China in the global inflation scare

THE market is worried about rising inflation, while I remain of the view that inflation volatility will rise in the post-Covid-19 environment but will not be sustained. Inflation risks are on the "cost-push" side with no evidence yet of "demand-pull" inflation amplifying cost-push pressures, especially in Asia. There is also no sign of a global wage-price spiral. Nevertheless, the market has reasons to be concerned.

China's rising producer price inflation (PPI) scares the world because it is a major buyer and supplier in global markets. The markets are right to worry if China is raising prices, and if buyers of Chinese goods are paying higher prices, China is exporting inflation to the world. Add in the scale of the Biden administration's American Rescue Plan, that has spooked global financial markets by featuring US$1 trillion in spending for 2021, another US$900 billion after that, and US$3 trillion pledged to infrastructure and energy programmes.

Are the inflation fears another "crying wolf" like in 2020 when many analysts warned that the US$2.2 trillion Coronavirus Aid, Relief and Economic Security (Cares) Act would ignite hyper-inflation by massively increasing money supply; or in the post-GFC (global financial crisis) years when analysts warned that the many rounds of quantitative easing (QE) would bring inflation roaring back? Note that 13 years after the GFC, there is still no sight of inflation.

The theoretical framework for analysing the inflation-unemployment (hence, by extension output growth) relationship is the Phillips curve developed by William Phillips and postulated by Paul Samuelson and Robert Solow in the early 1960s. It states an empirical inverse relationship between the inflation rate (on the vertical axis of a graph) and the unemployment rate (on the horizontal axis) - as one falls the other rises, so the curve is downward sloping.

IS THE PHILLIPS CURVE DEAD?

By conventional Phillips curve logic, America's massive stimulus programme would drive down the unemployment rate, and up the inflation rate. However, the Phillips curve has had a rough ride since 1969. In the following 25 years, the dominant economic thinking argued that it was not downward sloping, but vertical at least in the long run - meaning that any attempt to reduce the unemployment rate below the full employment "natural rate", or "non-accelerating inflation rate of unemployment" (Nairu), would only produce hyper-inflation.

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Intriguingly, since the mid-1990s, inflation has been absent even with lower unemployment. This suggests that the relationship was not vertical or downward sloping, but flat - or the Phillips curve was dead! Behind this backdrop was the rise of China as the world's factory with its manufacturing exports gaining critical mass in the world trade arena since around 1995.

Meanwhile, the forces that drove up US consumer prices after the 1970s, including US dollar depreciations, oil price spikes and cost-of-living adjustments for manufacturing workers (which were passed through to the consumer price index or CPI) all disappeared.

These structural factors argued that full employment was not the culprit for driving up inflation in the first place, so the low unemployment rate of the late 1990s did not bring back inflation.

I also argued elsewhere that the world's adjustment to the post-GFC balance sheet recession, which never ended even in the run-up to the Covid-19 crisis, had been an additional force curbing inflation.

China being the world's leading purveyor of manufactured consumer goods since the mid-1990s has added a disinflationary force to the global markets. In the prevailing Covid-19 adjustment environment, China has not taken advantage of high US demand to push up prices, despite its rising PPI back home. This is because:

• Chinese manufacturers fear losing global market share, and
• Chinese firms do not always maximise profits, as the market assumes, but aim at keeping social stability and output growth, preserving market share and more recently, reducing cost through new technologies.

China has been absorbing much of the rising costs stemming from its PPI inflation, hence limiting the pass-through to consumer prices. This has become an inflation conundrum for Chinese companies' margin growth at both the downstream level (approximated by PPI minus CPI inflation) and upstream level (approximated by PPI input price inflation minus output price growth); inflation has squeezed Chinese profit growth from all sides. As a result, PPI inflation has not filtered down to the CPI domestically and to export prices externally.

Generally, global households (including in China) are not suffering from a shortage of goods and services, but a lack of systemic confidence. This has led to a collapse in the money multiplier and money velocity in both the global system and China that has constrained inflation.

Under QE, central banks determine the amount of base money, but when the banks are not liquidity constrained, the transmission from base money to loan growth becomes impaired. Whether banks lend and people borrow depend on the system's confidence in the economic outlook, but not on the stock of deposits that banks hold; weak confidence dampens loan growth in both the demand and supply perspectives despite QE.

NO IMPLICIT GUARANTEES

In China, systemic confidence has been hurt by the uncertainty stemming from structural reforms, anti-corruption campaigns, a change in the macroeconomic policy objective to deleveraging from "growth at all cost", and Beijing's retreat from the implicit guarantee policy that is expected to push up corporate defaults and bankruptcies.

When economies, China's included, reopen, there will be price pressures coming from supply bottlenecks, due to Covid-19 disruption, clashing with post-Covid-19 demand recovery. But they should fade when economies are normalised in the absence of any wage-price spiral pressures.

So inflation volatility will rise in the coming months, but it may not be sustained, in my view.

Three implications follow:

• Much of the effect of fiscal spending will go towards saving and debt repayment, hence constraining inflationary pressures.
• Some of that money will go to buy goods and services to satisfy the pent-up post-Covid-19 demand, which is boosting short-term inflation.
• As for the rest (which includes money that has gone into saving), a good part will go into buying financial assets and even property.

The last implication is positive for asset prices once the short-term inflation volatility fades.

As for China, in an environment where the credit impulse is declining and inflation is squeezing corporate profit growth, pricing power and margins will be crucial factors for stock performance.

Stocks of companies with strong pricing power and margin positioning against this backdrop and other dynamics (notably carbon neutrality as per the 14th Five-Year Plan) will win.

• The writer is Greater China economist of BNP Paribas Asset Management.