China’s economic transition & inflation shock

Xu Sitao

Chief Representative, China, The Economist Group

Director, Global Forecasting, China,, Economist Intelligence Unit

Key points

• China’s inflation scare

• Asset bubbles: causes, policy measures and implications

• Policies to improve social welfare

• Risk scenarios & Investment implications

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Diagnosing inflation

• Short term concerns focused mostly on food. Supply shocks could send prices higher; PBOC’s target (4%) looking hard to achieve

• The impact of food prices is over-estimated but the effect of services is under-estimated; the net-effect is under-estimation of inflation

Source: EIU & CITI

• Factor price normalisation will put upward pressure on prices for electricity, water, other utilities, wages and cost of capital etc.

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CPI Cor e CPI Non- Food CPI Ser vi ce CPI Food CPI ( RHS)

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Smal l & Medi um Banks RRR Lar ge Banks RRRExcess Reser ves 1- Year Deposi t Rat e ( RHS)1- Year Lendi ng Rat e ( RHS)

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China’s exit strategy is being executed

Discussion on inflation, labor market & demographic dividend

• Inflation, if mainly caused by food, would benefit farmers, but urban poor would be worse off ,

• Is inflation caused by demand or supply?

Factor price normalisation is underway

• What are factor prices?• Why is normalisation good for

China? • Will normalisation result in inflation?• Examples: fuel prices, Hukou

system, interest rate deregulation• Sequencing• Will inflation scare affect normalisation?

Housing market remains robust despite repeated anti-speculation policies

• Strong housing market is being underpinned by lack of other investment choices & liquidity

• Recent policies in Beijing tighten scope for non-residents to enter market

• Other policies aim to reduce leverage

• Shanghai and Chongqing are experimenting with property taxes

• Beijing – the only city to pledge price reductions of properties

“China is Dubai times 1,000, if not a million.”--- James S. Chanos

Erdos, Inner Mongolia

Is this the end of the Chinese economic miracle?

Why short China… (according to James Chanos)

• Land prices surged faster than property prices in some Tier 2 cities. This is backed up by Ministry of Land & Resources data for recent years.

• Therefore, we expect margin pressure for developers that entered such Tier 2 cities in recent years.

• Oversupply approaching; Tightening measures extended to Tier 2 cities.

• Consequences of bubble bursting (banking sector, related industries, consumers, external impact…)

China’s 12th Five-Year Plan:

• Shift: from quantity of growth to quality of growth and sustainable development

• 1/3 of PM Wen’s Govt work report speech focused on livelihood of common people

• Pledge to significantly increase stock of low income housing

• Reiterate inflation target of 4%

Prepare for Currency appreciation

• RMB appreciation occurring in both real and nominal terms

• Real appreciation (China’s tolerance of inflation) will take center stage the next a few years

• A rise in the value of the RMB is consistent with factor price normalisation

Pros

• Trade surplus shrinks but is still significant in absolute terms

• Foreign reserves rise despite promotion of outbound investment

• Politicization of issue in US: House of Reps Currency Reform for Fair Trade Act; Krugman’s “Taking on China”; Samuelsson’s “Stand up to China”

• Growing international pressure on China to implement “exit strategy” and support global rebalancing (especially after the quake in Japan)

• Without exchange rate adjustment, asset bubbles may grow

RMB Revaluation – Ongoing debate (in the wake of shocks from oil and quake)

Cons

• Revaluation hampers recovery of export industry

• RMB is already appreciating against the Euro on trade-weighted basis due to sovereign risk

• Widening inflation differentials between China and the US will result in a stronger RMB in real terms

• Labor shortages and price reforms will increase pressure on thin export profit margins

• China should not have to “pay” (by revaluation) for global imbalances arising from irresponsible monetary policies in other countries

A Chinese Prescription: A more open capital account while a relative stable RMB

• RMB’s is likely to appreciate less than the market has discounted

• China will come up various creative ways of exporting her vast savings

• Interest rate reregulation is imminent

Discussion & debate on fiscal reform

• Is China a high-tax country?

• Likely changes on personal income tax (why so much attention?)

• Discussion on property taxes

• The link between fiscal reform and financial deregulation

• Goalpost of public finance reform

• Political and social factors affecting tax cut

Risks, policy responses & Unintended consequences

• Risks of stagflation in the developed countries and heightened inflation in the emerging world;

• Contradiction between housing-for-the-people and local governments’ dependence on revenues from property;

• Forced appreciation of the RMB, triggered by QE3 (Japan’s experience in the ’80s) when China is facing persistent upward pressure on labour wage rate