Wednesday, January 28, 2004

Inflated fears, deflated hopes

The Chinese fear inflation; the Japanese long for it.

WILL the year of the monkey be marked by economic mischief? The Chinese celebrated the lunar new year on Thursday January 22nd, gladdened by the news that the economy grew by 9.1% in 2003. But this heartening performance has stoked fears that the Chinese economy is overheating. It wouldn’t be the first time. During the last year of the monkey, in 1992, China’s then leader, Deng Xiaoping, made his famous tour of the south, urging the country to make the most of its new economic liberties. Liberty soon slid into licence, however, and within a year or two the economy was struggling to cope with rampant over-investment and inflation over 20%.

This year marks an equally troubling anniversary for China’s neighbouring economic giant, Japan. It was ten years ago that the economic superpower fell into a deflationary quagmire from which it has yet to escape. Core consumer prices registered a small increase in October, but fell again in November. The GDP deflator, a broader measure of prices, continues to fall by over 2% a year. While the Chinese authorities are acting smartly to head off inflation, the Japanese authorities are actively seeking it.

Inflation, said Milton Friedman, a Nobel prizewinning economist, is always and everywhere a monetary phenomenon. Maybe so. But Japan has phenomenal amounts of money, and inflation remains always and everywhere elusive. The Bank of Japan is pursuing a policy of “quantitative easing”. It cannot lower the price of money any further—nominal interest rates are already at zero—so it has boosted the quantity of money in the economy instead. Over the past two years, this policy has increased the monetary base by half. On Tuesday, the central bank surprised onlookers by increasing the money supply still further. It now aims to flood the banking system with reserves of ¥30 trillion-35 trillion ($280 billion-330 billion), up from its previous target of ¥27 trillion-32 trillion.

In China too, the money supply is increasing, though not with the central bank’s blessing. To maintain its currency peg, the People’s Bank of China has to create enough yuan to satisfy foreign demand for the currency at the going rate of 8.3 yuan to the dollar. As a result, it is losing its grip on the amount of liquidity in circulation. Broad money is growing by around 20% a year. Bank lending is expanding in step. Investment in plant, equipment and other capital assets is growing at rates not seen since the runaway years of 1993-94. Inflation has edged up, from negative territory a year ago to 3.2% now.

Even so, fears of overheating may be a little overdone. China’s modest inflation can be put down to a disappointing harvest, which raised food prices. There may be shortages in some sectors, such as electricity generation, but there is still much slack to be taken up in the rest of the economy. Labour in particular is never in short supply. Unemployment among those who have left the fields for the cities is thought to be quite high. Underemployment among those who work in loss-making state-owned factories is still higher. To keep the factory workers and peasants happy, China must mobilise labour on a grand scale. Economic growth of 9% or more is not surplus to requirements, because the country’s requirements are so stiff.

China is mobilising capital on an equally grand scale. According to official statistics, its investment rate is around 40% of national income and growing. The fear is that once mobilised, this capital will be mis-allocated. China’s state-owned commercial banks make over 60% of the country’s loans. Past history suggests they do not lend well. With marvellous understatement, the People’s Bank of China admits that the “mechanism of internal control” at these banks “still needs improvement”.

In the meantime, the Beijing authorities have taken to curbing, restricting or rationing the allocation of capital themselves. Investments in steel, cars, aluminium and luxury housing are all subject to new regulations. Last September, the central bank went a step further, raising the reserve requirements for banks in the hope of curtailing lending. The policy seems to be working for now. Bank lending in the final quarter of last year seems to have slowed.

If China’s problems stem from banks too willing to lend, Japan’s stem from banks unwilling to lend at all. Loans in Japan have fallen for 72 months in a row. Banks are reluctant to lend because the bad loans of the past still weigh heavily on their balance sheets; entrepreneurs are reluctant to borrow because demand for their products is weak and the price they can fetch for them falls every year; and, completing the vicious circle, households are reluctant to spend because goods will be cheaper next year. As a result, however much money the Bank of Japan creates, it is not being lent, borrowed or spent.

With spending at home flat, Japan relies more than ever on spending abroad. Indeed, the boom in nearby China may represent its best hope of escaping from its doldrums. Japan’s export-led recovery, now almost two years old, owes much to surging Chinese demand for its products. Morgan Stanley reckons that China accounted for no less than 66% of Japan’s export growth in the first nine months of 2003. In the space of a year, China has been transformed from scapegoat to saviour in Japan’s eyes. In December 2002, Japanese officials publicly rebuked China for exporting deflation around the world. Now, many recognise that it is helping their economy to reflate.

But Japan’s hopes may be thwarted by China’s fears. By taking steps to avert inflation in their own country, the Chinese authorities may halt the return of inflation to Japan. If the Chinese economy slows this year, its appetite for Japan’s exports will wane and its role as an engine of growth in the region will weaken. The Chinese believe that the year of the monkey is capricious and unpredictable. The Japanese may soon believe it too.

Source: The Economist Global Agenda
22 Jan '04