It is logical to assume that this year’s massive increase in credit and liquidity will generate serious consumer price inflation in China, but there are several factors which we believe will keep CPI moderate, at least in the near term. Rising M2 will instead lead to continued asset-price inflation, with potential problems in 2011.
30% rise in M2
China’s huge stimulus has been funded by a 122% YoY increase in new bank lending and a 30% rise in M2. Economists would normally expect this rapid increase in money supply – – M2 was growing at half that pace a year ago – – to result in higher prices, or inflation. But the equation is actually a bit more complex. A rise in the quantity of money in an
economy can cause three consequences: a rise in prices; a rise in quantity of output; or a fall in the velocity of money.
In the near term in China, we are more likely to see rising output and falling velocity of money, rather than inflation. Let’s take a quick look at each of the three possible outcomes of rising money supply.
Output is rising
First, it is clear that output is rising. The government’s PMI output index for manufacturing has been in expansion for the last 10 months, after having been in contraction for the previous 4 months. Apparent consumption of metals has been rising this year, and power generation – – a good proxy for heavy industry output – – rose every month since June, including a 27% YoY jump in November. Value-added in the chemical sector, for example, rose 31% YoY in November, compared to a decline of 3% a year earlier. Value-added in food manufacturing rose 21% in November, up from 10% a year ago. And with retail sales up 16% and household expenditure up 9%, it is clear that rising output is responding to strengthening demand.
Milton Friedman famously wrote that ‘inflation is always and everywhere a monetary phenomenon,’ but he qualified that statement by adding that ‘. . . in the sense that it [inflation] cannot occur without a more rapid increase in the quantity of money than in output.’ Although output is rising in China, it is not rising at the 30% speed of money
supply growth, so this only partially offsets the impact of rapid M2 growth.
Velocity of money falling
This is where the falling velocity of money comes into play. When evaluating the impact of money supply growth on prices, economists usually expect the velocity of money – – the speed at which money travels through the economy, or the number of times a dollar changes hands during a year – – to remain stable, and in most cases it does. But not this year in China. The velocity of M2 fell to .56 in 3Q09 from .67 in 3Q08, and the current pace is the slowest this decade. The velocity of M1 has taken a similar fall.
This slower pace of money changing hands is reflected in Chinese bank accounts. Since the start of the year, the amount of money in household savings accounts has risen 16% to RMB 25.3tn (US$ 3.7tn), and corporate savings has increased 32% to RMB 20.8tn (US$ 3tn). More money is staying in bank accounts, and is moving from wallet to wallet at the slowest pace in many years. This slower velocity means that much of the new money supply is not chasing goods and services; it is resting in the bank. In other words, there are more RMB in China this year, but each RMB is being used less often.
The growth rate of corporate bank deposits has increased at a pace similar to that of overall loan growth. The growth rate of household savings has been slowing, to 22% in October from 29% in May, as consumers have withdrawn money to support their increased purchases of goods and services.
CPI growth is all about food
With output rising and the velocity of money falling, the rapid growth in money supply has not, in most cases, resulted in higher prices. Headline CPI rose to 0.6% YoY in November, a significant pick-up from the -0.5% rate in October, and the first time CPI has been in positive territory since February. But 178% of the increase came from food, as non-food prices fell by 0.7%. And most of the food price rise was attributable
to weather and seasonal factors, not increased demand.
Manufactured goods prices still falling
In the near term, we expect that a combination of rising output and falling velocity of money will mitigate the impact of rising money supply on prices. Another factor which will prevent significant inflation next year is overcapacity in almost every manufacturing sector, which limits firms’ ability to raise prices of final goods. A good example is China’s auto industry: passenger car sales rose 49% YoY through November, but the average selling price of a domestic car had fallen 2.4% as of October.
Rise in asset prices rather than CPI
The two places where rising money supply have led to price increases are in residential property and A-shares. Property prices were up 14% YoY through November, according to CLSA data, and the Shanghai composite index is up 79% from the start of the year. But these two asset-price inflation cycles will have minimal impact on consumer price inflation. (China’s CPI basket includes rental costs, which have not been rising, rather than purchase prices.)
CPI will rise in 2010, to about 3% from an average of -1% in 2009, but almost all of that increase will come from food, and the food price rises will be supply, rather than demand driven. This means that while we expect Beijing to turn to interest rate increases in 2H10 in an effort to cool off asset-price inflation, rate hikes will not be an effective tool for managing CPI. (And with GDP to grow by 8-9%, 3% CPI is healthy.)
Summary for 2010
Next year the Chinese economy should remain strong, with GDP growth again in the 8-9% range, driven by increasingly strong private investment and consumption. I expect the RMB to resume its gradual appreciation (5-7% annualised) against the dollar by 2H10. Beijing will further reduce its stimulus measure
s in response to a recovering private sector, but I do not foresee any tightening until 2H10, when they will have to start worrying about bubbles.
Bubble risk for 2011
By 2H10, when demand for goods and services will be strong, real interest rates low, profits rising and, most importantly, the property and equity markets hot, outflows from corporate and household bank accounts could generate asset-price bubbles in 2011.
Timing will be everything next year.
China Macro Strategist
CLSA Asia-Pacific Markets