CHINA’S IMPENDING INFLATION BATTLE

Oh that dreaded government intervention!  To describe the contrast between the inflation situation in the United States and China as “stark” might be a bit of an understatement.  As we’ve previously described (see here), the inflation issues in the United States remain benign for one primary reason: aggregate demand is weak.  The U.S. consumer is grappling with a traumatic balance sheet recession (see here).  But none of these problems existed in China to the extent that they did in the United States.  Remember, China’s economy was growing relatively fast even at the depths of the recession in the U.S.  –  a whopping 6.1% at the trough.  Most importantly, their consumers were not saddled with debt.  Nonetheless, Chinese officials felt that it was necessary to inject the economy with a stimulus package that rivaled that of far more embattled nations.  The results have been tremendous.  M2 is growing at 25.2% while M1 is expanding at 35%.  Unlike Americans, the Chinese are borrowing and they’re using those borrowings to fuel their speculation.

The headline CPI is running at 2.7% year over year.  Food prices are up 6.2% year over year.  Real estate prices rose at a record 10.7% in February. Equity prices in China are up over 45% in the last 12 months.

In early February we ran this superb interview with the largest commercial real estate developer in China.  Her thoughts are almost eerily similar to those of Sam Zell’s when he was predicting a real estate debacle in the United States in 2007:

What is your overall approach to the real estate market today?

Basically – other than Qianmen [Street] in Beijing, which is the only project we decided to hold long term, our strategy for today is to sell everything we have. The real estate business should really be looking at rental yield; build a building and then lease it out with the rent giving a decent return. But, because of where China is with asset bubbles, people want to buy the assets regardless of whether they can be leased out or not. People just want to hold [property], even if it is empty.

Prices are too high, rent is too low, so if you hold property in order to get yield you are likely to get very little. For us it makes no sense to hold property, so our strategy is to sell everything. We see ourselves very much as a manufacturer. We buy land, we build, and then we sell. And the asset bubble has compelled us to be even more of a manufacturer.

When do you think the bubble will burst?

I don’t know. We don’t really have a view on when it will end; [but] we do have a view that this is a bubble. Real estate is very much driven by government policy. This year we have RMB 4 trillion through the stimulus package, another RMB 6 trillion from municipality bonds, another RMB 10 trillion from bank loans: We have RMB 20 trillion in the system and it all finds its way to real estate. If the government next year decides to continue the relaxed monetary policy the market will continue like this, regardless of whether this is a wasteful investment or not – people will still buy and we will still be building and selling.

These buildings are not fully occupied and people should be worried about it. I am sure the government is worried about it, but what do you do, they want the stimulus and if you want to create jobs then this is a by-product. There are a lot of dilemmas in this area – it is not a black and white easy decision.

What is your time period for selling properties?

As soon as possible. We came in [for the Exchange] when it was 30% full and now it’s selling out very quickly. I think in the next few months it is all going to be sold out. People want to buy. It has already reached 50% occupancy.

[Beijing’s] CBD has 35% vacancy but our buildings are all over 95% occupied because we push all these Chinese companies to come in. [Normally] if you go to Guomao as a small Chinese company there is no chance they will lease it to you, they won’t even talk to you.

The smart money in China is concerned, but for some reason government officials are talking these problems down, describing them as “moderate”.  They wouldn’t be the first central bankers to misjudge an exit strategy….

Analysts are now scrambling to alter their outlooks.  UBS predicts a rate hike in the “early second quarter” – much sooner than their previous estimate for the third quarter.  Barclays is also adjusting their timeline to Q2.   Morgan Stanley has been ahead of the curve on the global rate tightening fears and believes China could be facing multiple months of tightening starting in April.  Goldman Sachs is growing increasingly concerned with regards to the nonchalant stance by the Chinese government who continues to call the inflation concerns “moderate” (sounds similar to Bernanke circa 2007 & 2008 when prices were skyrocketing in the oil and real estate patch):

“Recent comments by a number of policymakers that there are no signs of inflation yet are worrisome as it indicates a lack of willingness to take more decisive measures until higher inflation actually occurs.”

Let’s not overreact to this news, however.  This is a slowly unfolding phenomenon.  China’s growth is the envy of the world, but they have quite a battle on their hands in 2010 and 2011.  They are confronted with the ever difficult task of threading the monetary policy needle – a task that ultimately led to the demise of Alan Greenspan (and certainly made Bernanke appear foolish in 2009).  This is, in many ways, the most difficult timing trade ever made.  Can you inject enough money into the system so that it doesn’t boil over and more importantly, can you sap the system of that necessary liquidity when the time is just right?  China would be wise to get ahead of these issues as we here in the United States are all too familiar with – pockets of mal-investment are too often a direct result of poor monetary policy.

Government aid might be the global economy’s greatest hurdle in the coming years, but it won’t be our own stimulus that is the great concern – it will be that of the engine of the global economy – China.   Luckily, with aggregate demand still very low in the United States and much of Europe there is little to no concern of inflation here, however, if China’s economy were to take a spill as government officials mishandle monetary policy it would almost certainly result in a global double dip.   And unfortunately, a global double dip would only strengthen the deflation that is hard at work around much of the globe.  Let’s all hope China gets ahead of this sooner rather than later.