Quantum Pranx

ECONOMICS AND ESOTERICA FOR A NEW PARADIGM

China is waking up to an inflation nightmare

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by Justice Litle
Taipan Publishing Group
Originally posted December 21st, 2010

AMONG CIVIL UNREST FEARS, fragile exporters and a speculative property boom, China has a very bumpy ride ahead… The inflation situation in China is getting out of control. Consider this from Bloomberg:

Chinese consumers are more concerned about rising prices than at any time in the past decade, underscoring the pressure on policy makers to step up efforts to counter inflation running at a two-year high… Authorities have held off on adding to October’s interest-rate increase, instead ratcheting up banks’ reserve requirements and using tools such as sales of food reserves to tackle inflation. The Commerce Ministry said [last week] it will “closely monitor” prices over the next quarter, especially during holiday periods, and keep releasing stores of pork and sugar…

The Chinese economy has gotten itself into a real jam. As we have detailed in the past in these pages, there are no easy solutions for China now. When inflation gets so bad that food and energy costs spiral out of control, civil unrest becomes a risk. The authorities in China have always put civil unrest fears at the top of the list, given the rigid nature of the authoritarian political system.

Western democracies are more flexible – when people get upset, they can “throw the bums out” even as the political institutions endure. In China, though, the party leaders are the institution. What’s more, in the face of rapid economic growth, the longevity of an authoritarian political structure such as China’s is an open question. (As China grows more prosperous, Chinese citizens will hunger for more rights and freedoms.)

So China is now in a place where inflation must be tackled, if only to head off the risk of civil unrest. But raising interest rates –  normally the obvious and clear step – is problematic as an inflation-fighting method because of China’s mercantilist export system. As we have mentioned before, many of China’s exporters operate on razor-thin profit margins. This is a function of Beijing supporting the export industry as aggressively as it can, in order to create jobs and underwrite economic output. The trouble here, though, is that razor-thin profit margins mean things like a hike in interest rates or a rise in the value of China’s currency can be fatal. Some exporters have said even a 1% rise in the value of the yuan could wipe them out.

Of course, China doesn’t want to admit that serious internal issues are staying its hand. So China’s leaders blame outside forces instead as a reason for their lack of action. Via Bloomberg again:

China’s central bank Governor Zhou Xiaochuan indicated that turbulence in the global economy is limiting the nation’s ability to raise interest rates to counter inflation, according to the China Daily newspaper. The government is taking a very prudent approach to increasing rates because of an unstable and rapidly changing global situation, the state-run paper reported today, citing Zhou. It didn’t say where or when he made the comments. China’s inflation climbed to a 28-month high in November and officials pledged this month to shift to a tighter, “prudent” monetary policy stance in 2011…

Adds Chang Jian, a Barclays economist in Hong Kong: “The procrastination in raising interest rates will further increase the risk of asset bubbles and worsen the inflation situation.” Yup. And that’s pretty much the modus operandi of governments everywhere. Decisions that look attractive in the short run are taken at the expense of nasty costs in the long run. One reason governments are able to do this over and over – make dumb decisions, then find themselves in awful jams – is because people are so bad at tracing the consequences of actions over time.

The inflation “nightmare” that is unfolding in China now, for example, is largely the result of the “sweet dream” super-stimulus China pumped into its economy circa late 2008/early 2009. In a way, then, stimulative government policy is like a powerful drug – heroin or crack or cocaine. When you take it, you feel great. Sometimes the “rush” can last for an extended period of time. But then the “comedown” is hell. (In his must-read autobiography, Keith Richards of the Rolling Stones mentions how a good line of coke should have you set for the next 24 hours. He also talks about the prolific nature of his work habits as enabled by heroin… and the reasons why he wouldn’t recommend heroin to anyone, mainly because the “cold turkey” process is so brutal.)

China’s other big problem, besides an inflation beast it needs to tame and a fragile export sector that could face collateral damage, is a still-spiraling real estate bubble. One more time from Bloomberg:

China’s property boom continues “unabated” and has even picked up since the government enacted policies to cool speculation, said Jim Chanos, the hedge-fund manager who predicted the market may crash as early as 2010.

Home prices in 70 Chinese cities climbed 7.7 percent in November from a year earlier, even after the government suspended mortgages for third-home purchases and pledged to introduce a property tax. Sales volume jumped 14.5 percent.

“A lot of regulations in China, they are designed to be skirted,” Chanos said in an interview with Carol Massar and Matt Miller on Bloomberg Television’s Street Smart program. “The boom has continued unabated. It’s actually even picked up a little bit recently towards the end of year.”

In gorging on stimulative policies, China has taken a page from the Alan Greenspan playbook. So it’s no surprise given that, just as the Maestro’s policies fueled a super-destructive housing bubble, China’s actions are doing the same thing.

We need to keep a close eye on China in the coming year. If the Chinese economic miracle implodes, there will be no escaping the fallout – the impact will be felt globally, sending shock waves through many asset classes. What’s more, we have a rough blueprint for how China’s latest series of adventures will end, given Beijing’s willingness to follow the Greenspan plan.

This isn’t to say the long-run China story is toast. The dragon may survive the aftermath of an Austrian “crack-up boom” and continue growing into its role as a 21st century power. After all, the 20th century was America’s century – and the USA had plenty of crashes and panics a century ago too.

The bottom line for 2011? “Fasten your seatbelts,” because China – and the rest of the world – could be in for a bumpy ride…

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