China’s Structural Inflation: Impact on Growth model
Five years ago, after living in the US and Hong Kong for 20 years, I moved back to Beijing to help Brookings set up its first overseas research centre at Tsinghua University. I rented an apartment of about 260 square metres in Beijing. Recently, my landlord told me that the market value of this apartment had increased from 4.5 million yuan to 13.5 million over the last five years. Searching for an apartment to rent in Hong Kong, I found that a similar apartment was at least twice as expensive as in Beijing.
This got me thinking about other price comparisons. Twenty-five years ago, I departed Shanghai for Los Angeles to start graduate studies at UCLA on a Chinese government scholarship. Despite a meagre stipend, I had enough money for fresh milk and frozen chicken legs, bought used books and a used car, and still had a few hundred dollars to spare to buy an imported Japanese-made TV and refrigerator – among the first in China - for my parents in our home city of Nanchang. Back then, in the early eighties, my mother had a salary of 36 yuan per month, working in a state-owned factory making electrical devices. Today, 36 yuan only goes as far as buying a meal at McDonald’s for my children. My part-time domestic helper in Beijing costs 1,700 yuan a month.
If you read the latest economic news from China, inflation is the number one concern of Chinese policymakers, with the CPI growing at 6.5 per cent last month. However, China’s inflation is not like traditional monetary inflation, which is usually driven by fiscal deficits, excessive aggregate demand, and trade deficits. Over the past decade, China’s fiscal revenues have, in fact, been growing at around 20 - 30 per cent annually. China has been troubled with excessive supply and has also run a large trade surplus, which points to insufficient domestic demand, despite high levels of investments.
China’s local government debt and investments by state-owned enterprises (SOEs) are cited as possible sources of inflation. But the root cause of the expansion of local government and SOE debts is their protected access to bank credit and low interest rates in the official banking system, which provides super-strong incentives to borrow.
At the same time, local government and SOE debt expansion usually creates over-capacity, excessive supply and even deflation in certain sectors experiencing over-supply. Hence, a better policy for China is to raise nominal interest rates so that they are in line with the rapid appreciation of non-tradable real assets, namely, structural inflation. Higher interest rates will deter excessive investment in over-capacity and encourage investment in high return projects.
The catch is that it is never popular for any government to raise interest rates. There is a popular view that SOEs, local governments, and property investors are indifferent to whether interest rates rise, as they may invest anyway for political and social purposes. I don’t believe so. Higher real interest rates exercise better credit discipline, so borrowers will be more careful with their investments.
Another popular view is that raising interest rates would attract hot money inflows from overseas due to zero interest rates in advanced markets. However, I do not think speculative hot money has the patience and freedom to gain from the cross-border interest rate gap, given China’s heavily-regulated banking sector and exchange controls. It is much easier to make huge gains from speculating on volatile currencies and property markets elsewhere. On the contrary, if the interest rate is high enough, bubbles will burst and hot money will disappear.
There is a further argument which suggests that if China does not like to raise interest rates, it could achieve the same effects by appreciating its currency, which would encourage imports, discourage exports, and reduce over-supply in the exporting industry, making the Chinese economy more balanced in its external payments. This argument is correct in terms of trade flows but overlooks pricing effects on the stock of assets. The exchange rate is not only a price for trade but also an asset price. When the yuan appreciates consistently over a long period against the dollar, investors in China and overseas will try to accumulate yuan assets while selling dollars to China’s central bank. As the People’s Bank of China takes dollars and gives out yuan to investors betting on its appreciation, we can expect to see a bubble arising from foreign exchange inflows.
My parents saved all the dollars I sent them over the past two decades in a foreign exchange account at a local branch of the Bank of China. They never spent a cent of these savings until about five years ago, when they turned all of their dollar deposits into yuan, in expectation of its appreciation against the dollar. Their dollar deposits are now part of the foreign exchange reserves at China’s central bank, which amount to more than US$3 trillion.
China’s 12th Five-Year Plan, for 2011-15, aims to change its economy from an export-led to consumption-led model with balanced, equitable, and sustainable growth. In my view, a key policy measure for the new growth model is to keep the price of capital right, which means making the real interest rate positive and high enough to be compatible with high real returns in China’s real economy. A high interest rate is not only necessary for efficiency but also essential for equity. In a low interest rate environment, my domestic helper, a migrant worker, who keeps deposits at her bank, is subsidising my landlord who has a large mortgage debt with his bank. Setting interest rate right in the context of China requires an entirely different understanding about structural inflation, one that has been missing in traditional western macroeconomics research and teaching.