ADULT WARNING: This post will have a slight XXX flavour to it. Some adult styled supply and demand graphs will be used to illustrate some of the factors currently affecting the Chinese macroeconomic themes over the coming year.
But bad economic puns aside, the question driving this post is as follows: are China’s increasing inflation pressures the result of endogenous factors (ie internal) or exogeneous factors (you guessed it, external) over its current macro-economic development?
In true 24-something style, I would contend that there is a little bit of both at work here, but that the current inflationary pressures are still being dramatically stoked by a domestically controlled furnace of centrally planned FX rate controls.
The Long Hand Walk Through
As previous posts have already noted, China’s FX currency controls are, by their very nature, both an unstable and unsustainable long-term policy setting (See Arbitraging the FX Windmills and the ending section of the Foresight of the Curve and its Maturing Future).
The official stance defending the currency controls imply that China’s export industry require a helping hand in order to confront the uncertainties of a global market. However, just as with other forms of trade subsidies and barriers, this form of macro support can prove to be ultimately self-defeating and, quite counter-intuitively, highly disruptive towards the markets own process of allocating competitive pricing towards productive capabilities.
From a short-term perspective, one can possibly propose that a stable FX regime assists economic agents to attain a more rational, and less emotion based, decision structure in making pricing decisions by essentially removing one center of uncertainty and variance within their decision matrix. However, this can only hold true in an environment where all other factors remain constant or where, at the vary least, all other rates of change remain constant and predictable.
Such an idealised market environment, however, simply does not exist beyond the confines of a central planner’s CGE (Computerised General Equilibrium) model. In other words, as the world changes (and the world always tends to that on us when we expect it least), then so do the factors that entail price consideration and formation. Therefore, a failure to correctly adapt to these changes leads to increasing inefficient pricing decisions or, if you prefer the following terminology, a compounding increase in the opportunity costs of any fixed price setting.
The World as it Once Was
In the world as it once was, a fixed FX rate regime seemed to be a fairly innocuous manner in which to ensure that pricing power remained both constant and predictable in the face of an uncertain and variable global trade environment. In such a world, the fixed FX rate allowed one’s exporters to maintain a cost advantage over international competitors and to absorb international capital inflows back into a central planning regimen that could assist in redeploying these funds (and its associated purchasing power) back into the global market place. This, therefore, in theory allowed a country to ensure that its capital account remained on a stable upward trajectory and ensured that additional and uncertain disruptive effects of an inflow of foreign currency was, so to speak, absorbed and returned to sender.
Πάντα ῥεῖ καὶ οὐδὲν μένει | Everything Flows, Nothing Stands Still
However, such a world would be far from existing in a stable state. Indeed, the act of ‘returning to sender’ this influx of capital would in effect have the external party to receive on a constant basis, relative to its trade balance, an ongoing monetary stimulus that would in turn affect its own price level equilibrium by unsettling its own market mechanisms for the demand and supply of its money stock.
Now, in theory, the market at this point should naturally recalibrate itself for this scenario by ensuring that the domestic FX clearing rate reflects the true supply and demand factors for the country’s own domestic economic activity. However, as noted, this would not be the case. Instead, as the rate would be fixed, the steady ‘reflow’ of foreign exchange would carry back towards the external party.
Actioni contrariam semper at æqualem esse reactionem
As the external party is unwilling and, more to the point, is unable to continually efficiently clear the amount of returned carried currency, there would be little other alternative but for the external party to then readjust its own pricing power of this currency ‘reflow’ towards the downside.
But herein is the shift in the model that reduces the value of a central planners control outlook. As the value of the external capital redirection flattens then so does the ongoing internal value of the local capital inflows increase and unless this value shift is represented by a market defined relative price shift (an FX rate revaluation) then this relative pressure ends up roosting internally within the domestic economic variables and, therefore, into other locally derived prices.
However, these local price pressures no longer become the province of just an internally matched clearing process but instead appear, to local economic agents, as being an ongoing and unending form of price support. Such is the push, that local economic agents may be misled into believing that this is a new natural constant supporting their price level when, in reality, they are actually receiving the effect of an ongoing pressure above and over their real fundamental expectations.
