Monday, November 24, 2014

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.

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    1. CommentedJonathan Lam

      Gamesmith94134: Dr. Doom Warns Wall Street and Washington---- Heed Karl Marx's Warning!

      Mr. Gert van Vugt,

      You make the best description on the theory on the economical growth Paradigm that the economic change seems like Malthusian’s diminishing return, and I agree. However, Mr. Roubini makes his point on the social disruption reverse itself through the diminishing demand. If we can put away the elements like the Ponzi scheme and benefactors in social caused deficiency or defects to growth. Corruption by capitalism and the dependency by socialism among societies both caused failure in the economical and societal development.

      Perhaps, we focus on the circuitry on the accumulation of wealth and consumable wealth that runs the economy. It seems both the capitalism and socialism ran short and proven wrong in the economical model or social model that became self-destructive; eventually, the economy runs from diminishing demand to diminishing return, or vice versa. So, if we use the living standard as the equilibrium position to the supply line of the circuitry of wealth balanced by both of the diminishing return and diminishing demand.

      How about I call my paradigm on the wealth circuitry in economical and social growth that supports and balances both accumulated wealth and consumable wealth; and it created a “Z” shaped development running both on the diminishing demand and diminishing return; which is based on the assumption, the route above the standard of living equal in length with the one below the standard of living is in agreement of its living standard to sustain a viable growth, which contains;

      • The base line as the diminishing return where the societies kept peace with its populace that consumable wealth that cause economical displacement like with its negative growth or no growth; it provides entitlement or social programs with non-productive individual citizens for example, 27% of its population on welfare with add-on with subsidies to sustain a standard of living.

      • The top line as the diminishing demand that ended with accumulated wealth favors of concentrated wealth owned by individuals that ended with profitless, 1% holds 27% of the global or national wealth, plus those with extra wealth is not in production yields to no growth.

      • And the diagonal line that connected to both ends is the support of the price and value in the middle is the standard of living which contains the most of the productive individuals who is moving up and down the ladder of growth.

      If more of the wealth accumulated than the wealth consumed, then it causes saturation of the wealth. The diminishing demand under the standard of living agreement made the demand idle because of the shortage of consumption. In the process, the standard of living will go down to meet its demand after the deflationary measure to make it consumable. In reverse, the wealth consumed is over the wealth accumulated, as it is less profitable. Then, it triggers the inflationary measures to aggregate demand to accumulate more wealth in its diminishing return mode; eventually it will balance itself again with the agreement of the standard living with a viable growth.

      It is not the supply and demand. It is rather the circuitry of wealth under the spells of the lower living standard that diminishing demand is being part of the deflationary measure. If the accumulated wealth became saturated, then it means the lower living standard that made the demand finite like lesser demand in loan of dollars in ECB.
      I am certain I am not being introspective; I may twist the theory a little; but the proof of the lower living standard in Europe made it plausible.

      May the Buddha bless you?

    2. CommentedTheStudent Economist

      In my amateur opinion, China's growth is a victim of its' ''copy cat'' culture. Unfortunately, entrepreneurship is not a top pick for China's intelligent youth. Instead, working as part of the Party is what most youth aspire toward. This stifles innovation that is needed to drive sustained growth. Instead of innovating, China's youth would rather take advantage of the weak private property rights that persist. Why put the time and effort into producing new products when they can be so easily stolen from you?

    3. CommentedJoshua Ioji Konov

      Mr.Yongding, a well presented conception. Actually, the change from an Economic Growth to a Market Development, whereas it is not just a natural consequence of touching some level of development, as much as it is a result of the changes in the global economy from a pro supply capitalism to a pro market balance marketizm...

    4. CommentedProcyon Mukherjee

      A very interesting point has been raised on the Phillips curve which is now showing signs of changing trajectory from being flat. The point to be noted is that China is moving from a commodity super cycle to a continued trough, which means the rising prices of commodities that propelled investments and growth in the past is no more going to be the engine of the economy. While this is the case, the growth in asset prices is a signal that monetary hardening is on the cards. These two factors would influence inflation and unemployment in a way that fiscal and monetary actions need to be directed towards to the latter more than taming the former.