We’ve commented before on the near-impossibilty of teasing decent inflation estimates out of China. Despite that, we were early to comment that inflation was getting out of control. From ajoint post with Marshall Auerback in February:
The government has engineered an enormous increase in money and credit in the past year. In fact, it seems to be as great as 5 years’ growth in credit in the previous Chinese bubble. The increase in money and credit is so great and so abrupt that you tend to get a high inflation quite quickly even if there are under utilised resources. Add to this the fact that China simultaneously is providing massive fiscal stimulus.
This combination is the making of a very messy situation. If China seeks to sustain demand via fiscal policy, the result is likely to be a big inflation problem. With many Chinese students steeped in Chicago School monetary theory coming home and assuming positions of authority, they could push for an aggressive, Paul Volcker-style effort to stop inflation.
But, what if the they don’t? Inflation can take off and thereby begin to ERODE the competitiveness of Chinese exports. Nouriel Roubini pointed out this issue in 2007: if China didn’t revalue, inflation would do the trick regardless. A continued high rate of inflation relative to its trade partners would push up the price of goods in home currency terms, which in turn translates into higher export prices. This might be the real reason why China is so reticent to revalue its currency. The Americans might go crazy if the Chinese devalued, but if the inflation is high enough, they might have to do it, as it will severely erode their terms of trade and cause their tradeables sector to collapse.
Or the hard-line monetarists triumphing by fighting inflation and the result is riots as unemployment increases.
Note that we pointed out that China was becoming less dependent on exports, but by increasing investment, which we also saw as unsustainable:
Exports are the only area where China makes any kind of money because they can sell these products for about 10 times what they obtain for a comparable product in the domestic economy (where profits are virtually nil). The export sector is a big contributor to overall super excessive fixed investment in China. Dollar appreaciation means foreign direct investment will go to zero net.
There will be strong forces for a reduction in fixed investment in this large sector. Hence, there is a good chance that even without monetary tightening by the Chinese authorities, the overall fixed investment boom in China will turn down….Nobody is thinking about this scenario but it is a real possibility. And with fixed investment now at fifty per cent of GDP (which is unprecedented in any economy) and exports at more than thirty, we’re looking at ratios that have never been reached before on a combined basis.