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China’s New Inflation Constraint

BEIJING – China’s economic-growth rate slowed in the second quarter of this year to 7.5% year on year, down from 7.7% in the January-March period, in line with Chinese economists’ forecasts in recent months. At the start of 2013, however, economists – both at home and abroad – were much more upbeat about the prospects for Chinese growth. So, what changed?

China’s growth has shown a cyclical pattern over the past two decades. Immediately after the collapse of Lehman Brothers in September 2008, China unveiled a ¥4 trillion ($650 billion) stimulus package. The economy rebounded quickly, with the annualized growth rate soaring to 12.1% in the first quarter of 2010.

To rein in a housing bubble and preempt a rise in inflation, the People’s Bank of China tightened monetary policy in January 2010. Then, to arrest the resulting loss of economic momentum, the PBOC loosened monetary policy in November 2011. Most people believed that rapid growth would quickly be restored once again. But the rebound did not come until the fourth quarter of 2012. Worse, instead of establishing renewed economic momentum, the growth rate fell in the second quarter of 2013 and all major forecasters are now revising their projections of full-year growth downward.

Of course, if the Chinese government wished, China’s growth rate in 2013 could still surpass 8%. But the country’s new leaders do not wish to pursue growth at the expense of structural adjustment, which has been delayed for too long. It seems that the government has established a floor for growth; as long as it is not hit, there will be no more fiscal or monetary stimulus.

But the new leadership’s reluctance to intervene in order to spur growth is just part of the story of China’s current slowdown. Something more fundamental has happened, weakening the government’s ability to stimulate the economy. In particular, even as the annualized growth rate in the first quarter of 2013 fell far below the average growth rate over the past 30 years, the annual increase in the consumer price index rose to a ten-month high of 3.2% in February, while house prices have been rising unabatedly.

Slower growth and higher inflation in the expansionary phase of the economic cycle (compared with previous cycles) reflect an essential macroeconomic change. For many years, China’s Phillips curve – the historical inverse relationship between inflation and unemployment – was rather flat, which meant that when the government used expansionary monetary and fiscal policies to spur growth, it did not have to worry too much about price instability.

But there is now growing evidence that the Phillips curve has started to rotate since 2010. Today, for a given rate of GDP growth, the corresponding inflation rate is substantially higher than it was over the past two decades. In other words, inflation – especially house-price inflation – has become an important constraint on growth.

The leftward rotation of China’s Phillips curve stems from many important structural changes. First, as a result of demographic and social changes, the marginal wage cost of production and minimum-wage levels have increased significantly. Second, with environmental concerns becoming more widespread, enterprises – especially those with newly installed production facilities – have been spending lavishly.

Third, the relentless exploitation of resources has caused the prices of energy and raw materials to increase rapidly. Fourth, feverish real-estate development throughout China continues to propel land prices to new heights.

Fifth, as a result of decades of catch-up growth, China is approaching the technological frontier in many areas and the latecomer’s advantage is diminishing, which means that the marginal productivity of its capital stock is diminishing, too. In short, the changes in China’s microeconomic foundations, together with the weaknesses in its economic structure, imply that the economy must pay a higher cost, in the form of higher inflation, for a given increase in GDP growth.

The question now is whether China’s leaders will tolerate higher inflation in order to maintain an annual growth rate of more than 8%. The answer seems to be no. As a result, China’s growth has reached a new plateau. The era of growth rates above 8% is over, at least for the foreseeable future. After three decades of breakneck growth, the Chinese economic juggernaut needs to slow down somewhat so that the machine can be fixed; only then can it return to the fast lane and accelerate anew.

But no one should bet on a Chinese crash anytime soon. China has faced much worse on numerous occasions; each time, it muddled through. There is still no compelling reason why this time should be different.