Are China’s Sharply Rising Inflation Risks Cause for Domestic and even Global Debt Concerns?
After several years in the doldrums, China’s producer prices are surging, while coinciding with, and partly fuelling, a major global upturn in producer inflation
China’s producer prices are spiking
Since the end of 2012, China’s producer prices (the selling prices between domestic businesses) have generally fallen. This deflationary tendency was marked by lows of -6% during the latter part of 2015 (see Graph 1 below).
It was not until the second half of 2016 that producer prices showed signs of a turnaround into positive growth. However, the upward pace of producer price change has been steep, surprising most analysts, rising from a -4.9% contraction, in February 2015, to 7.8% growth, in February 2017.
Perhaps what is most significant about the surge in producer prices is its links not only to raw materials prices (up 15.5% over the year to January 2017), as one might expect following nearly 12 months of steep rises in global coal, iron ore and other industrial commodities and energy prices, but that the reasons for the sharp producer price rises have been much broader based. This is evidenced in China’s manufacturing production costs which rose by 10.8% in February 2017, over the year, as did processing costs, which were up by 6.6%.
What explains the accelerating upward trend in producer prices?
Ever since the rise to power of the new Chinese government, headed by President Xi Jinping, in early 2013, economic policy has been oriented towards services and consumption, and away from the previous four decades’ focus on industrial investment and low-cost exports. During the last four years, Chinese policymakers have been fairly successful in fostering services sector growth. Services accounted for over half of economic output in 2016, while contributing as much as 84% to economic growth. Rising household incomes, in particular, lifted sectors such as tourism, hotels and catering. Other service industries such as insurance, finance, internet and software, telecoms and rail transport also saw significant gains.
The growth in service industries was reflected in both China’s official and private non-manufacturing Purchasing Managers Index (PMI) survey data which recorded expansion throughout 2013 to 2016. This was achieved in spite of declining rates of economic growth, which reached 6.7%, in 2016, the lowest since 1990. By contrast, various manufacturing PMI surveys, over the same period, exhibited mainly contraction, as reflected in the prices of industrial goods which saw persistent weakness.
However, since July 2016China’s manufacturing PMI survey data has shown consistent signs of a rising trend. Both exports and imports have been growing strongly in spite of increased domestic production costs. Consequently, the overall recent improvement in the performance of China’s manufacturing sector, following several years of contraction, along with persistently healthy growth in the services sector and improving external demand environment, contributed much of the recent sharp rise in domestic producer prices.
Will China’s surging producer prices feed into headline inflation?
GRAPH 1: CHINA PRODUCER PRICES VS OVERALL INFLATION (%)
Source: China Bureau of National Statistics
As Graph 1 illustrates, over the 2012 to 2016 period, China’s headline rate of inflation, which is essentially a measure of the rate of change in consumer prices, has remained in positive, albeit subdued, territory, mirroring the rises and falls in producer prices. The obvious question, then, is whether February’s 7.8% annual producer price surge, in particular, will feed into overall inflation? Headline inflation rose by 2.5%, in January, this year, which was marginally above consensus forecasts of 2.3%, firmly exceeding the 2.1% recorded at end 2016.
Critically, the rising tide of inflation risks was enough to prompt China’s central bank (the PBOC) to include a statement, in its Q4 2016 policy report, warning that increased attention should be given to rising inflation expectations. While headline inflation fell to 0.8% in February 2017, given that the data was heavily skewed by the Lunar New Year holidays, this should not be seen as indicative of an end to the inflation surge. We await the March data with interest.
How will China’s mounting debt levels cope with interest rate rises?
As inflation re-surfaces, the magnitude and timing of action by the PBOC to tackle inflation, by raising interest rates, will be pivotal in how the authorities balance their inflation-fighting efforts while avoiding financial market risks connected with the country’s soaring debt levels. At end 2015, China’s total debt (private and public) stood at 247% of Gross Domestic Product (GDP). This debt level is significantly more than it was on the last two occasions that China had to combat inflation with higher interest rates.
