Monday, April 11, 2011

Michael Pettis on China & Inflation

In his private newsletter, from which we are only allowed to make excerpts, released yesterday, Michael Pettis discussed China's inflation situation and policies and the potential effects on United States inflation.  Most western commentators and analysts get it wrong when they think a Chinese interest rate hike will combat inflation by encouraging Chinese households to increase savings and reduce consumption, because "Negative real deposit rates actually reduce household wealth in China by lowering the value of savings" and "Chinese households actually increase their savings when the deposit rates decline in real terms."  In China, interest rates have only been rising nominally and not in real terms.  Except for the wealthier with mortgages, Chinese households have been made poorer by a decline in the value of their savings, which should reduce consumption, and, in fact, consumption is weaker now than six months or a year ago.  This suggests to Pettis that, with respect to inflation, China "... has a self correcting mechanism embedded in the financial system."  He believes, barring no surge in global commodities prices, China will be able to control inflation by the end of the second quarter.

China's real problem is massive capital misallocation with low interest rates, because the financial system's counteraction to CPI inflation converts it into asset price inflation.  "Real monetary tightness in China is measured by credit expansion, not interest rates, which are far too low to matter much to borrowers."  China is already experiencing a slowdown in economic growth, because credit growth has already been constrained.  Credit markets continue to be strained and he repeats his observation that the surge in copper imports has more to do with attempts to convert trade financing into domestic financing while noting that commodities traders are telling him the same appears to be happening in the soya market.  Any reduction in credit growth translates into economic pain very quickly.

On his recent trip to the United States, many people were concerned that if China does rebalance, interest rates in the United States will soar.  The conventional argument is that a decline in the current account surplus means rising Chinese consumption with declining savings which would result in China purchasing less United States debt.  According to Pettis, Martin Fieldstein makes this argument in a Project Syndicate article, with which Pettis substantially agrees, except Pettis believes "... China will keep investment rates higher than they otherwise should be in order to reduce the immediate impact of the slowdown."  Pettis does not think a decline the amount of capital recycled by China is likely to lead to higher interest rates in the United States.  Pettis briefly goes through several scenarios of increasing current account surplus in the US, increased saving, increased consumption, increased employment and economic growth, increased unemployment and lower economic growth, increased fiscal deficit, etc., as possible results of China tightening.  Bottom line, rates in the US are as likely to rise as fall.  An increase in US current accounts can be contractionary, "... because a rising current account surplus can slow the economy and weak growth is likely to be associated with low interest rates."

If China's current account surplus declines, it can affect the United States in two ways.  On one hand the surplus could be transferred to another country.  On the other hand, as Fieldstein advocates, if China's consumption rises causing the Chinese current account surplus and the United States current account deficit to both decline, China, and foreigners in general, would buy less US assets fewer US government bonds.  However, Pettis believes the latter would actually be expansionary in a way similar to an increase in the fiscal deficit, because the impact on the current account would be offset by a reduction in fiscal spending.

"If the US wants foreigners to 'lend' it more money, all it has to do is engineer a larger trade deficit."  Worrying about China not buying US bonds is no different than what would happen if the US trade deficit contracts.  It all depends.  While most of us would assume a contracting trade deficit is expansionary and a good thing, it is actually dependent on how it happens.  If the US current trade deficit were to decline as the result of soaring unemployment causing investment to collapse, it would not be a good thing.  If the US current trade deficit declines as the result of China importing more US goods, everyone would be happy and not concerned with interest rates.

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