Inflation and Mercantilism

China's Money is Undervalued

By blackhedd Posted in Comments (22) / Email this page » / Leave a comment »

From the Understating-the-Case Department: This story tells of rising prices in China for staple foodstuffs. Long experience with official statements by China's leadership suggests that they're only letting the tip of the iceberg show.

Why are we concerned about inflation in China? Because it touches on a very sore subject in Congress and on this board, which often goes by the code name mercantilism.

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China's economy is continuing its double-digit growth this year, as it has for several years now and is expected to continue for quite a few years more. This is an extraordinary rate of growth, and if you do some simple math, you end up with a vastly larger economy in China after another decade or so. But is it what it seems to be?

China is fessing up to 3.4% inflation inside of 11% growth:

The government has been worried that China's sizzling economy, growing at an 11 percent pace this year, could accelerate politically dangerous inflation. The official inflation target is 3 percent.

Consumer prices rose by 3.4 percent in May, the National Bureau of Statistics said. That was the highest rate since prices rose 3.9 percent in February 2005.

Food prices jumped 8.3 percent from a year ago, up from April's 7.1 percent, the bureau reported.

Now in the first place, I don't completely believe anything the China regime says for public consumption. Remember what I said about icebergs. But if they do end up increasing rates and reserve requirements, that would be a clearly visible sign that they're trying to cool things down.

But that food-price number is crazy. 8.3%? In the US, food prices are quite volatile too, but if they move one percent (annual rate) in a month, that's a big move. Look a little farther:

Meat prices jumped 26.5 percent, while the cost of eggs was up 37.1 percent, the statistics bureau said on its Web site.

Communist leaders are especially concerned about soaring prices for pork, China's staple meat. They have risen by more than 40 percent over the past year, partly by a pork shortage caused by the spread of blue-ear disease, an ailment that the government said Monday has killed at least 18,000 pigs.

These are amazing numbers. I can't tell you whether the spin being given to the pork disease is coming from the AP reporter, or whether it's China's official explanation. But 18,000 dead pigs in a countryside with 800 million peasants ain't going to put pork prices up by 40%.

Remember the SARS epidemic several years back. China only admits to bad things when they figure they can't keep the lid on much longer. The inflation situation is probably a lot worse than it looks.

I'm not inclined to accept a story about a few thousand sick pigs to explain a 40% increase in staple-food prices. I think the phenomenon is monetary.

Much ink has been spilled (including by me) on China's currency peg. As you know, the value of the renminbi (called the "yuan" inside China) is pegged to a basket of currencies and securities that closely matches the US dollar, and is only allowed to fluctuate by a tiny amount per day. What's the problem? Well, renminbi is arguably undervalued by at least several tens of percent.

If you've been listening to the Wall Street Journal, Democratic Senators like Schumer and Clinton, or a standard-issue economics professor, your immediate reaction is: Ah ha! China is trying to make their manufactured cr*p cheaper for American consumers! With the predictable effect of wiping out manufacturing jobs in America and making Walmart richer. Many people call this "mercantilism."

The true picture is substantially more complex.

I believe that China has pegged their currency to the dollar for a handful of deliberate reasons, only one of which is to make their exports more attractive to US consumers. I always have to tread lightly around this here on RedState, because whenever I describe and analyze their behavior, someone pops up to accuse me of excusing or even advocating it.

But in lieu of the entire book I could write on the subject, I'll mention just a couple of key things the Chinese may be thinking. First, memories of 1997, the summer of the "Asian flu," which did not affect China but did affect several of her neighbors. Keeping renminbi undervalued is a way of ensuring that hot money and other sources of direct investment stay in China. China is taking in over $70 billion in direct investment per year. (For comparison, India, with more than half of China's population, takes in perhaps between 10 and 20 percent of that figure.)

Another issue is that China's financial system is primitive at best. As a command economy, China has nothing like the deeply-knowledgeable network of private institutions that make the US far and away the most efficient user of capital in the world. China's leaders know what they don't know, and they're content to import monetary policy from the US, in the form of a currency peg.

