The Need for Appreciation – China’s Battle with Inflation

On the 12^th of May, the Peoples’ Bank of China raised reserve requirements for the fifth time this year, by 50 basis points. This move, which will be effective from 18^th May, comes amidst a broad sell off in the global commodity markets. With Crude Oil settling around the $99 mark last week and a sell-off in gas and copper, the policy move seems to be lagging behind the markets. The increases in margin requirements across various commodities including more than three recent margin hikes in silver, and the announcement of hikes across various Crude Oil contracts earlier last week, has led to a cooling off in the recent speculative bull run in commodities.

The Chinese demand for commodities like copper has shown a decline in April, although imports of Crude Oil still continue to grow. Given that the economy is projected to grow at over 9% by the World Bank, it is unlikely that the overall pace of Chinese commodity demand is going to slow down in the longer term, which should continue to fuel energy and raw material inflation globally. Inflation is indeed economic priority number one for China these days, and the Chinese Premier Wen Jiabao confirmed this in his State of the Union Address at the end of last month. He stated that the government must “make it our top priority in macroeconomic control to keep overall price levels stable”. The quest for battling inflation is likely to spur a debate within the economic community in China, while they try to decide which limiting measure is best. With expectations regarding the medium term appreciation of the Yuan being strong, and some relaxation of commodity prices, their continued hawkish stance on monetary policy might be counterproductive. 

In international finance, there is a trilemma (an actual term in the Oxford English Dictionary), which is to say there is a policy choice between three particular goals of economic governance, and nations (open economies)  can only choose to control two goals as a necessary constraint imposed by the laws of economics. The goals are: to have open international flows of capital, effective monetary policy (in the sense that the central banks can actively control money supply using only monetary tools), and stable exchange rates. China has chosen to have a stable exchange rate by managing it actively, and an active monetary policy, while imposing capital controls, especially on exporter’s foreign currency earnings.  However, with the massive build ups of foreign currency reserves as a consequence, the Chinese government has been relaxing controls on foreign exchange earnings off late. This means that Chinese exporters are going to increasingly be able to retain their foreign exchange without converting them to the Yuan. 

The result of easing capital controls is that Chinese policy makers have to consider letting the Yuan appreciate according to market expectations, or continue to face strong inflationary pressures, even with aggressive monetary tightening. In a way, the interest rate and reserve rate hikes have reached a plateau, and there cannot be many more without severely undermining economic growth and the efficient allocation of capital in the economy. April’s CPI reading of 5.3% year on year was just 0.1% below the reading in March, which was a 32 month high for the figures. While authorities maintain that their 2011 inflation target is 4%, there are few options left to achieve such a drastic pull back, given that there have already been four interest rate hikes since October, and import growth slumped to 21.8% from 32.6% in March.

It is certainly not unusual for a country, which has now arguably become the biggest manufacturer and exporter in the world, to want its currency to stay depressed. Given that China’s top exports both to the US and to the world are electrical machinery and equipment and power generation equipment, the appreciation of the Yuan might lead to the US searching for more competitive bargains from other countries, especially the export oriented ASEAN nations and Japan. However, even with the ongoing rises in wages, Chinese exports will be able to stay competitive in the medium term since there has been a veritable shift in the manufacturing base from countries like Japan and Taiwan. Industrial output in April rose 13.4 percent year on year, while the Yuan has been allowed to appreciate by about 5% against the dollar during the same time.

Although Yuan appreciation is warranted, and there has been a marked change in Chinese policy off late with policymakers increasingly recognizing this fact, politicians in the US should be aware that this is not a panacea for global imbalances and especially their huge trade deficit. Appreciation of the Yuan will not change the import needs of the US, and the widening of the trade deficit to $48.1 billion in March, while the Yuan is at multi year highs relative to the dollar is indicative of this fact. 

From the Chinese point of view, persistent inflation, especially food inflation, is not good for the Communist government, since inflation erodes the value of money and is particularly harsh on the poor. Chinese policy makers are unequivocally united in their pursuit to tame inflation, and rightly so. At the same time, there is also an understandable instinctive dislike for being told what to do by the West. This internal conflict needs to be sorted out as soon as possible, and the West needs to recognize that this conflict exists and is not a projection of economic hubris. Increases in the value of the Yuan will increase the purchasing power of the people, and will give domestic demand a much needed boost, in an imminent shift away from a purely export driven economy to one driven by domestic consumption.

Negative interest rates are common in emerging markets these days, but countries like China and India cannot afford to get carried away by their own growth stories. The narrow output gaps in both countries suggest that both the economies are working at almost optimal capacities, and fighting inflation should remain top national priorities, not just economic ones. In this regard, keeping in mind the policy trilemma for China, there is definitely more room for the Yuan to appreciate.

