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Monday 15 December 2008
Declining Inflation a Worrying Sign
It was only a few months ago that newspapers around the world, including this one, were covering the intense debate over the cause of rising inflation on the mainland.
It was only a few months ago that newspapers around the world, including this one, were covering the intense debate over the cause of rising inflation on the mainland.
For some, including me, the underlying cause of the acceleration in inflation was monetary.
Inflation, we argued, was the all-too-expected reaction to explosive money creation caused by the country’s currency regime, in which the central bank purchased a torrent of in-flowing dollars in order to maintain the value of the currency.
As it purchased these dollars, it created the yuan that it used to fund the purchases. This yuan creation was intermediated by the formal and informal banking systems into rapid credit growth - the main measure of money supply.
For other analysts, however, this monetary explanation of inflation was flawed. The cause of mainland inflation, they argued, was temporary food supply constraints, especially diseases affecting pigs, which caused food prices to surge.
Harvard economist Kenneth Rogoff famously described the two camps in the debate as those arguing that inflation was caused by too much money versus those arguing that it was caused by too little pork.
While the money camp acknowledged the sharp rise in food prices, we argued that if monetary policy on the mainland was consistent with low inflation, the surge in food prices would have caused households to divert so much spending away from non-food items to food items that there would be downward pressure on non-food prices. Instead, non-food inflation accelerated.
The money camp claimed the still rapidly growing central bank reserves would ensure that inflation continued into next year. The pork camp argued that as the food supply came back into line, inflation would quickly come down to manageable levels.
As we all know, inflation stayed high through the summer but subsided very rapidly thereafter as food prices declined sharply.
So the pork camp’s analysis must have been correct, right?
Not quite. The problem is that the rapid decline in food prices should have caused households to spend less on food and more on non-food consumption. If monetary policy was not deflationary, this would cause the price of non-food goods to increase.
That didn’t happen. From September to last month, CPI inflation declined from 4.6 per cent to 2.4 per cent. As expected, food inflation declined from 9.7 per cent to 5.9 per cent. But non-food inflation also declined, from 2 per to 0.6 per cent.
This suggests that the pork camp still has a lot of explaining to do, or else the conclusion must be that inflation on the mainland has not been caused by changes in food supply but rather by changes in the money base.
The country’s reserves continue to rise, so the central bank has been continuing to create yuan at a rapid pace, but somehow money supply is contracting rapidly, as indicated by the decline in inflation.
What could be happening?
One possibility is that credit is contracting much more rapidly than we think. Most credit statistics are based on the amount of outstanding loans in the banking system, and these suggest credit is growing.
These statistics, however, miss out two very important residual sources of credit creation.
First, there is strong evidence that during the period of explosive credit growth, when the central bank limited the amount of credit creation permitted to the banking system, the market responded by accommodating explosive growth in off-balance-sheet items and within the informal banking system.
Now that banks are not willing to lend and companies not willing to borrow to invest, credit growth is mainly being caused by government pressure to maintain credit growth.
Transactions that were once off the balance sheet may be coming back on to the balance sheet to give the illusion of credit growth.
More worryingly, the informal banking sector, which may consist of as much as one-third of total loan assets, may be contracting rapidly.
The debate on Chinese inflation is not over - and may have taken a very worrying turn.
Michael Pettis is professor of finance at Peking University
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Declining Inflation a Worrying Sign
Michael Pettis
15 December 2008
It was only a few months ago that newspapers around the world, including this one, were covering the intense debate over the cause of rising inflation on the mainland.
For some, including me, the underlying cause of the acceleration in inflation was monetary.
Inflation, we argued, was the all-too-expected reaction to explosive money creation caused by the country’s currency regime, in which the central bank purchased a torrent of in-flowing dollars in order to maintain the value of the currency.
As it purchased these dollars, it created the yuan that it used to fund the purchases. This yuan creation was intermediated by the formal and informal banking systems into rapid credit growth - the main measure of money supply.
For other analysts, however, this monetary explanation of inflation was flawed. The cause of mainland inflation, they argued, was temporary food supply constraints, especially diseases affecting pigs, which caused food prices to surge.
Harvard economist Kenneth Rogoff famously described the two camps in the debate as those arguing that inflation was caused by too much money versus those arguing that it was caused by too little pork.
While the money camp acknowledged the sharp rise in food prices, we argued that if monetary policy on the mainland was consistent with low inflation, the surge in food prices would have caused households to divert so much spending away from non-food items to food items that there would be downward pressure on non-food prices. Instead, non-food inflation accelerated.
The money camp claimed the still rapidly growing central bank reserves would ensure that inflation continued into next year. The pork camp argued that as the food supply came back into line, inflation would quickly come down to manageable levels.
As we all know, inflation stayed high through the summer but subsided very rapidly thereafter as food prices declined sharply.
So the pork camp’s analysis must have been correct, right?
Not quite. The problem is that the rapid decline in food prices should have caused households to spend less on food and more on non-food consumption. If monetary policy was not deflationary, this would cause the price of non-food goods to increase.
That didn’t happen. From September to last month, CPI inflation declined from 4.6 per cent to 2.4 per cent. As expected, food inflation declined from 9.7 per cent to 5.9 per cent. But non-food inflation also declined, from 2 per to 0.6 per cent.
This suggests that the pork camp still has a lot of explaining to do, or else the conclusion must be that inflation on the mainland has not been caused by changes in food supply but rather by changes in the money base.
The country’s reserves continue to rise, so the central bank has been continuing to create yuan at a rapid pace, but somehow money supply is contracting rapidly, as indicated by the decline in inflation.
What could be happening?
One possibility is that credit is contracting much more rapidly than we think. Most credit statistics are based on the amount of outstanding loans in the banking system, and these suggest credit is growing.
These statistics, however, miss out two very important residual sources of credit creation.
First, there is strong evidence that during the period of explosive credit growth, when the central bank limited the amount of credit creation permitted to the banking system, the market responded by accommodating explosive growth in off-balance-sheet items and within the informal banking system.
Now that banks are not willing to lend and companies not willing to borrow to invest, credit growth is mainly being caused by government pressure to maintain credit growth.
Transactions that were once off the balance sheet may be coming back on to the balance sheet to give the illusion of credit growth.
More worryingly, the informal banking sector, which may consist of as much as one-third of total loan assets, may be contracting rapidly.
The debate on Chinese inflation is not over - and may have taken a very worrying turn.
Michael Pettis is professor of finance at Peking University
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