In 2011, total debt levels were roughly 210% of GDP. That year, inflation had topped out at about 6.5%, as did interest rates, which were raised, on several occasions, over a space of nine months, from 5.5%. Prior to that, in 2008, with debt reaching 170% of GDP, interest rates were raised several times, over a couple of years, rising from near 5.5%, and topping at about 7.5%, with inflation peaking at just over 8%.Evidently, the lessons the PBOC had learned from these two inflation busting experiences was that the quicker and earlier interest rates are hiked, the sooner inflation is controlled without increasing debt-related financial risks.
Naturally, there are other considerations to bear in mind concerning China’s rising mountain of debt and interest rate policy. For instance, more than 80% of the country’s debt is locally funded through domestic savings (e.g. funds in Chinese bank deposits). By contrast, at end 2015, the USA and UK had respectively, total debt levels exceeding 300% and 265%, and local savings levels of about 35% and 50%. Hence, China has significantly less need for recourse to external markets for debt funding, thereby relying on more stable domestic sources of funding which can also be more effectively manage through increasing capital controls.
Another consideration in China’s debt management policy is that the PBOC has considerable room for manoeuvre in shifting the burden of economic growth away from the heavily indebted state enterprise sector which accounted for 67% of outstanding debt in 2015. Since 2013, under the leadership of President Xi, China has shifted towards expanding the borrowing of relatively lower-indebted households, private businesses, central government and the official banking sector, while introducing polices to tackle the bloated balance sheets of state enterprises and local governments.
Nevertheless, unlike the two earlier bouts of monetary tightening, one of the major pitfalls the PBOC could face, in any near term rising interest rate cycle, will be the so-called “shadow banking” sector. Notably, while the PBOC employed relatively restrictive monetary measures and increasingly regulated the lending practices of the main state banks, in the years following the global financial crisis, state enterprises were tasked with building infrastructure on a scale that was unprecedented in world history. To fulfil this objective, state companies sought to circumvent the credit restrictions imposed at national level by sourcing their borrowing needs from opaque wealth management vehicles set up by non-financial institutions such as local government finance departments.
As a result, China’s shadow banking sector presided over a vast credit boom founded on an opaque and thinly-regulated area where financial risks may be significantly more difficult to estimate than during earlier periods of rising inflation. To be fair, the PBOC and other national regulatory authorities have done much to clean up and regulate the non-financial sector over the last few years. Even so, the level of non-performing loans among state enterprises is still widely considered to be under-estimated and under-disclosed, bearing in mind that the authorities have also had to significantly ease monetary conditions to alleviate the strain on state corporations. Given these factors, the PBOC’s capacity in coping with the impact of tighter monetary conditions, on current elevated debt levels, may become a much tougher challenge, this time around, despite the lessons learned from previous inflation-fighting experiences.
Evidence of rising producer prices across the global economy
Towards the end of 2016, and during the beginning 2017, all the major developed economies were experiencing marked increases in producer prices, typically following protracted periods of negative to flat growth. In the US, producer prices recorded growth of 1.6%, in both December 2016 and January 2017, following steady increases in the preceding three months, albeit in the aftermath of a year and a half of deflation or flat growth. It should be noted, albeit not necessarily connected, that over the last couple of months the US 10-year Treasury Bond (considered a financial instrument whose yields are reflective of long term inflation trends) has experienced its greatest price fall (and inversely a yield rise) since 1973-74, a period over which inflation spiked from 3.6% in January 1973 to over 12.3% in November 1974.
Similar producer price changes are evident across Asia. In Japan, producer prices rose for the first time, by 0.5% in January 2017, following three years of deflation. Similarly, in South Korea, after two years of deflation, there was a kick up in prices over the last three months, hitting a high of 3.5% in January 2017. The effects were even more pronounced with Singapore producer prices jumping 14.5% in the same month, while Malaysia’s rose by 10.2%.
In every case, the contributing factors went beyond surging prices in industrial raw materials and energy commodities, to include price rises in manufactured goods and processed products.
