Thursday, 11 March 2010

How China may deal with inflation

Looking back at a bit of history can shed some light on how the Chinese may proceed in cooling a heating economy


Guanyu 道 said...

How China may deal with inflation

Looking back at a bit of history can shed some light on how the Chinese may proceed in cooling a heating economy

11 February 2010

China’s economy weathered the ‘Great Recession’ better than most large states. The country’s gross domestic product (GDP) increased by an average 8.45 per cent in 2009, the fastest in the world.

This astonishing recovery was supported by a vast stimulus package that was financed through the budget as in most other countries that used the Keynesian approach to demand management.

But Beijing also used the banking system and directed it to pump large amounts of liquidity into the economy. Now the economy is heating. Year-on-year inflation has increased to 1.9 per cent in December. However, in the past 12 months prices declined in nine months, from February to October, and increased in three months, January, November and December.

What is worrying is the pace of increase; from 0.6 per cent in November to 1.9 per cent in December. What would be China’s approach to this developing problem? A bit of history would help to understand how the Chinese may proceed.

In 1991, I received a call from Zhu Rongji, a senior leader of China who went on to become the country’s prime minister. His request: if the World Bank could advise him on the best way to deal with mounting inflationary pressures. I was called since I was then in charge of World Bank’s China operations. Mr. Zhu handled economic issues in the Chinese cabinet. I assembled a team of five central bankers from several parts of the world and headed for Beijing. We had two meetings with Mr. Zhu and his colleagues.

In the first they provided us with basic information on the economic situation, in particular on price increases. Beijing then had carried out an economic stimulus programme aimed at increasing employment. This was as a follow-up to the Tiananmen Square crisis of June 1989.

I was familiar with the official Chinese interpretation of what went wrong that June and why so many people were prepared to risk so much to confront the regime. The Chinese leadership of those days believed that much of the discontent had economic reasons.

High expectations had been created by Deng Xiaoping’s policies that had, among other things, opened the Chinese economy to trade and capital flows.

One consequence was the sharp pick up in the rate of economic growth. However, there was not a corresponding increase in the level of employment, in particular for the educated. Students were unhappy and were prepared to come out on the streets and protest which was what they did that summer.

The official response was not limited to sending the army to Tiananmen Square to clear the place of the protestors. This is what the world saw on the TV screens. Beijing also launched a programme aimed at improving the distributive content of its growth policies.

The government ordered the banks that it controlled to lend large amounts of money for the projects that had a high employment content.

That was done and one consequence was a rapid increase in the level of prices which had an impact on the real incomes of the less well-to-do segments of the population.

When I took the central bankers with me to Beijing, the People’s Bank of China was still in the process of converting itself from a quasi-commercial bank to a regulatory agency that controlled money supply and also supervised the commercial banks. One purpose of our mission was to suggest how that process of transformation could be quickened and also what instruments could be used by the central bank to bring money supply under control.

Macroeconomic management was further complicated by the fact that tax collection was in the hands of the provincial authorities. The centre received its share by negotiating with the provinces.

Guanyu 道 said...

Unlike other federal systems there were no agreed formulas for the sharing of revenues among governments at different levels.

Our recommendations, therefore, covered both the monetary as well as the fiscal sides of macroeconomic management.

I mention this bit of history to underscore how far China has come in terms of modernising its economy as well as modernising the system of economic management. Even then it is less advanced than several other large emerging economies.

The state plays a much greater role and uses both direct controls and market operations to manage the economy.

That there may be some heating of the Chinese economy at this time is a matter of great concern for Beijing. As in most other developing countries, there will be greater impact of inflation on the real incomes of the poor than on other economic classes of people.

Beijing is determined to act but will wait until it has more data to suggest that the economy is heating up.

If that conclusion is reached, the authorities will move in two different ways. To paraphrase Deng Xiaoping, what we will see is macroeconomic management with Chinese characteristics. They will use monetary policy to reduce money supply. This is a standard approach most countries use in moments of stress.

This was the one we helped the Chinese to develop in the early 1990s. And there will be direct controls on expenditure. It is my hunch that there will be greater emphasis on direct controls. There is a reason why the Chinese may want to go that route.

By increasing interest rates while the rest of the world - in particular the United States - continues to keep them low would invite more capital flows into China and lead to the further swelling of its large dollar holdings. This would increase the imbalances in the global economy that are generally considered to have caused the ‘Great Recession’.

Beijing, therefore, will make a larger use of direct controls. It will send out strong signals to the banking sector, most of which it controls, to reduce lending especially for large projects, particularly automobiles. It will also use the fiscal system to withdraw the incentives it had provided consumers to buy more. The provinces will also be told to reduce their development expenditures. Interestingly, the return of inflation will increase pressure on China to revalue its currency since that will help to lower the prices of imported goods. This has been resisted by the Chinese but they may be a bit more accommodating this time around.

The writer is a senior visiting fellow at the Institute of South Asian Studies. He is former vice-president of the World Bank and served as Pakistan’s finance minister in 1996-97. He has authored and edited several books on China