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China Inflation Hits New High

April 15, 2011

This morning, China released its economic figures for March (and the year’s 1st Quarter).  Consumer inflation, or CPI, hit a new high of 5.1% year-on-year, up from 4.9% in February.  Producer inflation (PPI), hit 7.3%, up from February’s 7.2%.  China’s M1 measure of money supply (cash and checking accounts) grew by 15% year-on-year in March, while M2 (which also includes savings accounts) grew by 16.6% — both of these numbers down from the roughly 20% year-on-year rates of money expansion that prevailed throughout 2010, but still strongly outpacing real GDP growth.  Speaking of which, China’s GDP grew by 9.7% in the 1st Quarter, higher than most analysts expected.

As regular readers of this blog will know, I’ve been predicting (and warning) that China would be facing a strong run-up in inflation since early last year, when CPI stood at 1.5%.  I watched and commented as China’s money supply continued to grow and CPI climbed steadily upwards through 2010.  When CPI passed 3% in the late spring and early summer, most analysts — particularly the i-bank economists — focused on temporary disruptions in food supplies and argued that inflation would peak in the summer and start declining in the Fall.  I argued that monetary expansion, not supply shocks, were the primary driver, and that — given the fact that China’s money supply had surged more than 50% of the past two years — the real question wasn’t why we were seeing rising inflation, but why we weren’t seeing even more inflation sooner.  In a Bloomberg op-ed published in October, when the latest CPI numbers stood at 3.6%, I outlined my analysis of the situation and argued that inflation would rise, not fall.  By November, CPI passed 5% for the first time this cycle.  When it dipped back to 4.6% in December, I warned on NPR that it was “too early to declare victory over inflation,” and that China would likely see a resurgence in the months ahead.

Over the past year, I’ve been hitting away at several consistent themes regarding inflation in China:

FIRST, the main driver of inflation in China is monetary expansion, not temporary food shortages due to weather, logistics, etc.  The fixation by many analysts on the latter — focusing on supply shocks and ignoring the bigger monetary story — has led them to consistently underestimate or discount China’s inflationary trend.  The real story is that, over the past two years, China’s money supply has exploded by over 50%, as a way of boosting GDP through a massive lending binge.  One of the contributing factors to this story is China’s maintenance of its exchange rate peg with the dollar, which requires China to continually inject more and more domestic currency into its economy in order to accumulate excess dollars as reserves.       

SECOND, CPI captures only part of the inflation story.  Most of the new money that has been created in China went into an investment boom, not a consumption boom.  The result was asset inflation: dramatically rising prices in real estate, commodities, gold, artwork, jade, and other tangible forms of savings.  This asset inflation — which in many cases feels like a get-rich boom — is actually masking the true extent of the inflationary pressures at work in China’s economy.

THIRD, price controls won’t work.  Over the past few weeks, the Chinese government has leaned heavily on both foreign and domestic companies not to raise prices.  The NDRC, China’s top planning body, stopped Unilever from going forward with a planned 15% price hike.  The result is a squeeze on profit margins, as companies paying higher prices for wages and raw materials are unable to pass those increases along to their customers.  That’s a recipe for pent-up problems, not a solution to the real dynamics driving inflation.  The solution is to get China’s money supply back under control.

FOURTH, high GDP growth is not “good news” that offsets high inflation figures.  In fact, China’s obsession with high GDP growth is part of the problem.  Last year, well over half of GDP growth was due to investment in fixed assets, much of it fueled by cheap money and easy credit — the same policies fueling inflation.  These turbo-charged growth rates only measure the sheer amount of money being invested, not whether those investments are good or bad, or what the return will be.  Stupendous rates of GDP growth due to overinvestment or misallocated investment will end up being more of a curse than a blessing.   The real challenge for China isn’t racking up ever higher GDP figures, but putting its economy on a more sustainable footing going forward, even if that means “lower” rates of growth.

