The experience of the past several decades suggests that China is good at turning crises into opportunities for reform. This may again be the case today. Only two years after China began its astonishingly successful stimulus program, GDP growth may slow but will remain robust; inflation, on the other hand, is surpassing targets and catalyzing social tensions, demanding the government’s immediate attention. Excessive credit creation in 2009 and much of 2010—the full extent of which is still unknown as significant credit growth was not recorded—was largely responsible for this problem.
For the medium term, economic rebalancing remains China’s priority, challenging the economy to reduce its dependence on external demand, increase the share of consumption in GDP, reduce the income gap between urban and rural areas, and rely more on domestic innovation.
Inflation Demands Attention
Due to a number of structural factors, including slowing productivity growth, rising unit labor costs, and relatively weak external demand, GDP growth in the months and years ahead is likely to slow, but remain robust.
Inflation poses a bigger problem. Contrary to my expectations in September, inflation has accelerated in recent months. Consumer price index (CPI) inflation jumped from 3.6 percent (y/y) in September to 4.4 percent (y/y) in October, and from 7.1 percent (m/m annualized) to 8.6 percent over the same period. The GDP deflator, a broader measure of inflation, is currently running at about 5 to 5.5 percent. It is now virtually certain that inflation in 2010 will exceed the government’s 3 percent target. Higher CPI inflation (perhaps 4.5–5 percent y/y) is likely in the months and perhaps even years ahead.
Food prices, and vegetable prices in particular, have contributed the most to CPI inflation so far this year. Food prices rose by 10.1 percent (y/y) and 20.1 percent (m/m, annualized) in October. Rising real wages are pushing food costs up—most vegetables are grown and processed near urban areas where the effects of rising wages are most keenly felt—but excessive credit expansion has been the biggest driver of inflation.1
Although the People's Bank of China has slowly been tightening monetary policy since the last quarter of 2009—including recent hikes in interest rates and minimum reserve requirements—M2 money supply2 grew almost twice as fast as nominal GDP from the beginning of 2009 through October 2010. This means there is significant excess liquidity in the economy and explains why the government is enacting and promising price controls for ordinary consumption items. Further monetary tightening is also to be expected.
Thus, the current problem is more reminiscent of the early 1990s, when excessive credit expansion also accelerated inflation, than of the past decade, when supply shortages—like “blue ear” pig disease in 2007—drove up food prices and led CPI inflation. Unfortunately, this suggests that overcoming the current inflationary pressures will be harder and may take longer than it did in 2007.
Excessive Credit Expansion: “Made in China”
There is a popular but unfounded belief in China that the U.S. Fed’s quantitative easing policy is responsible for China’s inflation. Although “hot money” inflows have increased in 2010, however, China’s current inflation problem is almost entirely “made in China”—the result of excessive credit expansion in 2009 and much of 2010.
This was not previously highlighted as a major issue because the extent of unrecorded credit expansion was unknown. As has become increasingly clear in the past twelve months, however, state banks—driven by excess liquidity and a search for higher returns—have begun to extend unauthorized and higher-priced credit off-balance sheet. Meanwhile, financial intermediation in informal and unsupervised financial markets—also at higher rates of interest—appears to have increased. This comes on top of the fact that net official credit grew by RMB 6.9 trillion in the first ten months of 2010, suggesting that even the official credit expansion target for 2010—RMB 7.5 trillion, compared to the RMB 9.6 trillion expansion in 2009—will almost certainly also be exceeded. Estimates of informal and off-balance sheet credit expansion in 2009 and 2010 so far range from 20 percent to 30 percent of official credit numbers.
China’s banking regulator is keenly aware of what is going on and has taken measures to rein in excessive credit expansion—both official and unofficial. For example, it has recently ruled that all off-balance sheet bank assets and liabilities must be brought on-balance sheet by the end of 2011. How effective these measures are remains to be seen. Regardless, accelerated financial sector reform, including higher domestic interest rates and a more flexible exchange rate policy is needed.
The current challenge is to reduce inflation and inflationary expectations without killing the growth momentum needed to bring another few hundred million migrants into the modern economy over the next 20 years at stable or rising wages while avoiding urban slum formation. This can only be achieved if China successfully rebalances the economy, discussed in further detail below.