Lastly, memories of 1985-87. I'm speculating on this point, but I believe the Chinese are never going to let us jawbone their currency up relative to the dollar, as we did to the Japanese after the Plaza Accord. The result was an incontrollable asset bubble in Japan, and the economic distress they've suffered ever since.

Plenty of us free-market types like to warn the anti-mercantilists that taking protectionist action against Chinese imports would be self-defeating. Why? Well, I'll spare you the comparative-advantage theory that you've heard a thousand times before.

The real reason is because markets reflect reality. Free markets (even the putatively free ones we have in the US) tend to reflect reality without too much distortion or displacement. Command economies can do well enough, as long as they don't try to get in reality's way.

The undervaluation of China's currency relative to the dollar is a distortion of reality. China's leadership think they can get away with this, but you can only go so far before it starts biting you. Markets are vastly bigger and more powerful than governments.

We don't need to protect against China's "mercantilism," because the bad effects of denying reality will show up on their own. That's the real import of the food-price inflation you're seeing in China.

By artificially undervaluing their currency and importing and holding an enormous amount of dollar reserves (more than $1 trillion, including about $350 billion in long-dated Treasury debt), the Chinese have effectively created a monetary base that is far too large for the size of their economy. Inflation is the inevitable result. China has been trying to control inflation they same way they try to control everything else: by denying it exists.

It's impossible to say for sure, but a more natural rate of growth for the Chinese economy might be quite a lot closer to our nominal 4% than to their "offical" 11%. Why? Obviously because their economic activity is driven by our export markets.

But the China regime's political legitimacy (such as it is) depends completely on their ability to deliver what is at least an illusion of prosperity-growth for the country's urban populations. Hence the inflationary effects of China's foreign-exchange policy serve an important, perhaps a fundamental political purpose.

It's possible that China's inflation is far more severe than they are letting on. It's also possible that their growth is more hollow than we think.

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Much growing evidence shows China is experiencing lots of growth problems. Polution of the air and water and now inflation.


Managing Editor

...I just created an account expressly to let you know, blackhedd. Very good stuff.

Excellent article I have a couple questions though.

The food inflation struck me as kind of key. Does china control its imports or are they just suffering the effect of undervaluing their currency ? I am asking because, I have always heard their agricultural capacity was nearly maxed out. So, it would look like the food price inflation is coming from city money chasing goods it wants. Trade isn't just across what a country defines as borders after all.

The other thing that struck me is raw materials. Is any of this showing up in their commodity prices for raw materials ? I know oil is attributed to their demand, not certain of the truth of that. People are very good at explaining markets, predicting them not so much.
______________________________
"Those who expect to reap the blessings of freedom must, like men, undergo the fatigue of supporting it."
-Thomas Paine: The American Crisis, No. 4, 1777

In regard to food production: I wouldn't believe a word China says about the situation of their agriculture. They have far too much to lose by telling the truth. (What do you think would happen to the price they have to pay for imported rice if word got out they needed it bad?) So we have to do this by reading the proverbial tea leaves.

If food-price inflation is a supply-driven phenomenon, then China is in extremely deep yogurt, right now. Widespread hunger would be the worst possible news for the regime, and not just because every Chinese person older than 50 remembers the Great Leap Forward. If that were the case, I'd expect them to be scrambling now, but instead they're exporting wheat gluten to us.

Commodity inflation: anecdotally, Chinese demand is pushing up global prices for everything from scrap metal to tubulars for oil production. They're in the middle of a building boom that may rival anything in history. They're even pushing up prices for strategic assets like whole oil companies.

If, as I theorize, they are over-extending, then you can look for a fairly serious financial crisis in China about the next time we have a recession.

I'm far from an econ expert, but it rings very true, and seems to explain alot. I'm not a protectionist, nor would I ever be, for exactly the reason you bring up -- markets are vastly more powerful than governments, and something my mom always said (sage that she is) -- it'll all come out in the wash.

It's war -- so when can we start shooting back at the enemy Democrats?

There is a great deal of pressure being put on China today, primararly by Democrats like Senator Chuck Schumer, but also by the Bush Administration for China to re-value the Renminbi (China's currency) relative to the dollar. Some here in America think it would be great if China just let their currency float.

