Chinese Inflation and European Defaults

Part 1. Will Europe face defaults?

Its official – Spain and Portugal will need to be bailed out soon. How do I know? In one of my favorite TV shows, Yes Minister, the all-knowing civil servant Sir Humphrey explains to cabinet minister Jim Hacker that you can never be certain that something will happen until the government denies it.

So check out this article in Tuesday’s Financial Times:

Spanish and Portuguese leaders, with reinforcements from Brussels, are fighting a rearguard action to convince investors that there is no need for further eurozone bail-outs after the €80bn-€90bn ($109bn-$122bn) rescue agreed for Ireland at the weekend.

“Absolutely not,” said Elena Salgado, Spanish finance minister, when asked in a radio interview on Monday whether Spain needed help from the European Union. “Spain is doing everything it has promised to do, with tangible results.”

Portugal is regarded by bond market investors and economists as next in line for a rescue after the bail-outs of Greece and Ireland. But José Sócrates, Portuguese prime minister, was adamant that there was “no connection” between the Irish rescue and Portugal’s problems. “Portugal doesn’t need anyone’s help and will solve its own problems,” he said, insisting that the country had a clear strategy to cut its yawning budget deficit.

Was Sir Humphrey exaggerating? Perhaps, but I do remember that Dublin was pretty adamant just a week or so ago that there would be no restructuring of Irish debt.

The truth is we didn’t need the denials to know what was going to happen. Everything we are seeing in Europe has a great deal of historical precedence and events are unfolding very much according to the standard script. I think it is pretty safe to make the following predictions:

1. Greece will be forced to default and restructure its debt, and the restructuring will come with a significant amount of debt forgiveness. The idea that it can grow its way out of the current debt burden is a fantasy. Remember that when countries are in conditions of financial distress, they face systematic disinvestment and capital flight, and as a consequence are never able to grow at anywhere close to the necessary rates – especially since any growth they do manage to achieve generally comes from additional fiscal spending, which simply runs up debt further.
2. Greece will not be the only defaulter. Spain, Portugal, Ireland, Italy, Belgium and much of Eastern Europe will also face severe financial distress and possible default. History suggests that when a country is experiencing a solvency crisis, growth comes only after debt forgiveness, and many or most of those countries will also be forced into debt forgiveness.
3. Political radicalism in these countries will rise inexorably as a consequence of rising class conflict. As Keynes pointed out as far back as 1922, the process of adjusting the currency and debt will primarily be one of assigning the costs to different economic groups, and this is never an easy or conflict-free exercise. Of course the less stable a government becomes as a consequence of this adjustment, the more likely it is to prefer very short-term solutions.* This Sunday, by the way, Catalans are likely to vote in an election in which the “current Socialist-led coalition government in Spain’s northeastern region will fall, a slap in the face for Spain’s prime minister, José Luis Rodríguez Zapatero,”, according to an article in Wednesday’s New York Times. There will be a lot more of this sort of thing in the next few years.
4. So why not bite the bullet and just get it over with? Because the European banking system would not survive even the best-case restructuring scenario. As a consequence we are fated to witness several years of difficult economic adjustment while everyone pretends that these countries, under the right policies, can work their way through their debt burdens. What will really be happening is that European banks will aggressively rebuild their capital bases, with the unwilling help of the poor household sector, until they are sufficiently well capitalized to begin taking the write-offs. Only then will we recognize that some countries cannot repay their debts.
5. As an aside the European junk-bond market might take off. With banks crippled in their lending activities, Europe’s financial markets will probably go through a process much like that which the US experienced in the 1980s. American banks at that time were unable to fulfill their traditional lending function as they struggled to clean up their LDC and energy loan portfolios, leaving the way open for the likes of Drexel Burnham to create a massive junk bond market. This process will be helped to the extent that European policymakers try to avoid paying for the adjustment by liberalizing bank-lending practices.
6. Several countries, most notably Spain, will be forced to choose between giving up sovereignty to Germany, suffering extremely high rates of unemployment for several years, or giving up the euro. They will almost certainly choose the third option. There are still a lot of people who say giving up the euro is “unimaginable”, but that just shows a weak imagination. I especially remember in 2000 Domingo Cavallo dismissing the stupidity of foreign investors who imagined Argentina might be forced to suspend payments and devalue the peso – which it did in late 2001. More recently, on April 30, Cavallo warned Greece: “Don’t even think of abandoning the euro, whether temporarily or definitively, because that will provoke a financial catastrophe in Greece and various other countries in Europe.” Now there’s some useful advice, especially when you consider the huge surge in growth and the fall in unemployment Argentina experienced after it devalued.

