Inflation? Or stagnation?

For most of us the purpose of traveling to a developing country is to get the frisson of authenticity that we can’t get at home, and it annoys us no end when locals don’t play their roles correctly.  Last week at my friend’s wedding in Koh Samui I had to listen to a long diatribe by a very nice Australian lady involved in the arts who was furious that Westerners were apparently forcing Thai people to live Western life-styles rather than leaving them to enjoy their own culture.  In Koh Samui, I guess, there are too many refrigerators and motorcycles and not enough buffalo carts.  I was going to argue that the Thai might themselves prefer the modern urban conveniences, and were perhaps indifferent about helping us foreigners achieve our much-desired authenticity, but I didn’t want to be thought a cold-blooded imperialist by the many nice people at the wedding.

It’s not just in Thailand.  Most of my foreign friends who visit China, especially my European friends, are determined to see the “real” China while they are here, and of course they are even more determined that the “real” China look like it belonged in a Bertolucci film.  Of course enterprising Chinese know this, and so they have created little enclaves, like the annoying Nan Luo Gu Xiang, a little hutong street just north of the Forbidden City dotted with picturesque jewelry shops, backpacker bars, local restaurants, and various crafts outlets, most of whose merchandise looks like the vaguely Tibetan stuff you can buy in any authentic local shop in Guatemala, Marrakesh or New Mexico (or Koh Samui, for that matter).

Occasionally I like to bring foreign visitors to the neighborhood McDonalds, partly because it always generates a lot of outrage and partly because you are far more likely to find a McDonalds outlet replete with local residents conducting their everyday life than you ever would in Nan Luo Gu Xiang, which is much more likely to be peopled by European tourists and upwardly-mobile Chinese who like to eat and shop in the places foreigners do.  McDonalds, on the other hand, is as local as it gets for young urban life in most Chinese cities, and it is rare to see one that is empty.

I mention this not because I own McDonalds stock or like the food, but rather because there is a large headline in today’s China Daily:  “McDonald’s raises prices in China.”  McDonalds, along with KFC and Pizza hut, is extremely popular in most major Chinese cities not just with students but also with middle class families and dating couples.  The fast-food outlets are almost always full and often there are lines to get in.  Right-thinking Westerners may deplore this, but one of the best young underground bands in Beijing even has a song about how many times McDonalds has saved the singer’s life (mostly because of the clean bathrooms, however).  It is a fairly important place to many urban Chinese and so its pricing policies matter, as the China Daily headline indicates.  According to the article:

There’s no escaping rising inflation – signs of it are everywhere. The latest sign could be in your meal at a fast-food outlet. McDonald’s, the world’s largest fast food chain, yesterday raised its prices in China, for the second time this year, following measures to increase prices in January.

The US group is not alone in its decision. Many Western food chains are now increasing prices on their menus in China.

The article goes on to say that in the latest price hike, the cost of most items rose by RMB 0.5-1.5 per item (3-10 American cents).  I don’t know what the typical item in McDonalds costs, so I don’t know what this means in percentage terms, but I am struck by the fact that they hiked prices in January and then again in May, even though food prices declined in May.  This suggests to me that inflation, and possibly wage inflation, has become a serious enough problem for at least the fast food outlets.  I don’t know how much of their costs consists of food purchases and how much is non-food, but I would have thought that two price hikes in four months is a lot.

Most analysts by the way expect that CPI inflation will decline again in June because food prices continue to decline.  The question, as always, is whether non-food prices are stable or are increasing.  The hike in energy prices last Thursday will almost certainly have an inflationary impact, but it is too early to say what kind of impact.  The NDRC, whose policy-making role seems to have strengthened recently, apparently believes that the fuel price hike will only raise CPI by about 0.4%, but the Observatory Group’s Xinxin Li says the PBoC disagrees:

PBoC officials believed that the real impact to the general price level would be much higher.  Internally, the government’s 2008 inflation target has been readjusted to 6% from 4.8% since the beginning of the year.  After the recent price hikes, the PBoC essentially abandoned the 6% target, but is anticipating 7% now.  Whatever the formal target, it is more concerned about the pass through from this price hike to broad-based price levels and to higher public expectations of future inflation.