For the European Union (EU), which had suffered over three years of deflation in producer prices, in the aftermath of the Eurozone crisis, the pronounced rise in prices of 3.5%, in the first month of 2017 (see Graph 2 below) maybe further proof of a synchronous global increase in producer prices. As in other regions and countries, the EU’s producer price rises were not just attributable to energy prices, but also to increases in the prices of various manufactured goods, including intermediate products (up by 2.1%) and durables.
GRAPH 2: PRODUCER PRICES FOR CHINA VS EUROPEAN UNION (%)
Source: China Bureau of National Statistics and Eurostat
Is China exporting accelerating rises in producer prices into the global economy?
As the world’s second largest exporter with exports valued at US$2.1 trillion, in 2016, the degree of synchronicity evident in the recent marked rise in most economies’ producer prices (taking aside the strong effects of rising resource and energy prices), can be attributed, to some material degree, to the effects of a highly-integrated global supply chain in a wide variety of products made in China.
This is particularly evident in the rising demand, among the major industrial countries, for manufactured goods, as an outcome of incrementally strengthening domestic demand in the European Union and in the United States, arising from both higher household and business spending. For instance, the USA’s imports from China were US$41.4 billion, in January 2017, up on US37.1 billion a year earlier. The vast bulk of these imports were constituted of manufactured products including data processing machines, electrical devices for telecoms, motor vehicle parts, television receivers, office furniture, among others.
For the European Union, where China replaced the USA as its largest trade partner, last year, there was a trade deficit of US$200 billion, in China’s favour. As in the case of the USA, the vast bulk of trade was in the form of manufactured goods. The situation is no different for China’s neighbouring Asian economies, including Japan, South Korea, Singapore and the rest of Southeast Asia, each of which has China as their largest trading partner, particularly in its capacity as an outsourced production platform for these economies.
Is China’s net impact on global inflation becoming more demand-led than supply-driven?
In 2016, as China’s currency depreciated, the value of its exports also fell to the tune of 7.7%. Imports fell too, over the same period, but at a slower pace of 5.5%. However, in 2017, the decline in China’s trade with the world has not just seen a marked turnaround, but a new twist – rapidly advancing imports! Although exports grew by 7.9%, in the first month of 2017, and by 4%, in annual terms, over the January-February 2017 period, imports recorded a significantly higher annual growth rate of 38.1% in February 2016 (following a 16.7% annual increase in the previous month). Needless to say, only a few months’ trade data, for 2017, may not constitute a long term trend. Even so, by taking account of what may be early indicators of substantially changing trade flows, in the context of how the government’s economic policies have pivoted towards a consumption and services economy, there is a growing likelihood that China’s increasingly domestic demand-driven economy will weigh on global inflationary trends.
Recent short term data pointing to rising global producer prices is likely to be a result of a synchronous rise in global business spending: a so-called lift in business’ “animal spirits”. Given the depreciation of the Chinese Yuan, over 2016, and the decline in the value of China’s exports, it would seem unlikely that the recent lift in global producer prices could be attributable to rising Chinese producer costs.
However, should the pace of Yuan depreciation slow, or even reverse, the impact of China’s rising domestic cost base, evident in higher wages across the manufacturing sector, is likely to have a significant impact on global producer price inflation trends given China’s prime position in the global supply chain. More important still will be the substantial uplift in inflation arising from the effects of China’s growing role as a global buyer currently evident in surging imports whether that be for crude oil, base metals, agricultural products, electronics, high tech products or integrated circuits, among many others.
In the event of rising global headline inflation expectations – central banks will need to raise interest rates, as early as possible, in order to limit the extent of any impact from rising costs of borrowing on debt mountains evident across all the world’s major economies. What the world may soon discover is that the highly-integrated demand and supply chains between economies could soon transmit inflationary forces as rapidly as deflationary ones. In such an outcome, the world’s central banks will need to work with a degree of synchronicity, almost akin to a single global monetary authority, if they are to have any chance of dealing with the situation.
Britain’s former Prime Minister, David Cameron, famously said, “we’re all in this together”, referring to how the entire spectrum of British society needs to share the burden in coping with the ills of a post global financial crisis economy. As far as the risks of inflation and the global economy’s debt mountains are concerned –all countries across the world are in this together whether they like it or not!