I have your Chinese consumer price inflation right here

  I figured out a back way to get in to the account, but it took too much work to post regularly.  I’m here in the UAE on business, and have an impossible amount of other stuff to complete, so adding on hassles with proxy servers and the like was a large disincentive.  The government appears to have let up on Typepad — meaning that they’ve likely identified and blocked the offending sites — so I’m back on board.

Which is why my first post, of course, will be about China.  Why isn’t there more inflation in China?  We looked at that on December 28th.  On January 6th, Brad Delong wrote: 

Every month the People’s Bank of China pays 200 billion renminbi to China's exporters to buy up the dollar-denominated assets they have accumulated and so prevent those assets from generating upward pressure on the value of the renminbi. It gets those 200 billion renminbi by borrowing them from the good burghers of Shanghai. By now the central bank owes the good burghers of Shanghai some 16 trillion renminbi. To them, this wealth is nearly as good as cash. It has been piling up for years — and because it is nearly as good as cash, the good burghers of Shanghai should be spending it.

Here is a picture of the assets held by the People’s Bank of China (PBOC).  It shows fairly awesome growth, driven entirely by foreign asset accumulation.

 

They should be spending it. But the goods that are the counterparts of this financial wealth have been shipped via container to Long Beach. So demand in China should be massively outrunning supply, and China should be seeing strong and rising inflation.

Professor DeLong then links to James Hamilton, who suggests that the reason is that monetary growth in China leads to asset price inflation rather than goods-and-services price inflation.  He concludes:

The fact that our standard models do not appear — so far — to apply to Chinese inflation is yet another disturbing feature of today's world economy.

I’m not so sure that is correct.  Below the fold is a graphical representation of the liability side of PBOC balance sheet:

 

What does it show?  The bottom peach-colored indicator is currency in circulation:  the number of literal renminbi printed up.  Growth is fairly steady, almost linear.  Above it, in orange, is the amount of money that the nation’s banks have deposited at the PBOC.  From the Shanghai burghers’ point of view, this is as good as currency in the vault, and it rises slowly and steadily until 2007.

The PBOC kept its huge growth of reserves from leading to a huge growth in high-powered money via the two green indicators.  The dark green one represents illiquid bonds that the PBOC basically ordered the banks to hold.  The light green one represents government income (likely from state-owned enterprises, but I’m not sure that it matters) that was deposited with the central bank rather than spent.  Those two mechanisms mopped up most of the growth in high-powered money.

In 2007 and 2008, things changed.  High-powered money started to grow like gangbusters.  So why didn’t inflation get out of control?  Well, look at the red line:  China let the value of the renminbi rise from roughly 12¢ per dollar to a bit over 14½¢.  The rise in the renminbi helped keep a lid on import prices.  Much as I think that the Chinese government should have let the renminbi rise even more, I’m not sure that the lack of inflation presents much of a mystery. 

Fast forward to 2009.  The renminbi is no longer rising, so that can’t explain the lack of inflation.  Productivity is rising, but probably not enough to explain things.  (Productivity increases mean that Chinese producers are using fewer inputs to make the same output, which allows them to hold the line on output prices even as input costs rise, at least over a certain range of cost hikes.)  So how are the Chinese keeping inflation down as their reserves continue to balloon?

Well, look at the orange indicator.  High-powered money isn’t growing.  What is growing is the white block at the top, what the PBOC calls “other liabilities.”  I have no idea what those are, but they represent currency mopped up by the central bank.  In other words, the PBOC is keeping a lid on inflation by taking in liquid renminbi from somebody in exchange for an IOU of some sort.

At some point, the PBOC will no longer be able to keep up this balancing act.  They might sink the economy by sucking up too much liquidity and depriving the private economy of credit.  They might lose their ability to control inflation.  Or they might let the renminbi rise.  But there are reasons to believe — and I should mention that I have changed my opinion on this issue in the last year or so — that the Chinese government and PBOC may be able to keep up the balancing act for some time.  In theory, I think, it should be sustainable as long as Chinese firms remain profitable enough to finance themselves via retained earnings despite the fact that a big chunk of those earnings wind up metaphorically sitting in the PBOC coffers.

None of which is to say that China is not at the beginning stages of an asset-price bubble.  It very well could be; in fact, from the anecdotal evidence, it almost certainly is.  But I do not think that you need to postulate a bubble in order to explain the lack of inflation.

Does that solve the mystery, or am I missing something?  IANAME, just a fairly ignorant business school professor sitting in a Dubai hotel room wondering how he is possibly going to finish all the stuff he has to do.  So I almost certainly am missing something.  Thoughts? 

Comments

[Bernard Guerrero]

Great post, FWIW. I don't have a lot of immediate thoughts beyond the following:

a) Is a +20% revaluation enough to have kept a lid on that?

b) Is this really sustainable? "High powered money" growth has stagnated, I presume, because export growth has done likewise. That wouldn't be a problem if the Party has no interest in ramping up that engine again, but then they're back to having a lot of people with rising expectations but no way to hook into the system (with the previous method of choice having been migration to the coast or one of the inland manufacturing cities, and an exort mfg job.)

