Tightening China
One of the China characteristics from the past few years was that the world's new super-power in manufacturing was exporting deflation across the world, leading to ever lower prices for products "Made in China" and a sheer impossibility for manufacturers elsewhere to compete on a like-for-like basis.
That is changing, however, and rather rapidly. China will be battling inflation this year and one of the main drivers behind this change are rising wages. Anecdotal evidence has it that factory owners in the Pearl River Delta are finding it hard to attract labourers, despite offering wage increases of up to 15% versus a year ago.
China's headline inflation number in January looked okay at face value, but few economists would accept this as a blue print for the year ahead. In fact, and as rightly pointed out at the time by China watchers at ANZ Bank, the underlying trend in January is already pointing towards much higher inflation numbers in the months ahead.
At face value China's January CPI grew by 1.5% annualised, down from 1.9% in December, and still well below the central bank's target range of 3-4%. But there are plenty of signals, including the aforementioned wage pressures in factory regions, that suggest authorities better act now.
This is why the reserve requirements for Chinese banks have been increased on the Friday before Chinese new year, signalling Chinese authorities are well aware of the need for decisive actions, and they do understand there is a sense for urgency.
But lifting bank reserve requirements alone won't be enough. As more and more economists are looking into the problems and challenges facing Chinese policy makers this year, there is a growing sense that much more will need to be done.
So what should investors expect? More reserve requirements? We already had two of 0.50% each in both January and February. Will there be a hike in Chinese interest rates? Several hikes? A revaluation of the Chinese renminbi?
Most likely all of the above.
Chances are investors won't have to wait long either. Already the restrictive policy move just before Chinese new year shows the central government is aiming to stay at the forefront of the action curve, keen to contain future problems before they have a chance to grow out of hand, rather than having to play catch up at a later stage.
First, let us briefly return to why Chinese businesses are facing the prospects of rising labour costs. It was always widely assumed, and reported, that China has a sheer endless supply of labour, which is, of course, not true. If anything, China has a relative unfavourable balance in its population, being already skewed towards elderly, especially given the early stage of transition and development the country is in.
In addition, the sharp drop off in export orders during the GFC in combination with higher prices for agricultural products has narrowed the financial gap, and thus the attractiveness, to move out of rural areas back to the cities. This is even more the case since the Chinese government has absorbed a big chunk of job losses through numerous and large infrastructure projects that for many Chinese are closer to their rural roots than the cities.
China is a big country and exact insights are seldom available, even for economists on the ground who spend most of their days deciphering what is happening inside the country. Many of them will be watching the factories closely now the country jumps back into full gear after a week of celebrating.
But rising wages are far from the only threat to Chinese consumer prices. China watchers at Dragonomics, a division of GaveKal dedicated to researching China, reported this week they believe 9 out of 15 CPI components in China are now firmly on the rise.
And those China watchers at ANZ Bank who, earlier this month, were quick in picking up that China had an underlying inflation problem, arguing quick policy-response is a necessity, have now followed up with a special report on China. Their conclusion: if Chinese authorities do not act very soon their economy will start overheating a la the first half of 2008.
That wouldn't be good news as the unsustainable growth rhythm of 13%-plus was followed by a sharp decline into single digits after the Beijing Olympics later that year. No doubt, it is this scenario the Chinese policymakers are trying to avoid this time around.
According to ANZ Bank's proprietary China Activity Index, overall activity levels inside the Chinese economy have already exceeded the aforementioned levels of 2007/first half of 2008. This suggests China risks overheating in the very short term.
This is exactly what ANZ economists are predicting – in the absence of more restrictive policy actions. Enter the US Federal Reserve Bank. One of the immediate responses from economists worldwide after the Fed lifted the discount rate for emergency loans to US banks by 0.25% on Friday was that the move to normalisation would be welcomed by Asian central bankers as they are unlikely to act as long as the US remains in a policy bind.
ANZ highlights there is one important difference between China now and back in 2008. As export markets have remained weak, the Chinese economy is only overheating in the inland provinces, not in the coastal areas that are more export oriented. This is opposite what happened in 2007 and 2008. But then again, it would seem export markets are improving, so the problem will only become worse.
In addition, reasons ANZ, Chinese infrastructure projects will keep commodity prices at elevated levels, which means the country will continue importing inflation.
So far, Chinese authorities have lifted reserve requirements for banks by 100 basis points, in addition to various other restrictions, all aimed at draining excess liquidity out of the banking system. But it won't be sufficient to keep the brakes on inflation, property prices and demand for labour, argues a growing army of economists.
A consensus seems to be forming that more drastic policy-responses are forthcoming, even though not everybody is on the same song sheet when it comes to the exact timing. Will China finally revalue its currency this year?
Economists suspect there will be a one-off large re-adjustment in the USD-peg, which, of course, will take most of the world by surprise. Such a move would probably come in combination with a widening of the RMB trading band against the greenback.
And there will be more restrictions for banks and for property investors. Plus interest rates will have to rise too.
It's probably no coincidence that, given these prospects, the Chinese share market is among the worldwide laggards this year. And commodity markets have already shown sharply increased volatility. Both elements are unlikely to change any time soon as Chinese policy makers will likely have their work cut out for them this year.
Meanwhile, commodity bulls are anxious to find out whether a sharp revaluation of the Chinese currency will translate into more demand as it will effectively make prices cheaper on a relative basis (vis-a-vis USD prices).
Expect more policy actions soon.
This story was originally written and published on Monday, 22 February 2010.
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