Property Prices Compounding the Problem
Rising residential housing prices in major cities are further raising the cost of living. First-time home buyers without significant savings are finding decent apartments in desirable areas in tier one cities virtually unaffordable, which is creating social tensions.
Aggressive measures taken in April to cool housing speculation in major cities have not yet reduced prices significantly. Market turnover fell sharply and prices stabilized for a while, but turnover and prices have risen again in recent months.
At the same time, the official monthly price index for 70 major cities—which continued to show price increases in recent months—also shows that price growth is slowing—a hopeful sign the government will prevail in controlling the housing bubble. And the government is not giving up: it recently passed new restrictions limiting credit access for more than two apartments per family and now requires that foreigners prove they have been local residents for at least one year before they can buy an apartment (for their own use).
In response to social tensions, the government is also subsidizing large-scale “affordable” housing programs. Such programs are still in their early implementation stage, but many practical problems have already arisen. Nonetheless, Beijing remains very serious about this new program: it is central to China’s economic rebalancing strategy, which aims to promote domestic demand while also generating long-term productivity growth through urbanization. An outline of China’s 2011-2016 Five Year Plan, approved by the Party’s Central Planning Committee in October, clearly points to such rebalancing as the medium-term priority.3
Rapid urbanization is also a strong source of demand for urban housing, however, and will continue to drive house prices up for decades to come. Housing developers apparently do not expect prices to decline either, as the high rate of new housing starts has barely budged over the past six months.
Set for Rebalancing
Notwithstanding its medium-term goal of domestic rebalancing, and in spite of weak demand in the developed world, China’s trade surplus jumped to $27 billion in October, leading many observers to conclude that the crisis-related decline in the country’s trade surplus was only temporary.
We should not forget, however, that China’s external surplus has been trending down since the end of 2007, when the current account surplus peaked at 11 percent of GDP. In other words, imports have tended to grow faster than exports over the past 34 months.
In addition, China’s relatively high domestic inflation will lead its real exchange rate to appreciate even if the nominal RMB/USD exchange rate does not move—and the government is likely to appreciate the nominal exchange rate in an effort to battle inflation. Although it may modestly reduce growth in the near term, real exchange rate appreciation will help China pursue economic rebalancing.
Finally, the quality and adaptability of China’s macroeconomic management has greatly improved since the early 1990s, when modern macroeconomic management tools and institutions were created for the first time, suggesting that the country will be able to manage this transition.4
With its current account surplus not likely to exceed 5 percent of GDP in 2010, Beijing may achieve U.S. Treasury Secretary Geithner’s proposed 4 percent of GDP limit on current account imbalances in coming years irrespective of whether international agreements to that effect are struck.
Pieter Bottelier, former chief of the World Bank’s resident mission in Beijing, is a nonresident scholar in Carnegie’s International Economics Program and senior adjunct professor of China Studies at the School of Advanced International Studies (SAIS) at Johns Hopkins University.
1. International price increases for soy beans and other food—caused, in part, by China’s own huge and growing import needs—are contributing as well, and poor harvests for some grains in parts of China this spring pressured prices earlier in 2010.
2. M2 is a monetary aggregate which includes the most liquid means of payment available—currency, travelers' checks, demand deposits, and other checkable deposits--as well as somewhat less liquid financial instruments, such as small-denomination time deposits, savings deposits, money-market deposit accounts, and retail money-market mutual fund shares.
3. Full Plan details are still being drafted and will be submitted for NPC approval in March 2011. Since the beginning of market reforms in the late 1970s, China’s Five Year Plans have gradually evolved from detailed investment plans with specific output and growth targets to indicative policy plans and instruments for policy coordination. The 12th FYP is based on the assumption that external demand will remain subdued for an extended period and that China will have to depend increasingly on domestic demand, especially consumption, and domestic innovation for sustained high growth.
4. The most recent Global Competiveness Report (2010–2011) of the World Economic Forum, rated China number 4 in the sub-category ‘macroeconomic environment' (compared to a number 87 rating for the United States). 134 countries are ranked; 1 represents the best.