This has been said before, but in a way this crisis is the European equivalence of the American Civil War. Once the dust finally settles Europe will either be a unified country with fiscal sovereignty firmly established in Berlin or Brussels, or it will be fragmented with little chance of reunion.

Part 2. Will Beijing raise interest rates to combat inflation?

The big concern in China now is rising inflation. The market is obsessed with fears over what steps Beijing will or will not take to combat rising prices. Beijing has already hiked interest rates, raised reserve requirements, imposed price freezes, and is reportedly going to tough out the existing lending quotas. Beijing may even throw in the towel and declare a “new normal.” According to an article in Wednesday’s South China Morning Post:

Beijing is likely to raise next year’s official inflation target and tighten monetary policy, state media said Wednesday, amid expectations for consumer prices to continue rising.

The Central Economic Work Conference, which is expected to meet next month, will probably hike the government’s annual inflation target to 4.0 per cent from 3.0 per cent this year, the China Business News said, citing an unnamed source. The conference is the most important economic policy making event of the year and gathers top Chinese leaders, usually including President Hu Jintao and Premier Wen Jiabao.

As I mentioned in an entry last month, it was going to be very hard for the banks to stay within this year’s RMB 7.5 trillion quota, and there was a real question about whether or not the regulators were going to enforce the quota. On Tuesday evening the PBoC even announced that it was going to face challenges in controlling the lending pace for the rest of the year. Separately, Tuesday’s Bloomberg had an interesting article on the subject:

China’s biggest banks are close to reaching annual lending quotas and plan to stop expanding their loan books to avoid exceeding the limits, according to four people with knowledge of the matter. Industrial & Commercial Bank of China Ltd., Bank of China Ltd. and Agricultural Bank of China Ltd. are only extending new loans as existing ones get repaid, the people said, speaking on condition of anonymity. Lenders are also cutting holdings of discounted bills to make room for longer-term debt, they said.

Tuesday’s People’s Daily is suggesting that next year’s loan quota will be below this year’s:

Financial institutions forecast that the new bank loan scale will reach between 6 trillion yuan and 7 trillion yuan in 2011. Although the figure is lower than the 7.5 trillion yuan of new bank loans for 2010, its upper limit will possibly reach 7 trillion yuan. This is mainly associated with the loans to be allocated to reserve projects.

I am very skeptical that they will be able to reduce the loan quota next year, especially if trade tensions worsen, which I expect, but I did notice that there was sort of an “out’ in the PD article:

Furthermore, a certain amount of new loans should be extended in order to ensure continued economic growth and structural adjustments in 2011.

On the subject of interest rates there was also this article in Bloomberg about concerns that interest rates would rise:

China’s benchmark money-market rate rose to the highest level in almost seven weeks on speculation policy makers will lift borrowing costs again after raising lenders’ reserve requirements last week to tame inflation.

China’s central bank adviser Xia Bin said the nation should further tighten monetary policy next year due to the pressure of excessive liquidity at home and abroad, the Shanghai-based Oriental Morning Post newspaper reported yesterday. The People’s Bank of China said Nov. 19 it would lift the amount of cash banks must set aside as reserves by 50 basis points from Nov. 29. A press official at the central bank, who refused to be identified, declined to comment.

“Future rate hikes and inflation-curbing measures are now more adequately priced in but the bias for higher rates will remain until the next rate hike materializes,” said Delphine Arrighi, a Hong Kong-based strategist at Standard Chartered Plc. “We still see another 25 basis point interest-rate increase by the end of this year, and another three increases, all of 25 basis points, within the first half of next year,” she said.

Last month I said I doubted Beijing’s resolve to hold firm on the loan quotas, just as I doubted we would see much action on the interest-rate front, but it seems increasingly likely that the hawks are going to win this argument. So are interest rates really rising, and if so will it matter?