“All the world’s a stage,
And all the men and women merely players”
At this stage, it might be worth relabeling some of the aforementioned parties in order to clarify the argument here a little. The domestic actors mentioned above are in fact internal Chinese domestic agents. The capital redirection actually becomes a money supply determination. The FX Rate regimen is the pegged CNY rate policy. The relative shift in the global macro model from what it once was to what it has actually become is the concerted effort by non-Chinese central banks to crowd out their own money markets with cheap capital and growth driven liquidity measures. These policies have, in turn, reduced the international relative rate of return compared to China’s own internal potential nominal return. And the ensuing prices pressures, experienced in China’s domestic economy, is in fact inflation with (the most concerning aspect of this shift) an increasing push of higher inflation expectations coming to roost in areas of the economy that were not necessarily linked back to the export market.
“We can evade reality, but we cannot evade the consequences of evading reality”
Once this point is reached, the poor central planner is left with a real conundrum on his hands: increased pricing-out mechanisms over the local money supply basis usually implemented by a progressive increase in the cost of capital (so called interest rate hikes) further intensify the cycle. The relative price value of locally based investments increase relatively to their global peers and, given that this relative increase is not reflected through a floating FX rate, it then tends to express itself through further localised price pressures.
But even if one assumed that such effects were to be entirely sterilised, by absorbing in and writing off in a big currency furnace this externally pressured price stoking, this would still only confront just one factor within the myriad of pressures already propping up the domestic economy. The net effect over a local economic agent would be insufficient for him/her to shift his actual expectations. Worse, in order to meet his ongoing pricing expectations, he or she might be irrationally led to accept that a certain subsidised area of economic activity (export driven industries) would better benefit his economic value.
The consequences, therefore, can lead to increased irrational allocation of resources to an export sector and, worse of all, an ongoing entrenchment of increased inflation expectations, which, by its very nature, becomes a self-fulfilling prophecy of realised inflation across a domestic economy.
Schematic Walk Through
Long handed descriptions aside, the inflationary phenomenon can also be observed with the supply and demand diagrams presented earlier.
CHART 1: Shift of the Demand for CNY currency from D(0) to D(1)
As China’s trade balance increases positively, the demand for Chinese currency increases leading to a shift in the demand curve as illustrated by the A vector. This shift essentially represents the higher price willing to be paid for each Renminbi. All other things being equal, one would expect that the FX rate would therefore rise, with each Chinese Renminbi increasing its relative purchasing power over a foreign currency cross. In the chart presented above, the cross was set against the USD, so with the shift in the demand curve comes an increase of price in terms of USD.
The other point, important for the subsequent graphs, is that that quantity of CNY in circulation of the market essentially increases. This is due to the equilibrium point reaching a higher level of cleared supply at the added price level.
CHART 2: Chinese Fixed FX Rate Policy comes into action with a shift in the supply of Renminbi from S(0) to S(1)
China does not want its FX rate to rise against other currency pairs or, at the very least, does not want this rise to occur through a market defined clearing rate. In effect, China wants to control the price effect over its exports by artificially dampening the rate at which its currency can clear on international capital markets. China can not control the demand for its local currency, this is a factor set by the international market, however, it can negate the shifts in demand (A) by its own shift in supply (B). In effect, for every added Renminbi demanded by the market, instead of letting this demand meet against the resistance (or elasticity) of China’s own supply curve, China chooses to simply shift out the supply of its own currency.
This is a fairly simply process of just hitting ‘print’ or, in other words, in matching the state of scarcity in the market by the injection of new CNY. This shift in effect lets the FX rate clear back below in a controlled manner towards the original FX rate as shown by the B vector and new equilibrium point. However, this control of the FX peg comes at the price, with now an even higher quantity of CNY injected back into the local domestic economy. The amount of Renminbi now washing around is even higher (and potentially even more stimulating) than the cleared equilibrium rate of a higher priced yuan.