The argument that Shumer and other Democrats plays well to their base. Th USA is "losing" manufacturing jobs to China, and its their fault (the Chinese), because their currency is priced so low. The fact is, even if China did re-value its currency, I doubt there would be much improvement in American manufacturing jobs. More than likely, a major recession would occur resulting in lots more Americans losing their jobs.

I think it would be a disaster for both China and the US to have China suddenly re-value the Renminbi. Prices of Chinese goods would skyrocket resulting in substantially lower sales. WalMart prices for many of its products would rise substantially, hurting the very people that Shumer and his ilk are trying to appeal to. I think you would see a recessuion in the USA and a substantial slowing down of the economy in China, neither of which would be good for China and the USA.

I hope the Chinese Government continues to resist the pressures from the Bush Administration and from economic know-nothings like Chuck Schumer. Its strange, to me, that a quasi-Communist Chinese Government seems to have more sense than our American politicians kike Bush and Schumer. It makes one wonder whether their political system is not a better one for a free market than ours, when stupid politicians can pander to the uneducated masses.

Rudy

It makes one wonder whether their political system is not a better one for a free market than ours, when stupid politicians can pander to the uneducated masses.

I suspect you didn't quite say what you meant to.

As I said in my post and in reply to Joliphant, reality comes to the fore sooner or later. If China's growth is the real thing, they'll be able to keep it up. If they're using currency policy to make things look better than they are (for internal consumption by their sheeple), then it's just a matter of time before they have a very bad day.

Many people call this "mercantilism."

Selective use of scare quotes aside, this is mercantilism, if the word has any meaning at all. If you object so vehemently to the word, which one would you use instead?

Worse than that, it is mercantilism by mutual agreement. The people running both countries like this arrangement. Logically, if the Chinese lifted the peg tomorrow, the US should put it back from our side. All the supposedly great benefits we accrue would still apply, after all.

whenever I describe and analyze their behavior, someone pops up to accuse me of excusing or even advocating it.

Well, you certainly are not condemning it or objecting to it. You seem to see it as somewhere between neutral and desirable.

I don't disagree with the substance of your analysis of what is going on in China. I've felt for a long time that their system is fairly rotten. The difference is that you seem to feel that we have a mutual interest (with them) in keeping it propped up. I feel that it is in both our and their best interest, long term, for them to change it.

What's your point of going after him and accusing him of supporting Red China's policies? What is there to be gained on threadjacking like this?

Run like Reagan!

I addressed his thread directly.

I use quotes around "mercantilism" as I always do when the definition of a term is imprecise, context-sensitive, open to interpretation, or contentious. In this case, it's all of the above.

I feel that it is in both our and their best interest, long term, for them to change it.

I really don't know what is in China's long-term interest, so you're already doing better than I am. I know what I want for America, and that's to stay competitive in a world that is changing far faster than most people appreciate. I also want stable, permanent peace, which as everyone knows only comes after strength.

Note, I didn't say I want to beat the Chinese- that's "hubris" if the word has any meaning at all. But the fact that they don't do freedom creates a wide range of exploitable weaknesses. And when you're dealing with a competitor that has the ability and the desire to set the terms of the game, that's what you need to be looking for.

I really don't know what is in China's long-term interest, so you're already doing better than I am.

Being a free market type, I believe that free markets would be in Chinas best interests. YMMV.

I know what I want for America, and that's to stay competitive in a world that is changing far faster than most people appreciate.

And our current trade policy with China accomplishes that, how?

the fact that they don't do freedom creates a wide range of exploitable weaknesses

Agreed. Lets start exploiting them.

when you're dealing with a competitor that has the ability and the desire to set the terms of the game

They don't have that ability, unless we grant it to them. Why would we want to do that? Why have we done that?

I don't. I'm a businessman. I believe in intelligently assessing the facts as they present themselves, adapting appropriately, and going after the most "promising" target.

I use scare quotes around "promising" by way of pointing out that some days you go after the low-hanging fruit, and some days you go for all the marbles. (Ugh, sorry for the mixed metaphor.) It's all part of adapting to the situation as it presents itself.