The answer to the first question is: No. Inflation this year is rising much faster than interest rates, which have only managed a 25 basis-point hike. It will take at least 200-300 basis points, probably a lot more, just to bring real deposit rates back to where they were earlier in the year.

As for the second question, I am not sure raising rates will reduce inflation at all. On the contrary, in China they may actually increase inflation. I know this is going to seem pretty controversial – how can raising rates make inflation worse?

Bear with me. In the US, I think, most of us agree that raising interest rates is anti-inflationary, but why? I would argue that it reduces inflationary pressures primarily through three channels. First, raising interest rates makes it more expensive for consumers to borrow money to finance purchases.

Second, because most Americans save in the form of stocks, bonds, and real estate, rather than bank deposits, higher rates are associated with declining asset prices, and so Americans feel poorer. This (the “wealth effect”) causes them to reduce their consumption. Finally, raising rates reduces investment and so raises unemployment, further reducing consumption by increasing uncertainty and lowering household income.

In other words raising interest rates in the US puts downward pressure on prices by reducing demand. But will raising interest rates reduce demand in China?

I am not at all sure it will. Take the first of the three effects. Excluding mortgages (whose pricing reflects other concerns) there is very little consumer financing in China, so increasing its cost is not likely to have much effect. You might argue that it will affect demand for automobiles, where there is some financing, but this is a small part of the consumer basket and most of the inflationary pressure is anyway on food prices.

What about the wealth effect? Here raising rates may actually be counterproductive. The vast bulk of Chinese savings is in the form of bank deposits, and China’s artificially low interest rates are effectively a major hidden tax on household income, as I have argued many times before. In this case raising the deposit rate is like reducing taxes, and this is hardly likely to reduce demand. On the contrary, by raising disposable household income it will actually raise household consumption, although this may take several months before it is significant.

Finally what about the effect on investment and employment – will raising rates cause unemployment to rise? Maybe, but with real lending rates so low, perhaps even negative, and with the credit risk on much of the lending effectively socialized, the mechanism by which interest rates regulate lending does not work in China they way it does in the US. What limits credit growth in China is primarily the new lending quota, not interest rates, and perhaps not even reserve requirements. Interest rates themselves are likely to have little impact on the amount of lending – at least in the formal banking system, but in the informal banks, where there is no financial repression, it might. Anyway I am very skeptical that the State Council will let rates rise enough to let rising unemployment bring down demand.

In a funny way, then, rising inflation creates its own resolution in a financial system that is severely repressed. As inflation rises, real interest rates decline. This reduces real household income and so reduces demand. It also reduces the real borrowing cost for manufacturers, and so supply rises. In my opinion this is the main reason why countries with severely repressed financial systems can accommodate rapid monetary growth and low inflation, as China has for most of the past two decades.

This doesn’t necessarily mean that inflation won’t be a problem in China next year. Many things affect inflation besides the monetary response. My point is not that thanks to financial repression China can never experience inflation, it is merely that raising interest rates might not be nearly as effective in combating inflation as we might otherwise think and may even be counterproductive.

My former student and Shenyin Wanguo associate, Chen Long, after he saw the early version of this piece made a strong counter-argument that one of the consequences of inflation and negative real deposit rates is that households are reducing deposits and rushing to anticipate consumption – i.e. buying stuff now that they don’t really need as a store of wealth. This drives up consumption today, albeit at the expense of consumption tomorrow, and in that sense it may add inflationary pressure. Hiking interest rates, Chen Long pointed out, may reduce the incentive to do so. He is right, of course, but it is not clear that this effect outweighs the wealth effect.

While financially repressed systems are very good at combating inflation, this comes with a cost – overinvestment and low household consumption. Already we are seeing household deposits flee the banking system and much of this money is going to end up fueling even more asset bubbles. Meanwhile the value of Chinese savings continues to drop, making Chinese fell poorer and so reducing their consumption.

In my opinion this is the real reason the PBoC wants to raise interest rates. They want to slow down the massive capital misallocation China is experiencing and they want to rebalance the economy towards consumption by increasing household wealth. But are they succeeding? Not really. It would take an awful lot of interest rate hikes just to bring real interest rates to where they were a few months ago. Chinese growth is getting more, not less unbalanced. But perhaps we won’t have to worry about inflation too much longer.

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