In conclusion, I want to post the following chart, which I came across in Red Capitalism, a recently published book written by Carl Walter and Fraser Howie, both of whom have extensive experience working in China’s banking sector.  It shows what happened in the 1980s in China, after a remarkably similar explosion in lending.  In 1984, lending grew by 33% — the same rate as in 2009.  It persisted for two more years at 31% (compared to more modest 20% in 2010).  About a year after the lending boom began, China saw a run-up in inflation, peaking first at 8.8%, then rising to 18.5% in 1988.  Many people credit the sharp rise in inflation as a contributing factor in sparking the Tiananmen protests in 1989.

I’m not going to claim any identical parallels.  China’s economy and its banking system have changed significantly from the 1980s — for one thing, there was no private real estate market at that time.  Lending increased at a higher rate for a longer period of time.  So let’s grant that, in many ways, the dynamics are quite different.  But the basic story — a huge lending boom followed by a big run-up in inflation — is still remarkably striking, when you consider what’s unfolding today.  If nothing else, it demonstrates why China’s money and inflation numbers matter, and are worth keeping a close eye on.

5 Comments leave one →
  1. April 16, 2011 3:36 am

    Thank you for this excellent analysis Dr. Chovanec. Especially appreciated the comparison with the 1980s.

  2. prchovanec permalink*
    April 16, 2011 10:42 am

    I should hasten to clarify that I’m not a doctor in any way, shape, or form — I have an MBA, not a PhD. But I appreciate you comment in any event.

  3. James Greenleaf permalink
    April 17, 2011 10:48 am

    Mr. Chovanec,

    I had a number of questions that I put asked in the comments section responding to your article on dodgy Chinese bank balance sheets. I posted the comment several days after you initially posted the article, so you may have already thought that comment thread had fizzled out and not checked. I am re-posting those questions here, though you’ve already partially answered the fourth question by mentioning that book about the lending boom in the 1980’s. I greatly look forward to any answers you can provide on the other questions, and my thanks for all your terrific analysis of the Chinese economy.


    Excellent post. I have been following your blog since last year, and have come to greatly respect your insights into the Chinese economy. I have a number of questions arising from having followed your blog that I hope you might be able to help me answer:

    1) Is there any way to trace Western economic and investor exposure to bad Chinese debt? In this regard I would like to call your attention to an article from The Economist the other day ( about Chinese companies frequently engaging in shady “reverse mergers” with shell companies to raise capital while avoiding significant portions of the disclosure process involved in more legitimate IPOs. The article also mentions Deloitte’s resignation as auditor from China MediaExpress, a reverse-merged NASDAQ-listed company, after losing all confidence in the financial reporting done by the company. A large number of Chinese small cap firms have appeared on US exchanges in the past few years, but I know the bulk of equity capital raised has been on Hong Kong exchanges and I know nothing about the disclosure requirements and transparency of those capital markets. I would very much like to know if there is any way to trace the amount and sources of capital raised by Chinese firms of questionable solvency on capital markets throughout the world.

    2) Related to the first question, is there any way we can determine how much of the global economic recovery is owed to the continued strong GDP growth of China post-2009? The 2007-8 economic crisis was, by all economic measures I’ve seen, the greatest credit-crunch since the 1929-32 crisis, and yet the pain inflicted seems to have been similar in magnitude and duration to any normal cyclical downturn that has occurred in the past 50 years. My fear is that the relatively swift recovery has been largely attributable to a Chinese engine which deliberately overheated itself in the hope that they could bluff their way through the recession until Western consumption returned and thereby avoid the nightmare of having to justify party control in an environment of economic stagnation. The problem is that they didn’t understand that Western consumption would not return to prior levels any time soon given the massive deleveraging made necessary by the credit-crunch. Instead, I fear China may have temporarily replaced US consumerism with a false, inflation-driven consumerism which has created a fool’s gold recovery. I see this in two major areas. First, the strong German recovery is fueled largely by surging exports of luxury goods to China and other booming developing-world countries. Second, those same developing world countries have been booming on the basis of high commodity prices, which are again fueled by demand from Chinese industry and infrastructure spending.