Again the differing interpretations of domestic problems are making policy difficult.  PBoC governor Zhou Xiaochuan last Friday warned again about inflation and hinted pretty broadly that he was considering an increase in interest rates.  In response, Chinese bond markets have been pretty bedraggled this week, especially today.  According to today’s Bloomberg:

China’s 30-year government bonds fell the most this month on speculation the central bank will raise interest rates as early as this month to cool inflation…The yield on the 4.5 percent 30-year bonds advanced 14 basis points from the price compiled by Bloomberg yesterday to 4.91 percent as of 5 p.m. in Shanghai.

But it is very widely believed that recent meeting of top government officials made it very clear that an economic slowdown is now a much greater concern than inflation.  That would make it very hard for the PBoC to garner much support for a rate hike, especially as both the real estate and stock markets would probably be badly affected and the stock market has only just managed to pull itself back from the brink.  I have no real expertise in handicapping the race, but it seems to me that the PBoC is probably facing a lot more opposition to its monetary concerns, and my guess is that the pro-growth camp has the upper hand for now.

Talking about stock market exhaustion, last Thursday’s fuel price hike certainly seems to have impacted the stock market in a positive way.  After the big run-up in stock prices on Friday I expected the market to be weaker this week, but I was wrong.  The week did start badly, with the SSE Composite dropping 2.5%, but over the next two days it turned around and gained a total of 5.2% before, after a very rocky day today in which it bounced around several times in an 80 point range, it closed at 2901.85, down 0.1% for the day.  That leaves it up 2.5% for the first four days of this week.

Before closing I want to mention two things.  The first is a June 24 Financial Times article I read yesterday on the plane (“Vietnam suspends gold imports”).  Because my adorable godson is Vietnamese, and his parents are involved in the world of finance and government, I have been keeping an eye on the events unfolding there.  No, I don’t think the problems in Vietnam are at all like those facing China – with its massive current account deficit Vietnam has a very different set of risks than China – but I was intrigued by the fact that this week Vietnam had to suspend gold imports in order to ease its large and growing trade deficit.

Apparently, and in order to protect themselves from inflation, so many Vietnamese are buying gold that Vietnam has suddenly overtaken China and India as the world’s largest market for gold bullion.  This orgy of gold buying has, of course, worsened Vietnam’s trade deficit, although I would argue that gold imports for investment purposes should be seen more as a reduction of the capital account surplus than an increase in the current account deficit, but either way it represents a drain on reserves.

Although gold imports are regulated, until the suspension Vietnamese gold imports had soared.  Gold imports for the first quarter of 2008 were up 71% over the same period last year, and imports of gold bar (which of course is what gold investors typically buy) were up 110%.  I have said many times in this blog that I suspect that if we see problems with inflation or capital flight in China, one form these are likely to take are through gold purchases.

The second thing I want to mention is a very strange story on Chinese Law Prof Blog, written by a friend of mine, Donald Clarke, who teaches law at George Washington University Law School and who is particularly knowledgeable about legal and business conditions in China.  According to Don, government officials had turned down a foreign acquisition of a Chinese asset on the grounds that the appraised value of the asset was much higher than the price at which it was held on the owner’s books (the “book value”) , indicating to them that the foreign investors were paying too much for the acquisition.  A friend of his was the legal advisor on the transaction.  Don goes on:

A market price higher than an appraised value is not surprising or indicative of anything wrong; Chinese appraisers often rely on book values that take no account of certain intangibles and future earning power. In the past, foreign acquirers have run into difficulties with approval authorities when the negotiated price was lower than the appraised price; the authorities, who have more faith in the solidity and apparent objectivity of book numbers than in evanescent and subjective market valuations, would suspect that assets were being sold off cheaply to crafty foreigners, or that kickbacks or other underhanded dealings were involved.

It is clear why the authorities should be concerned if the buyer was paying too little – that might indicate that there was corruption or some form of fraud taking place, but why should anyone care if the buyers seem to be paying too much?  Apparently, according to Don’s friend, because it might indicate a very different kind of illegality:

What’s going on here? The problem is that apparently approval authorities are now more worried about hot money inflows than they are about Chinese sellers getting taken to the cleaners by crafty foreigners. They just don’t want all this money coming into the country. Surely there is something wrong with an exchange rate policy that leads to this kind of result.

In several of my entries I have tried to explain why it is not such a simple matter for the authorities to deal with burgeoning speculative inflows by imposing tighter restrictions on the inflow and outflow of capital.  With so many legitimate transactions of such a wide variety occurring over so extensive a trading border, it would take an enormous amount of monitoring to reduce speculative inflows, and this monitoring would seriously hamper real economic transactions.  Don’s story is a particularly bizarre example of just how such hampering might occur.