EconSouth - Fourth Quarter 2007

Fed @ Issue banner with David Altig inset
David Altig is senior vice president and director of research at the Atlanta Fed. Is China's Economy Losing Its Luster?

From one perspective, China appears to be one of the few countries that are, at the moment, living large, economically speaking. China's gross domestic product (GDP) growth in 2007 will likely clock in at an annual pace near 11.5 percent, according to the Organisation for Economic Co-operation and Development (OECD). This spurt followed a half-decade in which yearly growth did not fall below 9 percent. What's more, as financial markets in the United States, Europe, and Japan struggle with the fallout from American housing market woes and the U.S. dollar depreciates, the Chinese government holds, by central bank estimates, more than $1.4 trillion worth of U.S. Treasury securities.

From another perspective, however, I believe the gloss on the Chinese economy is less shiny than it first appears. A story reported that as of November's end, the CSI index (an equity index that includes stocks from the Shanghai and Shenzhen exchanges) had declined by about 18 percent relative to its mid-October peak. This drop was even larger than simultaneous declines in Japan's Topix index (14 percent), the U.S. S&P 500 index (10 percent), and the U.K. FTSE (10 percent).

An inflation conundrum
China also appears to be facing an issue that for some time had been yesterday's news: inflation. The OECD estimates that consumer prices in China will increase by about 4.5 percent this year. That rate may not sound dramatic, but year-over-year inflation averaged a mere 1.3 percent from 2002 through 2005.

Much of the current commentary about the resurgence of Chinese inflation has focused on the rising prices of food and raw materials. But it's interesting to consider the possible connection between China's recent inflation concerns and the much-discussed claim that the Chinese yuan is undervalued. "Under- valued" is an imprecise term, but let's presume it means that the currency's exchange value against the dollar is lower than it would be if the market were left to its own devices, independent of government interventions.

What sort of interventions do governments undertake? Generally speaking, we can think of the intervention process in terms of supply and demand: If a government wants to lower the value of its currency relative to the dollar, the straightforward procedure is to print more of its own currency and buy dollars—a simple plan, but with a catch. Inflation is caused, in essence, by too much money chasing too few goods. A government may try to suppress the value of its currency with the printing press, but, if it does so, the headline will ultimately be "Inflation on the Rise."

Can this explanation possibly be what's behind the re-emergence of Chinese inflation? After all, China has been pegging the value of its currency to the dollar for some time, without any overt signs of trouble containing price pressures. Why would China's exchange rate policy be problematic now when it has not been in the past?

A question of timing?
Part of the answer is that, until recently, the Chinese government has been "sterilizing" its exchange rate interventions. In short, sterilizing an action taken in the foreign exchange market means undoing that action's effects on the money supply, typically by reducing the amount of liquidity in the domestic banking system. Sterilizing can be thought of as creating a new pile of money in one place while burning a pile in another place.

From 2003 through the first three quarters of 2006, the Chinese government sterilized 60 to 70 percent of its foreign exchange purchases, according to data from China's central bank. In 2007, that figure declined to just over 40 percent of its foreign exchange purchases. Less sterilization has meant accelerating money growth in China and—I believe, not coincidentally—a jump in Chinese inflation.

This explanation, of course, is simplistic. Even if the money supply is rising more rapidly because the People's Bank of China is no longer offsetting the monetary consequences of its currency peg, the critical questions are, Why is there less sterilization, and why now? Whatever the reason, if attempting to peg the yuan below its unfettered market value is the source of current inflationary pressures in China, the Chinese government would appear to have three options in the short term: (1) accept the inflation; (2) let the yuan "float" (that is, let market forces determine the exchange rate without intervention); or (3) attempt to keep the lid on inflation through controls on capital flows, banking activity, or private expenditure.

These options are not mutually exclusive, and I don't know what course will ultimately be taken. But it looks as though China may have reached a point where it must make some hard choices.