Inflation and China

* Inflation Warning: Did any one catch last week’s headlines that the price of iron ore has doubled, with an expected increase in steel prices of 33%? If you did see it, did you think it mattered? This headline comes out of negotiations between China and the top 3 iron ore producing companies, which include Australian and Brazilian interests. What is behind the new negotiations centers on China’ relentless demand for iron ore, which is the main component of steel. With the price of iron ore set to double in the second quarter of 2010, this should increase the price of steel by 33%. In turn, this will push up the cost of cars, commercial real estate, and anything else which uses steel. This will occur despite global recessions in both industries.


Chinese demand for iron ore, and steel, by association, is directly trace-able to the twin US deficits, which are behind the growth of the world’s money supply. In addition, the Fed might be able to cite the growing supply of unused domestic bank reserves, (and hence, the idea that the excess reserves they have printed), but clearly the Fed has enabled the US government (in the 18 months just ended) by printing $1.5 trillion of new money. I can revert to my discussion on the dampening influence on the world economy if the US was on a gold standard, and not able to run $7.5 trillion in cumulative deficits over the past 30 years. But that is not the case.


Since China is behind the latest increase in prices, I will endeavor to try to understand what is going on in China, how this ties into USmonetary and fiscal policies, and where it might lead us. There is no denying that China has been the dark horse which has emerged from the shadows over the past decade. China’s growth has been spurred by their massive trade surpluses. China is an interesting situation, because for the most part, it is a controlled economy, so on the one hand, it is difficult to interpret the data which comes out of China, inasmuch as it is difficult to figure out how much of it is due to direct government control, and how much is due to market influences. Nonetheless, I am going to take a swing at understanding what is going on in China. 


Let’s start off with the first graph on the attachment, which shows the trade surplus. This graph must understate the Chinese trade surplus, since the sum of the last few year does not match up (it is alot less) than the increase in China’s FX reserves, which I show later on. Nonetheless, the surplus has been running in the pace of $150 to $300 billion a year, for the last 4 years for a total of $900 billion. At the same time, FX reserves held by China have increased by $1.5 trillion, for a difference of $600 billion. No small change for sure. Could the difference represent the amount of Chinese Yuan sold by the Chinese government to those wanting to invest in China? That is a possibility.


The next chart shows China’s GDP, which has been growing at a 9% pace for the past 21 years, fluctuating between 6 and 15%. Clearly, something looks contrived. This is a controlled economy, and there is definitely someone behind this puppet show. 


Accompanying this economic miracle, has been a wild growth in their money supply (M2), which now almost equals $10 trillion, which by the way, is greater than the US’s money supply, at approximately $8.5 trillion. Even if I compare the Chinese M1 money supply, at $3.3 trillion, it is almost twice the US M1 measure, which stands at $1.7 trillion. In other words, China’s economy which is 1/3 the USs, ($4.3 trillion vs $ $12.5 trillion), has a greater money supply. I would link the continued growth in the GDP with domestic money printing by the Chinese government.


On some level, you might be able to cite the growing amounts of FX reserves as backing for the explosive growth in the money supply. In fact, FX reserves (see prior graph) have grown by $1.8 trillion of the $2.4 trillion total, since 2004, for an increase by a multiple of four. During the same time period, M2 has grown by over $5 trillion. But if so, where did the other $3 trillion of M2 come from?


At the end of the day, the Chinese government is letting their money supply grow. A look at the inflation rate, which is also suspect in my opinion, because the government controls most companies that set the prices for goods within the country, show a modest amount of inflation. I included two graphs on inflation: the first is a longer term graph which shows the inflation rate from one year to the next going back to 1978, while the second graph shows more recent data which is reported monthly, and is useful in understanding the shorter term picture. For the last 12 years, the data shows that CPI has been fluctuating between -2% and +8%.


What do these inflation numbers mean? Let’s see, inflation is modest and money supply is growing at break neck speed, along with an expanding economy. The only thing you can say for sure is that the velocity of money is not as dramatic as it might have been in the US during such a period of growth. My best conclusion is that the Chinese government is stoking the economy and printing money.


Prior to my survey of the Chinese economic data, I would have thought that China was feeling empowered to print money based on the amount of foreign exchange reserves it had amassed. In fact, China has been printing money for the last couple of decades. Despite that, I have to think that China’s recent growth and resource grab has been spurred on by its success at foreign trade. The analogy I like to make is the comparison to Holland in the 1600s, when a good share of the wealth (gold and silver) found in the new world, was deposited in the Bank of Amsterdam, which backed their money by the gold and silver which people deposited. In turn, this spawned the one of the greatest price crazes in all history: The Great Tulip Bulb Bubble. It got so wild that the value of tulip bulbs, which needed to stay in the ground a certain amount of time each year, were selling far in excess of the ground they were planted in. This is what happens when the wealth of the world increases as it did during that time period, and flows to one location in particular. It is with that back-drop that I am suspicious that something else might be afoot with China. The wealth of the world is flowing to China, which in turn is directing their surpluses to purchase resources in the world economy.


This brings me to consider the inflationary side of the US deficits, and the willingness on the part of the Fed to allow the US to transfer so much of our wealth overseas. In turn, this wealth is finding its way into other parts of the commodity food chain. However, since we are freely printing money, the issuance of government debt and the printing of money is enabling the inflationary spirits in China to flourish. In turn, this will make its way back to us. Of course, the Fed and everyone else in the government will see nothing wrong with their behavior.


* Inflation/Deflation – despite the deflationary headwinds, which have many more years to unfold, it still occurs to me that inflationary pressures, as evidenced in resource pricing, could be just starting. In fact, with Oil up almost $2 today, to a new 15 month high, to $86.75, reinforces this point.


* Foreign Exchange Rate of the Yuan and the coming trade war: This dialogue brings me back to understanding why the Chinese do not want to let their currency fluctuate freely in the global markets. The government is used to controlling everything, and I cannot imagine that letting the currency fluctuate will be a good thing in their eyes. Let’s think for a minute what will happen if the Chinese let their currency float in the international markets. For starters, there are many investors who would like to invest in China, and this might open China up to international capital flows which it does not want. While there are markets for stocks and such in China, and a burgeoningcapitalist market system, the government is involved in the operations of many companies. Theoretically, a floating Yuan would spur demand for the Yuan over the short term. I really do not think the Chinese want to have to manage their economy in an environment of a floatingcurrency rate. If the currency appreciated too much, then it’s export pricing would rise. Offsetting that concern is the fact that the cost of resources in Yuan terms would drop, which in turn would mitigate the squeeze on prices which exports are sold for. I think debating whether the Chinese allow their currency to freely float is a moot point. The folks running the Chinese government understand the downside to having a freely floating currency will be a loss of control of their economy. 


My take-away to this discussion is that if the Chinese do NOT do anything to allow their currency to weaken to the world’s economies, it is only going to be a matter of time before other nations, including the US, are forced by unions and the like, to retaliate. The other take-away I will submit for your consideration is concern about the amount of money which China has printed to date. I am not sure if their economy could handle a floating exchange rate, given the largess of money in their economy. In other words, the Chinese might not be able to let their currency float freely, nor remove capital controls which dominate their banking system. In fact, the reverse might happen and the Chinese currency could weaken further if their monetary system was open to the world.