China’s CPI numbers look bad

Michael Pettis

Finally the November CPI numbers for China are in.  I said I would try to write about other things besides China, but here I am, my third post on Brad's blog, and still nothing but China.  I apologize, but there are so many interesting things happening here that it is hard to get excited by the rest of the world.                                                                                                                                  

China’s CPI was up 6.5% in October, up from 6.2% in September.  This matches CPI inflation for August and, with that exception, is the highest monthly CPI inflation number since the 7.0% recorded in December 1996. On the one hand October inflation slightly exceeded the consensus forecast of 6.3-6.4%, but on the other hand it is below the 6.8-7.0% that some people (including me) were worrying about. (However you can read my own blog to see why I think October inflation may actually be over 7 %.)  This is the third month of inflation over 6%, and I think that given the recent cut in fuel subsidies it is hard to see what can drive CPI inflation below 6% for the rest of the year. 

I think by now it is pretty clear that this is no longer just a food thing, although some analysts continue to say that it is.  For example they argue that the non-food component rose just 1.1% last month from a year earlier, the same pace as it did in September, whereas food prices were up 17.6%. 

That suggests that food is still the primary force driving prices upward, although in a poor country where one-third of the CPI basket is food, I would think that rising food prices must affect wages and, through wages, the rest of the economy.  More to the point today we were also told that PPI was up 3.2% in October, compared to 2.7% in September (and 2.6% in August, 2.4% in July, and 2.5% in June).  Food prices were a big part of that, but oil and raw materials were up 4.8% and mining was up 5.4%, (4.5% and 1.2% in September), and this doesn’t fully take into account the 8-10% increase in gasoline and diesel prices that was passed late last month. 

There is a lot of disagreement on where this will go.  Goldman Sachs have just changed their 2008 inflation forecast from 4.0% to 4.5%, whereas Credit Suisse keeps saying that it is going to be very hard to bring inflation down next year.  In explaining their forecast, Goldman said to its clients in a note today that “We believe the central bank will likely respond with additional tightening measures including strict control on bank lending and two more rate hikes before the end of this year.”

I have a great deal of respect for my Goldman Sachs friends, but I have to go with Credit Suisse’s Dong Tao on this one. Goldman, and everybody else for that matter, is right in saying that the high CPI inflation number is likely to lead to additional tightening measures, but given China’s monetary policies I cannot see how these tightening measures will work to reduce inflation.  

The whole point of tightening will be to reduce consumer demand as a way of putting a lid on inflation.  But if consumer demands moderates, what will that do to the trade surplus?   Of course it will rise even faster, and as the PBoC is forced to purchase the additional inflow, China’s money supply will expand even more quickly. 

In addition, whether or not you believe that speculative inflows are a serious problem for China (I think they are), it is hard to argue that raising interest rates won’t have at least some positive effect on inflows.  PBoC tightening, in other words, is likely to increase current and capital account inflows. The only market tools they have to attack inflation will, perversely enough, increase monetary expansion, and if you believe as I do that the root cause of Chinese inflation is excess money growth, that cannot be a viable solution. 

I think China is stuck and can do nothing about domestic inflation without fixing the currency problem.  This gets to the nub of the reason why I think China will be forced into a maxi-revaluation (or at least a significant speeding up of the daily appreciation).  The authorities have no control over monetary policy and never will until they address the currency regime. 

This pessimism of mine was confirmed, I think, by other October data.  M2 was up in October by 18.5%, a very high number, and more or less in line with monthly growth over the past four or five months (and at record levels since 2003).  Bad as this is, it was exceeded by the 22.2% growth in M1 in October (also at or near record levels since 2003). With M1 growing faster than M2 every month since November of last year, (before than for several years either the two grew at near-identical rates or M2 grew substantially faster) depositors seem to be shifting money into more liquid facilities so causing money velocity to rise. 

Logan Wright, of Stone & McCarthy, in a recent uncirculated report finds even more to worry about in looking at October numbers for the composition of bank portfolios.  Not only is loan growth at near-record levels on a seasonally adjusted basis (loan growth in October tends to low or even negative, whereas this year it is up by RMB 136 billion), but banking deposits actually declined in October. 

More alarmingly from the perspective of the central bank is the data on banking system deposits, which reveal that absolute levels of overall deposits in the banking system fell on a month-on-month basis for the first time since July 2001. Renminbi deposits in the banking system fell by 449.8 billion yuan, and total deposits fell by 434.2 billion yuan. Renminbi deposit growth fell sharply to 14.9% year-on-year from 16.8% in September and 16.5% in August…  

…Household deposits are now rising at only a 3.7% rate year-on-year, and these deposits have traditionally been the primary source of banking system liquidity. Interestingly, enterprise deposits, which have been rising much more rapidly in recent years, declined month-on-month as well, by 194.7 billion yuan. Enterprise deposits are still growing at a 22.7% rate year-on-year, and this constitutes the bulk of the growth in banking system deposits throughout 2007, meaning that the banking system is becoming even more dependent upon the profits of Chinese enterprises and the macroeconomy as a whole. We should caution that this is only one month of data, and a somewhat distorted one at that, being October, but the central bank is unlikely to be pleased with the flows of deposits out of the banking system and into the equity market, given its previous statements about the importance of maintaining positive real deposit rates.  

It is hard not to look at all of this and not conclude that the fears that some of us had as far back as 2003 – that China’s currency regime was locking it into a monetary trap – were unjustified.  Monetary conditions have played out almost exactly as expected.  In my opinion, as this thing continues to unfold the logic of a maxi-revaluation will only become clearer, but it is probably too late to undo all the damage.