Five Ways Inflation in China Can Affect the US

This is a post by Minyanville.com.

Author James Kostohryz is an entrepreneur and investment professional.

In Why Inflation in China Could Get Out of Control, I predicted that, to the extent that China continues to grow at a rapid pace, inflation in that country will be a serious problem in coming years.

Is inflation in China a relevant factor for the US economy and financial markets? Let’s make a short list of the ways higher inflation in China can affect the US.

1. Moderately higher inflation in the US.
Wholesale price and wage inflation in China will raise the cost of Chinese imports for Americans. The business model of most Chinese businesses is to crank out massive volume at razor-thin margins. Therefore, Chinese producers won’t be able to absorb the rise in costs within China. These costs will be passed on in the final price of Chinese goods and therefore this will put some upward pressure on US inflation as measured by consumer prices. This inflation bias will result from the direct impact of the rise in cost of Chinese imports but will also result in greater pricing power for US and other Chinese competitors that sell into the US market.

What’s the relevance of moderately higher inflation, say 150bp higher? In an economy with debt levels as high as the US, and the risk-free rate currently around 3.00%, a symmetrical 150bp rise in nominal borrowing costs can have a substantial impact on the economy and financial markets.

2. Moderately higher US competitiveness. The rise in Chinese wholesale and wage costs will increase the price competitiveness of US products relative to that of Chinese imports, alleviating some of the pressure on some US producers and workers. This has a stimulative effect on the US economy, profits and employment.

3. Real exchange rate depreciation of USD. The competitive gains referred to above will occur only to the extent that Chinese inflation is greater than inflation in the US. When inflation in China is greater than in the US there is an adjustment in what is referred to as the “real exchange rate,” in which the real purchasing power of the yuan increases relative to US goods and the real purchasing power of the USD declines relative to Chinese goods. Again, this should have a stimulative impact on the US economy.

4. High inflation in China creates pressure to revalue yuan. High inflation in China is in part being driven by its policy of fixing its currency exchange rate to the USD. Therefore, high inflation in China makes it increasingly likely that the Chinese will alter their exchange-rate policy and allow the yuan to appreciate.

Let me briefly explain the connection between Chinese exchange-rate policy and Chinese inflation: In the context of large current account and capital account surpluses, in order to maintain the value of the USD constant relative to the yuan, the Chinese central bank must intervene directly in foreign exchange markets by purchasing USD and selling yuan. Where does the Chinese central bank get the yuan that it sells? Well, it controls the “printing presses.” It simply “prints” yuan (or creates electronic money) and uses the newly minted currency to purchase USD. Thus, all else remaining equal, in the context of massive current account and capital account surpluses, the Chinese policy of pegging the yuan to the USD is a highly inflationary policy in that it results in a massive increase in the Chinese money supply. If China wants to control inflation, it has to stop printing so many yuan. But the only way it can stop printing so many yuan is if it stops purchasing so many USD. And China can only stop purchasing so many USD to the extent that it is willing to allow the exchange-rate value of the USD to decline and the exchange-rate value of the yuan to rise.

It’s critical to understand that yuan appreciation is a major inflation-fighting tool at the disposal of Chinese officials. Let’s review a few main reasons:

* As the yuan appreciates, fewer dollars go to China via the trade account. This means that the Chinese central bank prints fewer yuan to purchase USD and therefore the Chinese money supply doesn’t expand as rapidly. All things being equal, slower expansion of the Chinese money supply should alleviate inflationary pressures.

* Global “hot money” that flows into China creates inflationary pressures as the Chinese central bank must buy foreign currency brought into China to purchase Chinese financial investments with newly minted yuan in order to maintain the exchange-rate peg. As the yuan appreciates, less of this sort of “hot money” will flow into China. Why? Much hot money is currently flowing into China based on the expectation that the value of the yuan will rise relative to the USD. Once some appreciation has occurred, yuan-denominated financial investments will become relatively less attractive relative to USD-denominated investments. Therefore, less hot money will flow in, and some hot money will actually flow out of China as investors cash in on their currency gains.

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* Appreciation of the yuan causes the price of imports to fall in China. For example, appreciation of the yuan causes the price of oil, copper, iron ore, and many other inputs to fall in yuan terms. Therefore the prices of everything produced in China that employs these material inputs will tend to fall or at least be held in check. Furthermore, falling import prices creates greater price competition within the Chinese market, thereby eroding pricing power and serving as a sort of “anchor” for inflation.

To the extent that Chinese inflation, measured by consumer and wholesale prices, begins to accelerate, Chinese officials will have to seriously consider adjusting their currency peg and allow the yuan to appreciate substantially. This obviously has implications for the US, as discussed above. On the one hand, the price of Chinese imports rise. On the other hand, production and employment in the US will tend to rise. As I have pointed out in various articles, such as Is Chinese Protectionism Good for the US?, the net effect for the US of a Chinese appreciation of the yuan is positive.

5. Chinese inflation could seriously destabilize global financial markets. Perhaps the greatest impacts on the US and global economies that could result from accelerating inflation in China are those that could flow from associated financial markets’ instability. The issue is this: High inflation in China could create severe social and political problems for the Communist regime and sooner or later officials will have to take serious measures to prevent this from occurring. Given the very acute imbalances that are present in the Chinese economy, the corrective measures taken by Chinese authorities could have unpredictable consequences for the Chinese and the global economies.

There’s no free lunch. All potential “solutions” to the Chinese inflation problem come with serious associated potential costs and risks. For example, raising interest rates could devastate the real estate industry and other sectors that have become addicted to cheap credit in China. Quantitative credit restrictions in a country that has relied on subsidized credit to fuel growth could cause certain areas of the economy to grind to a halt. For many Chinese industries that operate on razor-thin margins, yuan appreciation could cause thousands of companies and millions of jobs to disappear.

The bottom line is this: Inflation control will come at a high cost for China, and given the severe imbalances created by China’s growth model, the eventual scale and scope of these costs are largely unpredictable. This can create substantial uncertainty and volatility in global financial markets, particularly in areas where the Chinese have been key drivers in recent years such as energy, food, and materials markets.

Conclusion

The era of goldilocks in China is over; the era of trade-offs and tough choices for the Chinese has begun. The kind of growth rates that China has enjoyed in the past couple of decades can no longer be achieved without high rates of inflation.

This sets up a series of dilemmas. Chinese officials are clearly “behind the curve” in dealing with a building inflation problem in China. This signals that until this point, Chinese officials have chosen to prioritize economic growth above and beyond price stability. However, as inflation gets more and more out of control, the measures that will need to be taken by Chinese officials will pose increasing threats to economic stability in China and globally. Due to the severe imbalances that currently exist within China, and in the global economy at large, the ultimate consequences of Chinese policy responses to inflation are quite unpredictable.

We all need to start thinking through the potential scenarios because high inflation rates in China are not a mere threat; they are already a reality.