China's Frantic Policy Pulse and the Inflation Threat

The recent stop-start yo-yo of China’s monetary policy reflects not just the attempt to keep policy loose enough to stabilize the economy without fundamentally de-railing the strategic necessity of fundamental reform. It also reflects the fact that China’s inflationary potential is far greater, and is looming far sooner, than is recognized. So far, in a world concentrated on deflationary threats, an inflationary outbreak is on virtually  no-one’s horizon. Except, perhaps, in the People’s Bank of China.

Financing slowed very sharply in April: the addition to aggregate financing was a mere Rmb751bn, which was the lowest monthly gain since October 2015; bank lending slowed to Rmb 556 bn, on a monthly movt which was 0.6SDs below consensus.  Over the last four months, the monthly aggregate financing total has been  unprecedentedly volatile: January’s Rmb 3,425bn feast was followed by February’s Rmb 825bn famine; in turn that was followed in March by surprise gains of Rmb 2,336bn, whose largesse was revoked by April’s shockingly feeble Rmb 556bn.

This yo-yo accurately reflects the unprecedented volatility of PBOC’s open market operations. The chart below shows PBOC’s weekly interventions, and it resembles nothing so much as a cardiac arrest followed by defibrillation. It is a mistake simply to view this volatility primarily as a seasonal phenomenon, although the need to finance the end of the tax year, and then Lunar New Year holidays does drive some of the volatility. But even accounting for these flows, the volatility of the last few months is unprecedented. Twice PBOC has flooded the market with liquidity (end-January, middle of April), only subsequently to claw back the money over the succeeding weeks.

There are two main reasons why the central bank is unwilling to commit to the sort of grandiose monetary relaxation we’ve become used to elsewhere in the world, and indeed, in China during the slowdown of 208/09. First, there are the well-rehearsed set of strategic reasons why no repeat of the credit splurge of 2009/10 is to be expected. An excessively generous monetary policy do nothing to foster the transformation of the economy from an excessive investment/low return on capital model, to a model based on improving returns on capital and sustained growth in consumption. And in practical terms, it probably wouldn’t deliver the goods: in the 12m to December, the efficiency of finance had deteriorated sufficiently so that Rmb 100 of new aggregate financing was associated with only Rmb 25 of extra GDP growth. So not only would a 2009-style credit splurge subvert core strategic policy goals,  it wouldn’t even work particularly well. 

At the same time, however, China’s authorities have long blamed the collapse of the USSR on the disruption caused by the ill-considered and clumsy haste of structural economic reforms, and the need to avoid anything similar is axiomatic. As a result, in order to advance the long-term strategic goals, sufficient support must be given by monetary and fiscal authorities in the short term to sustain the economy in reasonable health. Whilst in the West there is a tendency to see the policy choice as binary (either tough reforms or monetary accommodation to flunk them), the Chinese authorities say they see things very differently: accommodation now in order to underpin the viability of reforms in the medium term.

There is, however, an additional factor which circumscribes how generous PBOC can be: inflationary pressures have to be contained, and they are stronger than consensus wishes to acknowledge. A previous post explained how the absence of viable savings products and vehicles was driving surplus savings into real assets, notably real estate and commodities, in a way which was already producing speculative bubbles. This highlights the need to accelerate financial reforms, including effective regulation. But these speculative bubble are also hinting at the likely emergence of wider inflationary pressures. 

This is only just beginning to surface in the data. April’s CPI stayed steady at 2.3% yoy, and the current deflections against trend suggest that it will stay above 2% throughout the year. This will be a surprise to a consensus which still expects it to fall to around 1.8% by 3Q.  A more worrying straw in the wind was China’s PPI, which  fell only 3.4% yoy in April, with consumer goods down only 0.2% yoy.  Not only was this less deflationary than expected, but looked at more closely, the index rose 0.7% mom, which was the steepest rise since Feb 2011, and was 2.9SDs above historic seasonal trends. 

But this may be only the tip of the iceberg. Historically, the relationship between China’s CPI and monetary policy has centred on growth in M1, with inflections in M1 growth coming usually around six months before inflections in CPI. In momentum terms, M1 growth bottomed out in the middle of 2015, and has been accelerating moderately at first, but quite vigorously since the latter part of 2015. By April, M1 growth was running at 22.9% yoy and the underlying momentum was still accelerating sharply, with April’s monthly gain 0.9SDs above seasonalized historic trends.  Unless the relationship between M1 And CPI breaks down, we should now be expecting inflation to pick up by 4Q to nearer 4% than 2%.  

Will it be different this time? Currently, the consensus apparently thinks so. That’s where the risk lies. 

What would an unexpected outbreak of accelerating inflation do to China’s policy choices? It would produce the worst of all possible world for China. To be very blunt, it would compel exactly the combination of necessary credit crunch and subsequent hard landing, followed by far-reaching structural reform, which China’s leaders are so keen to avoid. Perhaps it is this realization which is behind the dramatic gyrations of monetary policy.