Chinese policy makers have acted for the last year and a half as if their inflation problem could be solved easily while growth continues to tick along at 8% or faster. Now they are starting to realize that the problem is more serious. But they still misunderstand why China is overheating. The root cause is a massive increase in the money supply over the past two years that is still filtering through the economy.
Data released last Friday showed consumer prices in March rose by 5.4% year-on-year, the highest in three years. And there's more yet to come, as Beijing was too slow to start cooling China's red hot economy. Being too slow means that unless policy makers bring real GDP growth sharply below trend, China is at risk of runaway inflation.
There is a tendency among Chinese policy makers to attribute the cause of inflation to supply-side factors, like bad weather that creates food shortages. But the real cause is Beijing's stimulus plan after China's economy plunged into recession in late 2008. The increase in broad money as a share of GDP was close to 40% in 2009 and the first half of 2010, much higher than the previous peak of 27% in 2003.
Beijing's monetary boost certainly revived growth. The rebound that started in the spring of 2009 was spectacular, but within just a couple of quarters the economy had overheated. By the middle of 2009 inflation began to accelerate, and it did so on all fronts. Consumer prices, property prices and wages all began to rise at a faster pace. Against this evidence, it is hard to argue that inflation in China has been anything else but a monetary phenomenon.
The dangers of this monetary excess are becoming evident. China may be on the brink of a vicious wage-inflation spiral, which could undermine the authorities' grip over the economy. Actual inflation could well be higher than the official 5.4% in March. That's why Beijing is now hurriedly tightening. Still, this policy action comes too late in the day: Inflation had been on the rise for over a year and real deposit rates had been negative for nearly a year before the authorities began a meaningful withdrawal of the monetary stimulus.
It is important to trace the monetary impetus to inflation through the stages of the business cycle to understand what the delayed policy response now means for growth. An economy is overheated and inflation starts to rise if the level of actual output is above the economy's potential. Potential output can be defined on the basis of a given degree of spare capacity: Wherever there is a tradeoff between higher output and higher prices, essentially some capacity must remain idle. The closer an economy approaches the full use of its limited resources, the more prices rise to pull unused resources into production.
There was spare capacity in the economy in late 2008 and early 2009, because the external demand that kept China's factories chugging had slumped, pushing the economy into recession. So actual output fell below potential, and annual inflation slowed quickly, turning negative in early 2009. By mid-2009, growth had rebounded strongly and spare capacity started getting used up, with too many yuan chasing too few goods and services. By the fall of 2009 the level of actual output was already above the economy's potential and has stayed there since. If the tightening had begun then, inflation wouldn't have gotten as bad.
The good news is that the recent tightening efforts may have begun to bite. On a three-month annualized basis, a better guide to recent trends, broad money, or M2, growth slowed to 8.4% in March from as high as 28.5% last October. China published quarterly real GDP growth for the first time last Friday, showing growth slowed to 2.1% in the first quarter of this calendar year from 2.4% in the fourth quarter last year. Lombard Street Research estimates its own quarterly real GDP growth for China, which suggests that the official data could be understating the extent of the slowdown in the first quarter.
好消息是，近来中国政府做出的紧缩努力可能已开始初见成效。广义货币供应(M2)可以帮助我们更好地看清最近的趋势。按每季度的年化统计数据来看，中国的广义货币供应从去年10月高达28.5%的增长率已放慢至今年3月的8.4%。上周五，中国第一次发布了有关GDP季度实际增长率的统计数据。数据显示，中国实际GDP增长率从去年第四季度的2.4%减缓至今年第一季度的2.1%。宏观经济预测顾问公司Lombard Street Research对中国GDP季度实际增长率做了自己的估测，结果表明，官方数据可能对今年第一季度经济增长放缓的程度有所淡化。
Beijing seems serious about winning the battle with inflation. Policy makers have also shown that they understand the need for China's growth model to move away from the credit-fuelled investment binges of the past, and that this means structurally lower growth. The question is, how prepared is Beijing to accept much slower growth and its social and political consequences?
The US Congress moved closer to punishing China for allegedly manipulating its currency, as a key committee of the House of Representatives voted to advance legislation that could