[Noel Maurer]

I think that Delong assumes that banks could borrow against the assets they hold against the central bank. I doubt that's true in the People's Republic.

About the revaluation: Imports averaged 31.2% of GDP between July of '06 and Sept. of '08, and the renminbi rose at an annual rate of 7.2%. So that gives you 2.2% off inflation right there, assuming full pass-through.

High-powered money grew at a CAGR of 32%. That's high! But real GDP grew at a CAGR of 11%. Inflation ran about 5%. So that's 11% + 5% + 2% = 19%. It leaves a residual, but considering that (a) that the Chinese government was leaning on its banks to be restrained, (b) the reduction in import prices has big effects, since they are inputs to all sorts of other stuff, and (c) this relationship isn't really stable, I'm not shocked that inflation wasn't higher.

Plus, what matters from the point of view of external sustainability is inflation that affects the Chinese cost of production --- since most imports to China are used as inputs to export stuff and not consumed locally, the effect on tradable price inflation is going to be much larger than the effect on inflation.

Make sense?

[pc]

you got mentioned by Yglesias...

http://yglesias.thinkprogress.org/archives/2010/01/chinese-inflation-revisited.php

[Twofish]

I don't see that much of a mystery. The primary way in which the Chinese government controls the economy is through reserve requirements, in which the banks are forced to take a huge amount of their wealth, and keep it in the form of government bonds. The "other liabilities" that you see on the PBC balance sheet consists of bonds issued by the PBC which it forces the banks to hold in as part of it's required reserves.

Forcing banks to hold required reserves has two major goods point in that:

1) it makes the banks more resistant to shocks. If you have a massive drop in real estate prices, then you have the reserves to prevent a liquidity crisis while you figure out a way of recapitalizing the banks.

2) it gets you out of the liquidity trap. One reason that the Chinese economy bounced back very quickly from the recession, is that the PBC pushed down reserve requirements allowing banks to pump massive amounts of cash into the Chinese economy.

All of this requires a huge savings rate. If you don't have savings then you can't have the banks hold large amounts of reserves.

[Twofish]

Quote: At some point, the PBOC will no longer be able to keep up this balancing act.

I'd be curious to know why not.

Quote: In theory, I think, it should be sustainable as long as Chinese firms remain profitable enough to finance themselves via retained earnings despite the fact that a big chunk of those earnings wind up metaphorically sitting in the PBOC coffers.

And I don't see why this can't continue for another generation. PRC companies have no shortage of capital which they use to build factories which increases productivity which creates more money that gets put into the bank. As long as productivity can be increased by capital expenditure, there isn't anything that keeps things from growing.

All this will end when you have enough urbanization and capital investment at it's that point that you might see either a Soviet or Japanese crisis, but that's at least 20 years in the future. The other thing that will cause disruption is when you have retirees pull money out of the banks, but by that time, you have enough profitable factories so this is possible,

[Noel Maurer]

Actually, the "bond issue" wedge represents the bonds issued by the PBOC which the banks have to hold. The other liabilities are mysterious, although they have the same effect.

Never predict, especially about the future. That said, it is very hard to imagine the PBOC being able to continue sterilizing such large-scale capital inflows for a generation. Margins in many Chinese industries are already wafer-thin; if they drop much further, then Chinese firms will need more outside credit to finance growth.

And that's the rub. As long as China is running a massive trade surplus, the PBOC will be hard put to allow the banking system to provide that credit without sparking inflation.

That is another way of saying that fast productivity growth makes the PBOC's job much easier. Once that growth starts to slow, the options will close to (1) deprive the economy of credit; (2) appreciate; or (3) allow inflation to accelerate.

Productivity might continue to grow at 10% per year for 30 years, but that's not how I'd bet.

(Best pizza in NYC, by the way, is Patsy's at 117th and First.)

[Joao Carlos]

Just a comment on your text :
"In 2007 and 2008, things changed. High-powered money started to grow like gangbusters. So why didn’t inflation get out of control? Well, look at the red line: China let the value of the renminbi rise from roughly 12¢ per dollar to a bit over 14½¢. The rise in the renminbi helped keep a lid on import prices."

I believe this is part of the story. The other part, an important one, has to do with mandatory reserve requirements (RR). From mid 2006 to mid 2008, the PBoC progressively increased RR from 7,5% to 17,5%. In practical terms, it means that while overall bank reserves were increasing at a very fast pace during this period, banks were not able to increase their loan books at the same fast pace. The PBoC was effectively reducing the money multiplier during this period.

[N]

Very interesting. One point I just noticed is that according to the map showing visitors in the top left of your page, there have been no visitors from China.....

[Noel Maurer]

Hah! Perhaps it's censored? Somehow I doubt it, but you never know.

[Anonymous]

I believe this is part of the story. The other part, an important one, has to do with mandatory reserve requirements (RR). From mid 2006 to mid 2008, the PBoC progressively increased RR from 7,5% to 17,5%. In practical terms, it means that while overall bank reserves were increasing at a very fast pace during this period, banks were not able to increase their loan books at the same fast pace. The PBoC was effectively reducing the money multiplier during this period.