Tuesday, June 01, 2004
The inflation danger from China
Posted by David Smith at 07:09 PM
Category: David Smith' s magazine articles

China, as everybody knows, is becoming a dominant player in the global economy. Long-term projections from Goldman Sachs show that in three years time China’s gross domestic product will have overhauled that of France, Britain and Germany, Europe’s big three. By 2020 China will be bigger than Japan and during the 2040s larger than America, and thus the world’s biggest economy.

There is, it should be recognised, many a slip ‘twixt cup and lip. It may be that China’s path towards matching her economic importance to her huge population of 1.3 billion is not quite as straightforward as that. But we do not, in any case, have to wait 40 years for a demonstration of China’s significance.

In 2002 the Chinese economy grew by 8% - a typical rate of expansion - and in doing so contributed no less than 36% of global economic growth. In 2003 China again boomed (as it has done, more or less, since the late 1970s), with growth this time of 9.1%. In a stronger international environment, China’s global contribution slipped slightly. But it was still equivalent to a third of total world economic growth. The global economy, plainly, has been tilting towards the east.

There is another way of demonstrating this.

China, still for the moment only the world's sixth largest economy, is a voracious consumer of raw materials to fuel the industrial boom, accounting for between a fifth and a third of global consumption of aluminium, iron ore, zinc, copper and stainless steel. Antofagasta, the Chilean copper-mining firm that entered the FTSE-100 in March, has been one of the most obvious beneficiaries of booming Chinese demand.

It would be wrong, however, to think of China as merely a consumer of large quantities of commodities. Volkswagen sells more of its vehicles in China than in Germany. General Motors is increasing Cadillac production by 50% to cope with demand from China’s new business elite. And this is merely scratching the surface of the country’s emergence as a consumer on a huge scale. After all, gross domestic product per capita in China only a twentieth of average levels in the European Union. Real incomes are set to grow hugely, and rapidly.

If all that makes China the most exciting story of the world economy, it also raises one or two worries. Given the fact that China is already emerging as a dominant player, these worries fall into two related categories.

The first relates to the sustainability of the Chinese boom and, in particular, the consequences of any bursting of what could be an economic bubble. As China has become the world’s leading recipient of foreign direct investment, the reverberations of a sudden economic cooling, let alone a crash, would be felt around the global economy.

The second relates to the effects of the boom itself. Commodity prices have been rising sharply in world markets. This is partly a consequence of the weak dollar, as producers have sought compensation for the US currency’s weakness, most commodities still being priced in dollars. But it is mainly due to rampant Chinese demand for raw materials. Against expectations of a price fall following the Iraq war, oil has stayed high, mostly above $30 a dollar. Many metals and other commodities stand at their highest level for a decade, and have risen particularly strongly over the past year or so.

Not only that but China itself is emerging from a long period of deflation – falling prices – and is experiencing inflation again. Food prices are showing annual rises of 9-10%, while general inflation is closer to 3% but is rising. Higher food prices are not necessarily a bad thing in China, because they have the effect of redistributing income to the rural poor, but they underline the re-emergence of inflationary pressure.

A monetarist looking at China, indeed, would conclude that there is an inflation accident waiting to happen. The M2 money supply measure has been growing by more than 20%. Actions by the authorities to intervene in the currency markets to preserve the renminbi-dollar link have had the effect of sharply boosting China’s foreign exchange reserves, and therefore the money supply.

So how big are the risks? The investment boom is of legendary proportions. This is an economy bent on building for the future, to the point that investment has risen to more than 40% of GDP. This raises the spectre of “over-investment”, something rarely seen in Western economies, but typical of Asian countries ahead of the Asian economic and financial crisis of 1997-98. Thailand. Singapore and Malaysia all had investment-GDP ratios of around 40%.

How big is the risk of a Chinese economic accident, with nasty knock-on effects elsewhere? While it is tempting to draw parallels between China and the Asian economies of a few years ago, it is also unnecessarily alarmist. For one thing China’s sheer size means its capacity to absorb large amounts of foreign direct investment is enormous.

In addition, the Chinese authorities are in far greater control of events than the governments and central banks of the smaller Asian economies. A run on the renminbi, of the kind that brought down the Thai baht a few years ago, is almost unthinkable, not least because all the pressure on the Chinese currency has been upwards, but also because of the ability of the authorities to control dealings in the currency.

What about the inflation danger from China? It is undeniable that the China effect has pushed commodity prices up sharply. It is also clearly the case that China has moved from deflation to inflation.

Neither, however, should worry us too much. Commodities, even oil, do not have the impact on inflation that they used to, because Western economies have become less industrial, and therefore less sensitive to shifts in raw material costs. As for Chinese inflation, it is only necessary to go back to the mid-1990s for a time when prices were rising at a 25% rate, without affecting the benign global inflation environment. A much smaller rise in inflation is in prospect this time, and the effects outside China will be minimal.

Indeed, it may be entirely the wrong thing to look for inflation from China. For the past decade the China effect has been deflationary, through lower prices for industrial products. That effect has not gone away. Low-cost Chinese production will continue to help keep a lid on global inflation.

From Professional Investor, June 2004

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