
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