STAFF NEWS & ANALYSIS
China's Growth Is Huge Inflation Risk
By Staff News & Analysis - October 23, 2009

China's stimulus-induced lending binge probably propelled growth in the third quarter to its fastest pace in a year. Now, policy makers have to figure out how to wean the economy off state support. The country's rebound has been powered by 4 trillion yuan ($586 billion) of spending on railways, roads, power plants and public housing. The program ends next year, forcing Premier Wen Jiabao (pictured left) to find new ways to sustain the expansion with increased consumer spending and the financing of small businesses. "This has been growth on steroids," said Michael Pettis, a Peking University finance professor and former head of emerging markets at Bear Stearns Cos. "The question now is how to stop pumping so much money into the system without a sharp reduction in growth." State-directed support will make up more than four-fifths of growth this year, says the World Bank, spurring record iron-ore production at Rio Tinto Group and car sales in China at Volkswagen AG. An exit from the stimulus won't be easy without unnerving investors: A plunge in July loan growth sent the Shanghai Composite Index down more than 20 percent in August. Extending the stimulus for too long risks the diversion of funds into stocks and real estate, an erosion of bank asset quality and inflationary pressures, the Asian Development Bank said in a report last month. – Bloomberg

Dominant Social Theme: A cautionary note?

Free-Market Analysis: We've been pointing out the breadth and depth of the potential China financial bubble for years, but only recently has the mainstream media, timidly (in our opinion), begun to conclude that there may be a wee bit wrong with double-digit growth rates.

Now comes Bloomberg to point out to readers (the few who haven't read the Daily Bell!) that China is a country on financial "steroids." Bloomberg has a way of wording things that may make figuring out what they're talking about a little complex. They call it a "stimulus-induced lending binge."

Well, that's one way to put it. Another way is to call the recent growth "a central-bank binge." Of course you really wouldn't get that idea from the article which tap-dances around the issue of money creation. The money – which comes from somewhere (does it not?) – is said to have been lent by the government, some 4 trillion yuan. And the program, writes Bloomberg, ends next year.

We would only update this perspective by adding that we think China's central banking binge has been ongoing for years and years, and is probably a bit long in the tooth. However, the recent Chinese stimulation is fairly beyond the pale in terms of the numbers it has generated and the terrible price-inflation it has likely set in motion – a series of events resolutely not commented on in the world press thus far.

Yet incipient Chinese price inflation has tremendous implications for the industrialized world, since China's economy is in a sense, "the last man standing." Japan and Europe are struggling and the United States is in no condition to rebound rapidly. South American economies are in various stages of health, but it is really China that stirs the drink at this moment in time. And we would point out, as we have before, that there is no telling when a bubble collapses or at least begins to lose altitude.

Just as importantly, because of what the Chinese have just done (remarkably underreported in our opinion), the world's last engine of growth is soon to be faced with the same dilemma as its Western counterparts. Chinese central bankers will have to decide when and how to drain the stimulus cash from the economy.

Yet from what we have observed, the idea of draining anything from the Chinese economy in monetary terms is a non-starter. The old men who run things are deathly afraid of even the teeniest slow down. This likely means China is looking at significant price-inflation over time. And that won't make the Chinese any happier than a slow down would. China is apparently stable right now, but the present does not confirm the future.

Here's some more from the article.

Industrial output probably grew 13.2 percent in September and investment in properties and factories surged 33.1 percent in the first nine months, pushing GDP growth to 9 percent in the third quarter. It was the fastest pace since the third quarter of last year, according to the median estimate of 34 economists surveyed by Bloomberg News. The data will be released tomorrow.

Figures this week will probably show no signs of inflation, allowing the People's Bank of China to keep in place what it calls its "moderately loose" monetary policy. China will stick to that policy, guide reasonable loan growth to boost domestic demand and further cement the nation's economic recovery, the central bank said Sept. 29.

Consumer prices dropped an estimated 0.8 percent in September, according to the survey. Retail sales rose 15.5 percent last month, the fastest pace since January, according to the data survey. Car sales surged 84 percent to more than 1 million units for the first time, putting China on course to overtake the U.S. this year as the biggest market for sales of new cars.

The stimulus, record lending, tax cuts and subsidies may help push China's imports 30 percent higher to $313 billion this quarter, according to Zurich-based Credit Suisse Group AG. Iron ore imports jumped to a record 64.6 million metric tons last month while copper imports rose 23 percent. China's demand for goods from overseas can play "a critical role in some locomotive way for the world," Jim O'Neill, chief economist at Goldman Sachs Group Inc. in London, said in a Sept. 2 research note.

The lending boom, equivalent to about 50 percent of China's GDP in the first half, drove public and private investment in factories and properties 33 percent higher in the first eight months, helping restore investor confidence in stocks and property after the start of the financial crisis. The Shanghai index has soared 70 percent this year as government-influenced spending helped growth rebound from 6.1 percent in the first quarter, the slowest pace of expansion in almost a decade.

We have a hard time looking at these numbers with a straight face. It is testimony to humankind's ability to fool itself on a regular basis. With the West staggering from bubble to bubble, you would think there would be some level of suspicion about an economy the industrial output of which grows by 13 percent IN A SINGLE MONTH. But the Bloomberg article simply relays this stuff with a metaphorical straight face.

Did you catch it all, dear reader. How about a 15 percent rise in retail sales IN A SINGLE MONTH? Or how about a surge in car sales by 84 PERCENT? Or a 30 percent hike in imports IN A SINGLE QUARTER? Fortunately, there is no inflation to speak of (Bloomberg reports in a grateful way!). In fact, according to the Chinese, prices seem to have dropped despite all this phenomenal demand! (Something doesn't seem quite right about any of these numbers in our opinion.)

You know, we calculate inflation slightly differently than the Chinese do, or Bloomberg for that matter. We believe the inflation has already happened for the Chinese, quite a bit of it just recently. And even more worrisomely, the money that the Chinese central bank has injected into the Chinese economy is probably something of a topping-off of the monetary stimulation that has been ongoing for more than a decade. The inflation, therefore, has already been injected into the Chinese economy over years.

This is a HUGE story, one of the biggest, because it means that the Chinese central bankers will be faced either with rip-roaring price inflation over time or they will have to get as lucky as Western Central bankers in figuring out when and how to drain cash. A 13 percent monthly growth rate, for instance, is a pretty big figure.

We recommend that people reading such information retain a bit of skepticism when it comes to Chinese industrial reporting. Fifty years ago, Chinese leaders were literally hanging intellectuals or at least putting them to work in labor camps. The idea that all of a sudden, Chinese numbers are to be implicitly trusted is a foreign one to us. In fact, we're on record as writing we don't believe any of it – much anyway. It's a kind of fairy tale, in our opinion.

Yes, China has been able to egg-on industrial growth by monetary stimulation, but the surrounding financial infrastructure, the banks, the stock markets, etc., these are suspect, and ought to be given their history. They've been created by the Communist Party in the middle of a great industrial expansion. We think a lot of it is for show. When the financial tide inevitably recedes, the flotsam and jetsam will present some pretty ugly realities.

After Thoughts

We're not saying China is going to blow tomorrow. But we don't believe the Chinese miracle for a minute. Oh, we believe the party knows how to goose the economy via monetary expansion, but that's about all we believe. We also believe that once China does finally blow up, it may usher in for the world, amidst great hand-wringing, a private gold and silver standard. That would be the best thing that could come out of the latest bout of fiat monetary insanity in the great country of China. And by our count, they've had at least eight such bouts of fiat unreality in the past few thousand years.

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