If I were China, I'd be playing a massive game of "grab market share while it's cheap." And that is in fact what they appear to be doing. Once you have market share, you can't lose it unless someone takes it away from you. Not easy.

What does our current trade policy with China accomplish? Gee, I don't know. Don't particularly care either. Our government officials want exactly what China's want: to stay in office. In America, that's a lot easier because We the People do the heavy lifting. All they have to do is look good on television. The less attention I have to pay to the people who make our so-called public policy, the better I like it.

I don't read Chinese, so I'm not about to say for sure what's good for China. You say that free markets are good for them, on what I suppose are axiomatic grounds (since you don't spell out your reasoning).

Free markets are good for people who love freedom. The Chinese don't love freedom as much as they love stability and international prestige. Different strokes. I can see the idealistic case for trying to change how they operate. I wish you the best of luck with that, but my opportunities are somewhere else.

China plays dirty. The country is a snakepit of piracy and corruption from top to bottom. But that's life in the big city, and we're stuck with it. The only way that will change is if they start getting closed out of markets as a result. But in an increasing number of areas, they are the market.

And don't forget the main point of this whole thread, which is that their shenanigans are going to land them in some hot water sooner or later.

I think we are pretty much in agreement on most things.

"You seem to be coming at this from the POV of public policy."

Indeed I am. I see this as a political issue with economic implications. You, I think, see it the other way around. I'm not sure the distinction is that big at the end of the day.

Free markets are good for people who love freedom. The Chinese don't love freedom as much as they love stability and international prestige. Different strokes.

Wonderful comment. Any further response would spin way off topic. But quite thought-provoking.

don't forget the main point of this whole thread, which is that their shenanigans are going to land them in some hot water sooner or later.

I have not forgotten, and I agree with that assessment. The question I see is to what extent we should fear that happening and try to prevent it, and to what extent we should welcome it and try to bring that day forward.

Sorry for the interruption, but thought you might want to hide if the Masters of the Universe (aka bond traders) are stalking you!

s

Right you are, Streetwise. And right on cue, USD/EUR is at 1.33. Yen rate almost 122.

As I said the other day, this is the biggest business story in the world right now.

As far as the MotU are concerned, I'm sure they're lapping up the volatility. I've been superbusy with work, but it looks like great trading weather.

Tell all your friends, you read about it on RedState first ;-)

http://www.timesonline.co.uk/tol/news/world/asia/china/article1917927.ec...

So it tends to look like its real grain shortages and they don't have surplus or fallow capacity.
______________________________
"Those who expect to reap the blessings of freedom must, like men, undergo the fatigue of supporting it."
-Thomas Paine: The American Crisis, No. 4, 1777

That's how much the article says China is currently manufacturing (doesn't say whether that production is all from corn or not). By the back of my envelope, that's about 8 million barrels of ethanol a year. Saudi pumps more than 8 million barrels of crude oil a day.

Something tells me that the Times article is reaching.

I was just reading off the fact that ethanol production was being reduced for the stated purpose of lowering grain consumption.

I found this link for chinese corn usage

http://www.nationmaster.com/graph/agr_gra_cor_con-agriculture-grains-cor...

problem is I am pretty certain its wrong as it has china's corn production at 128 million tons. This would imply roughly .1 tons/per person usage in china. And a 2* percent change in usage if your figures correct. For tight markets a 2 percent change in supply or demand can be significant.

*guessing 50% conversion by weight
______________________________
"Those who expect to reap the blessings of freedom must, like men, undergo the fatigue of supporting it."
-Thomas Paine: The American Crisis, No. 4, 1777

...for ethanol. They merely quoted a Chinese "official" at some conference (no date given, it could have been a year ago for all we know), saying that corn-to-ethanol was not the direction for China.

Here's how I did my calculation:

The article says that four firms are together producing one million "tonnes" of ethanol a year in China. An imperial ton is 2250 pounds, is about 350 gallons of ethanol, is about 8 barrels. Multiply by one million.

 
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