Lower inflation in May?

According to today’s China Daily Morgan Stanley is predicting that year on year inflation for May is likely to decline dramatically from 8.5% in April to 7-6-8.0% in May. I haven’t seen the Morgan Stanley report but the article says “vegetable prices in the third week of May dropped 5.6 percent week-on-week, meat was down 0.3 percent, and eggs were up 1.7 percent.”

Morgan Stanley said inflation in China should gradually ease over the rest of this year as domestic supply improves and international prices stabilize. But it warned that the devastating earthquake in Sichuan province earlier this month could fuel more upward pressure on prices in the short-term.

“In the absence of any further major natural disasters, China inflation should ease gradually over the course of the year,” it said.

If they are right it would imply that CPI declined by 0.2-0.5% month on month.

This would be a very welcome event if true, but even if it is true (and I am not so sure it will be) I am afraid that it would only be a temporary respite that would give the financial authorities, especially those in the Ministry of Commerce and the State Council who oppose further tightening, more ammunition for their arguments. And if prices do rise again in June and July, it would almost certainly be attributed, again, to a temporary and one-off factor – in this case the effect of the earthquake – and so a number of government officials would argue that there is little information about monetary conditions implied in the CPI price increases.

Two days ago, Ma Hongman, in a piece in the China Daily, argued yet again that any serious monetary tightening is the wrong response to current conditions because of the adverse impact it might have on economic growth. For him, and many like him, the only proper and effective tools are those likely to increase food production:

As a matter of fact, the traditional monetary policy tool, the interest rate or the deposit reserve requirement, could hardly work exactly upon the price-driving elements mentioned above.

Both measures could reduce the money supply in the economy, but they could do nothing in the short term to boost the supply of meat, eggs, poultry products or any other plants grown in the farm. The supply of agricultural produce cannot get free from the time span of their unique production cycle. In this cycle, raising the interest rate would only make the agricultural production more expensive, which, in turn, would push up the price of these produces, worsening the inflation pressure.

According to this argument policy-makers should ignore inflation and focus instead of measures to boost the economy. He goes on to say:

At a recent financial forum in Shanghai, Zhou Xiaochuan, governor of the People’s Bank of China, described the dilemma of the decision-makers: to boost the economic growth, consumption should be nurtured or stimulated, while consumption needs to be curbed to ease the inflation.

He has really got the crux of the problem. The contradictory targets to maintain the economic soundness are really challenging the wisdom of the policymakers. Therefore, they should drop the customary practice of tightening the monetary policy once the inflation indicator is lifted, but fix more flexible countermeasures according to real-time changes.

I agree and disagree. I disagree of course with the argument that inflation is not a monetary problem, but I also don’t think most of the current monetary measures will make much difference. The problem in China is the growth in the money supply caused by the PBoC’s forced purchases of currency inflows, and as I wrote two days ago, foreign currency inflows have grown from astounding to even-more-astounding. The only way to address the problem is to reduce currency inflows.

On a related note it is worth noting that demand for PBoC’s paper has softened over the past month. My student Shang Ning has been keeping track of interest rates and auctions of PBoC bills, and he says recent auctions have been small and heavily weighted to the short end. I think that is why we have seen so many increases in minimum reserve requirements, and will see still more. The PBoC is having trouble selling paper, and so raising minimum reserve requirements is one of the only ways it can affect the domestic money supply by reining in the banks. Whether this will work is an open question.

By the way I am hearing more and more that one of the main reasons for the irregular appreciation in the currency has been as an attempt to stop hot money inflows. In today’s report, for example, the G7 Group says “It is likely that the PBoC will continue to induce artificial volatility in the pace of RMB appreciation to reduce speculative capital inflows.”

If this is true I think they have it completely wrong. Inducing volatility in the exchange rate really means nothing as far as speculative inflows go – although it may help exporters learn about hedging. Everyone pretty much knows that the RMB is a one-way bet, and even if it declines a little for one or two days that only means that it will have to run up even more in the future to make up for the decline. This is hardly likely to cause speculators to lose any sleep, especially since anyone who thinks Chinese hot money inflow is caused by George Soros and all the other assorted evil-doers out there has it very wrong.

In fact most of this massive inflow is likely to be the consequence of hundreds of thousands of much smaller transactions involving money brought in by small Chinese businesses with extended family networks abroad. A little bit of intra-week volatility is hardly going to scare them away, and since the slower appreciation and greater volatility of April coincided with the largest one-month inflow in the history of central banking, I hope and expect it shouldn’t take too long to jettison this particular strategy for reducing inflows. I worry that the authorities here are so determined to keep the mythical speculators from profiting (they all seem to have read Currency Wars, a very silly book about the financial cabal – mostly Jews, of course – who control the world and want in particular to profit by destroying China) that they are missing the point.

At any rate I am still marveling at the size of the reported April surge in reserves. I can’t wait to see what May brings.

6 Responses to "Lower inflation in May?"

  1. mikmak   May 29, 2008 at 4:58 pm

    How can China reduce currency inflows? Lower exports (though this might entail job losses)? Capital controls (though their effectiveness is limited by their finite lifespan)? Lowering interest rates (might dispel carry trades, if any, but would fan inflation)? Raising interest rates or large revaluation (though this might attract more inflows into RMB bonds)?

  2. Victor   May 30, 2008 at 12:22 am

    Hi Michael, thanks for the inflation update. I am always amazed at the naive optimism that very smart people continue to have on inflation. Perhaps it is not naivety; they know all too well what the Chinese government would like them to say. One mechanism may slow hot money inflow somewhat. The CBRC’s window guidance forbids banks from lending to foreign real estate projects (well, in principle…). A lot of inflow has come in hoping to land a RMB loan after obtaining a piece of land. However, this new guidance, which banks seem to be taking seriously, may slow this kind of leveraging by foreign investors. This particular affects HK and Taiwanese investors who make frequent use of Chinese banks.

  3. Michael Pettis   May 30, 2008 at 6:58 am

    Perhaps, Victor, but I think much of the hot money inflow is coming in because of the expected 8-10% annual appreciation of the RMB, with a bigger chance of an upside surprise than a downside. With such a wind at your back you don’t need a lot of good investment ideas in China to make good money.Mikmak, you are right to see few options, which is why I have been arguing for over a year that China is moving inexorably to a one-off revaluation. It won’t happen immediately, but by late this year or early next if hot money doesn’t slow dramatically they are going to be forced to act.