The Stoic Greeks:

Pacifying bond vigilantes (bondholders who punish nations for having weak monetary or fiscal policies by selling government bonds), has been Greece’s biggest strategic nightmare ever since Prime Minister Papandreou announced the acceptance of a bailout package of 110 billion euros this time last year. The entire year has gone by in efforts to assuage its citizens and the markets, while both are unequivocally unhappy about the slew of austerity measures imposed by the government. What the Greek government has failed to acknowledge is that there is an overpowering interest present in the bond markets which is making continued membership of the European Monetary Union nearly impossible. The ancient Chinese strategist Sun Tzu noted in 600 BC that “there is no instance of a nation benefitting from prolonged warfare”, and this holds true for the Greeks, who have so far deluded themselves into believing that holding a brave poker face long enough will somehow buy time to get out of their existing economic mess.

The return on the Greek 10 year bond is hovering around 15% which when compared to its historically stable German counterpart, the Bund, which is yielding a little over 3% for the same maturity, seems unmistakably unsustainable. Furthermore, the returns on the shorter term Greek debt signal that the markets are in no mood to wait for dithered decision making. Simultaneously the cost of insuring the sovereign debt is also at record levels (according to CMA prices for credit default swaps). The yield on the 3 year Greek bonds is around 21%,  while the negative GDP growth in 2010 of -3.3% indicates that there are only socially undesirable solutions left since slow economic growth is clearly going to be of no immediate help.

Greek economic growth has suffered a huge setback since it joined the Euro area and the loss in competitiveness caused by the inherent restrictions of joining a currency union is something that the economy never recovered from. This whole process has been exacerbated by the global financial crisis that for economic survival; has highlighted increased efficiency and productivity like never before. Although measuring competitiveness is not a clear cut task, both for economists and statisticians, all studies have indicated that in Greece it has suffered considerably, especially wage competitiveness. Earlier last month, IMF chief Dominique Strauss-Kahn said that a decrease in “public sector wages” was the key for restoring growth in the Greek economy. Given that the public sector wages have risen by over 100% since the Greeks joined the euro, this is a fair point. However, considering that public sector workers have already lost many months of wages and incurred cuts in their pensions following the acceptance of the terms of the EU-IMF bailout last year, the strong roots of patronage politics in the country will hardly allow more room for forced austerity going forward. A majority of economists agree that a debt to GDP ratio above 90% is negative for economic growth, since key resources are diverted away from productive uses and are used for unproductive interest payments. With the debt to GDP ratio of 140% in 2010, there is little doubt that the Greek economy is left with little room to manoeuvre. 

On April 14^th this year, the Greek government reiterated that it is not considering restructuring of its debt, which is a less crude way of saying that there is no imminent possibility of debt default. However the slump in Greek bonds tell a different story, and sure enough a few days on, Greece has asked for a 45 billion euro safety net from 15 EU countries to prevent default. With the imminent meeting of the European Central Bank policymakers on May 5, the Greeks may as well see that victory lies in admitting that there are serious problems that cannot be solved by overconfident rhetoric aimed at market manipulation. The markets are hungry for assurance and fast action, which ironically are the exact ingredients that have been missing in all post-crisis decision making in Europe, whether in the case of Greece, or any of the other troubled “peripheral economies”. Policymakers should also pay heed to the lessons of the recent past, which dictate that bail-out packages are not permanent cures, and if the problem is serious and deep rooted, as in the case  the Greek economy, severe long lasting solutions are required even if palpably more painful.

The negotiations for financial aid are certain to be mired by a lack of trust for Greece’s ability to commit to tougher and longer austerity packages than before. Germany, the ‘trust fund’ of the euro – zone, is getting increasingly impatient with regard to bailouts. Chancellor Angela Merkel is going to be extremely cautious in dealing with the German response to the requested money ahead of the regional state election on May 9 after already suffering heavy political setbacks due to the emergence of such post-crisis issues. The recent Finnish general elections are also certain to have an impact on the negotiation process. The True Finns party, which won the second biggest number of seats, are staunchly against EU bailouts, and are likely to be given a bigger role in the next government. According to EU rules, no country can be offered a bailout without the consent of all the members, and with political parties in Europe increasingly turning hostile to the idea of supporting the economically diseased members; bailouts are not going to come easy in the future. In Finland, parliamentary approval is required for supporting bailouts, and this is likely to also impede the pace at which Portugal negotiates its 80 billion euro rescue package. 

There cannot be general blanket solutions to the problems in the euro-zone and European policymakers seem to be taking an awfully long time to realize this. Every time a member nation is in trouble due to the unsustainable condition of its sovereign debt, the same few steps seem to be repeated. Initially there is always strong denial in attempts to confuse market participants, followed by talk of bond haircuts and fiscal austerity inevitably followed by the acceptance/deliverance of a bailout. In the event that a Greece or a Portugal were to default, and therefore be excluded from participation in the markets, the costs on the euro area’s collective credibility would significantly outweigh the benefits of imposing stricter fiscal discipline. This cost-benefit balance will not remain so forever, and the existing structural problems in countries like Spain and even France, would necessarily lead to some re-examination of the prescriptions used so far. From a Greek point of view, although unlikely due to the aforementioned cost benefit analysis, a default might force the country to look inwards and make the required long term changes to rejoin the markets when on a sustainable debt trajectory.