By Houze Song
China’s October inflation data reaffirms that deflation is now no longer as much of a concern for China as it has been over the past two years, when the overall price index was sliding into negative growth. The new data, which shows firming consumer and producer inflation, is a positive sign, as it makes the repayment of Beijing’s significant debt easier. The question now is, will Beijing readjust its inflation targets, pump more money into the system, and pursue a policy of allowing higher prices?
To reduce the impact of higher inflation on Chinese citizens, Beijing has already announced a plan to subsidize lower income households when consumer price index (CPI) growth goes over 3.5 percent. The Chinese economy has been undershooting its inflation target since 2012, with CPI inflation currently running around 2 percent. Beijing’s CPI inflation target is 3 percent for this year. So judging from inflation targets alone, there is large room for monetary easing.
But there are both benefits and costs associated with higher inflation. On one hand, higher inflation will make it easier to repay China’s enormous debt, which is now 250 percent of GDP. Since China’s debt problem mostly lies in the state sector (state-owned enterprises and local government debt, which are mostly on state banks’ balance sheets), Beijing eventually will have to bail out these state entities. Instead, Beijing may choose in the short run to simply roll over these debts. But unless Beijing chooses to explicitly default on some of its debt, the debt will eventually need to be repaid. Either way, higher inflation will make the repayment of debt interest and principal easier as inflation erodes the purchasing power of money and any assets denominated in money. As inflation moves higher, the real value of debt declines (debt is worth less in terms of real goods). This is bad news for creditors, but good news for debtors.
The last time Beijing took measures to pay off significant debts, between 2000-2008, prices on average went up by more than 40 percent, translating into an annual inflation of about 4.4 percent. In the meantime, the one-year deposit rate was held at a low 2.5 percent for the majority of the period. This translates to a negative 2 percent annual real interest rate, which means the purchasing power of saving depreciates 2 percent per year. This greatly helped China’s state banking sector absorb the losses associated with SOE non-performance loans.
If Beijing can replicate its previous success inflating away debt, given China’s domestic debt of about 250 percent of GDP, a 2 percent lower real interest rate will reduce its debt burden by about 5 percent of GDP, or $500 billion, every year.
If Beijing can successfully modulate people’s inflation expectations after the initial inflation jump, it’s possible that there might be no wage-price spiral and ensuing higher inflation. There inevitably will be a onetime adjustment in the RMB exchange rate; but if the exchange rate is fully adjusted quickly, capital flight should not be a concern. Overall, if people believe that the government will maintain inflation at around 4 percent, the aftermath of such an inflation shock would be manageable.
Eventually, of course, artificially low interest rates would lead to runaway inflation, and Beijing would have to step in and raise interest rates to their natural level to prevent inflation from growing out of control. In other words, Beijing could save some interest expense on its debt repayments, but not for long.
But there are reasons for real concern if Beijing opts to really pursue a higher inflation policy. For starters, there is the risk that unchecked expectations of increased inflation could drive more capital flight. What’s more, while increased inflation could be a relatively cheap and easy way to deal with China’s debt problem in the short term, it would merely postpone the much more difficult but necessary work of tightening budget constraints on various state players, such as the state-owned enterprises.
In the meantime, a higher inflation policy would present significant longer term challenges: If Beijing has trouble controlling expectations of ever-rising inflation following the short-term inflation jump, then prices could end up rising much faster—eventually leading to an almost unavoidable policy backlash. If people believe inflation will surpass 4%, for example, this could trigger a wage-price spiral that eventually would require significant monetary tightening.
Since inflation is the cheapest way for the government to get rid of debt, people naturally would speculate that Beijing would later aim for an even higher inflation rate. As a result, they would start demanding higher interest rates for their savings. If the state-dominated banking system doesn’t accommodate people’s demand for higher interest rates, investors would likely either convert their savings into foreign currency or invest their funds in real estate and commodities—leading to even higher inflation. Eventually, the central bank would have to step in and significantly tighten monetary policy to contain inflation expectation.
Given China’s current high leverage level, such a monetary tightening would very likely trigger a debt crisis. Why? Because tightening monetary policy would make it difficult for borrowers to get the money they need to make repayments, while simultaneously pushing interest rates higher, making them pay more for their borrowing. The end result: increased likelihood of defaults.
Overall, since China lacks central bank independence, it seems that a wage-price spiral is more likely if Beijing is to pursue higher inflation. History has shown that all forms of government have a preference for loose monetary policy and high inflation, and so central bank independence is now accepted internationally as the foundation of sound monetary policy. However, in China, the central bank’s power is limited: the central government has the freedom and ability to engineer inflation. Unlike central banks in other major economies, the People’s Bank of China doesn’t have a clearly defined inflation target, and its conduct of monetary policy is supervised by the State Council, China’s cabinet. Consequently, there is more uncertainty regarding the long run outlook of inflation, and inflation expectations are less well anchored than in many other economies.
In China, inflation can rise very quickly because of such unanchored inflation expectations. Within a year after the global financial crisis in 2009, for example, overall inflation increased from around zero to near 8 percent. The Consumer Price Index is slightly less volatile, but generally follows a similar pattern.
There is a high possibility, therefore, that inflation will not settle at a new higher level after Beijing begins engineering for more inflation. This will help Beijing inflate away some debt in the short run. But high inflation is almost always politically unpopular, and any prudent government will be very cautious in handling inflation.
China appears to be on track to get rid of widespread deflation in the industrial sector—it’s clear that for the last several months, the government has been pumping money into industrial projects to boost economic growth. In the short run, that approach may solve some problems, facilitating debt repayment, keeping workers employed, and so on. But the real fear is that looser, inflationary monetary policy begets more inflation, while doing nothing to tackle China’s more profound industrial economic problems, such as inefficiency in the state-owned sector. The bottom line is that a higher inflation rate than currently anticipated will do more harm than good for the Chinese economy.