    Two more points I have noted in my capacity as a law student. First, US firms have come out of the crisis producing record earnings, which they are by-and-large retaining as enormous cash hoards. Much of the reason for this is the deferral under US tax law for earnings attributed to overseas subsidiaries until those earnings are redistributed domestically. This has given incentive to those managements who want to report higher earnings by deferring as much tax as possible to use those retained earnings to purchase assets overseas. This not only boosts demand for Chinese assets and accordingly contributes to inflation, but means that such acquisitive companies may be increasing Western economy’s exposure to any China bubble by taking those inflated assets onto their balance sheets as goodwill. This is especially worrisome if any of these companies used debt to make such acquisitions. The second thing is that, whereas the major multi-national law firms ceased hiring and made layoffs in almost every practice area when their financial services clients nearly collapsed, the one practice area which seems to have remained relatively hot (other than bankruptcy) has been the China FDI and M&A business. Wherever lawyers are busy making regulatory filings and writing disclosure documents you can be fairly certain that Investment Bankers and Fund Managers are heavily involved as well.

    Suffice it to say, for all these reasons I would very much like to have better insight into the exposure Western economies have to these concerns with China.

    3) Do you believe that the recent intense crackdowns on Chinese dissidents and free communication by the Communist party may presage an awareness on their part that these financial issues will not be able to be swept under the rug, and that economic pain for Chinese citizens is not far off? This may be pure coincidence, because the Arab revolutions have made Communist official paranoid, but I can’t help but wonder at the accounts I have read that this particular crackdown is of an especial intensity.

    4) Finally, for those of us too young and uneducated to be familiar with how Chinese monetary policy-makers handled the previous bouts of non-performing loans, could you provide us with that historical context? I’ve read some things (which were frankly beyond me intellectually) about how the Government, banks, and SOEs cycled the debt through in such a way that it became not a problem (sounded something like money-laundering to my, admittedly uneducated, ears), but I would greatly appreciate your describing the process as clearly as you laid out the bank’s solvency concerns in this post.

    Again, thank you sir for your excellent blog, and I look forward to your response.

  4. Jeff Hayes permalink
    April 18, 2011 7:28 am

    Hello Professor Chovanec,

    Thank you for your recent posting regarding the important issue of inflation. I very much enjoy your analyses and writings concerning China, which is definitely a compelling subject.

    For your (and readers’) possible interest, here is a link to an article describing a civil racketeering and antitrust complaint recently filed with the U.S. Justice Department against Goldman Sachs and the credit rating duopoly of Standard and Poor’s and Moody’s Investors Service, exposing their complicity in assisting China in shedding an estimated $260 billion of its foreign sovereign debt obligation:

  5. M. Crowell permalink
    April 21, 2011 11:51 am

    Re: “The fixation by many analysts on the latter — focusing on supply shocks and ignoring the bigger monetary story — has led them to consistently underestimate or discount China’s inflationary trend. The real story is that, over the past two years, China’s money supply has exploded by over 50%, as a way of boosting GDP through a massive lending binge. ”

    If the exploding money supply is primarily being put to use in building factories, housing, offices, infrastructure or entire cities on top of rural farmland, then wouldn’t these two stories (money supply vs. food supply shocks) be two patches on the same quilt? As you said in your speech in Chicago, it’s natural to expect that some of this money supply is leaking into the domestic consumption side of the equation, thus inflation. But I wonder to what degree the money supply–via fixed-asset appropriation of farmland– is correlated to food price inflation. Less farmland, less food. Less food, higher prices. More urban workers (that were once farmers) eating Yum branded meat (grain intensive), means even higher food prices. And it seems like a double whammy since that urban worker actually used to produce his own food, plus the food of others. Now the system has to feed him, plus all the people he used to grow for. Is this thinking too simplistic?

    Articles like this one ( keep coming off the press. I think I heard a similar story on NPR a few months ago.

    I’m just wondering how much I should be paying attention to this story. Wasn’t there a famine in China in the early 60’s due to over industrialization? Build, build, build seems to be the motto, without paying much attention to long term consequences. It smells like over capacity to me. With food prices as high as they are, you would think that the government would stop appropriating farmland for the purpose of building empty cities or those airports you mentioned in your Chicago speech. And instead use the land in a way that’s actually productive and brings in revenue–making food. Also, I wonder how much this issue revolves around the political environment within the PROC, which to my understanding is powered by the proletariat, not the farmer.

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