CHART 3: Chinese Sterilisation Efforts, contracting the money supply by increasing the cost of capital within the Mainland
The problem now comes to roost back into the Chinese mainland. With the FX peg mechanism comes the added problem that the local economy becomes awash with an increased money supply. This tends to have a number of nefarious consequences. Imagine a world where there is X amount of currency around. Now imagine a world where there’s 2X amount of currency around. Between these two worlds, which would be the cheapest to borrow from? In which world would the state of scarcity be the lowest for access to cash, capital, loans, etc. In other words, in which environment would it be easiest to take risky investment decisions, in which environment would it potentially be the cheapest to go and make mistakes?
This inflow into the local money supply therefore causes a strong stimulatory environment over the local economy. The economy is awash with cash, the availability is such that risk and reason become almost second-concerns compared to the ease of access of capital. And this is, unfortunately, quite a problem.
Once such a setting enters into into play, the added inflow tends to promote ongoing expectations of increased inflows, of ever cheaper capital. And, to make matters worse: because money is cheaper, prices tend to rise… Without wanting to press this point too far, the cheaper the money base supply, the higher the risk, propensity and, more to the point, the expectation that prices will want to rise. As money becomes cheaper, everything becomes more expensive. This is known as inflation and it is not a good thing.
The graph above presents one of the options available to the Chinese central authorities to confront this issue. By increasing the cost of capital, they can assist in constraining the shift of the money supply back towards manageable levels. This can be illustrated by a shift from S(0) to S(1) across the C vector and by bringing the equilibrium rate back over to the original and non-inflating money-supply quantity.
However, such a shift requires that the central planners know exactly where the right equilibrium price point should be and, furthermore, that they have the right tools to implement such cost increase effectively. The first assumption of perfect information, 20/20 hindsight and ideal foresight is a difficult one to assert. The latter aspect, however, of policy implementation can also be just as worrying.
Most global economies implement this contraction of the money supply by a progressive increase of interest rates, which is an option explored by China. However, it is a telling signal that China is forced to rely on other less standard measures in order to complement its money supply contraction policies.
At the moment, China is trying to absorb and sterilise the added inflow of currency back onto the books of its financial institutions, as well as through standard interest rate mechanisms. The first of these policies imply that banks must hold on to added cash, so called tier one capital, at a rate notionally around 18.5% of their assets. However, in a booming economy, such a measure might still be insufficient in order to fully absorb the effect of the money inflow.
This leads me back to the added issues mentioned in the long hand walk through: the uncertainties and unreliability of money market policies, the ongoing constant inflow of cheap money supply through the currency control mechanism, and the added inflationary pressures built across the economy that can then lead to highly systemic irrational practices.
“Don’t judge each day by the harvest you reap, but by the seeds you plant.”
Banks that are locked with added reserves will require high yielding investments in order to compensate for the added costs of operation from increased tier one reserves. It would therefore be sensible to assume that they would focus their investment on domestic export led industries. They will focus primarily on local investments as these would appear cheaper given that their FX rate is un-naturally depressed and their pricing power incerased in overseas markets. There will also be an incentive to focus on export industries as these are benefiting from a systemic support from the government in light of the pegged exchange rate and therefore offer more guaranteed returns than other potential industries.
Individuals will seek employment primarily over into export driven industries as well. Again for much the same reason as the banks, they will see the export sector as being better equipped to confront the increasing price pressures that are being built internally. This development can lead to systemic gaps throughout the local economy where, due to an out of equilibrium scarcity of labour and skills in other industries (remember that other industries will suffer from an opportunity cost disadvantage compared to export industries), price pressures start to build up. If it is relatively more expensive to run, say, an agrarian or a local services sector venture, then this will then reflect back towards their price offering.
“What is cheap is rare; what is rare is expensive; hence, what is cheap is expensive.”
As the export sector becomes more appealing and less risky, so does the comparative cost of other businesses become more risky and, therefore, more expensive: it becomes less safe to invest in a farm than an export widget maker, it becomes more risky to invest in a local service provider without government guarantees than in a subsidised government-mandated export venture. All of this leads to added inflationary pressures…
Finally, as the export industry still source their goods, labour, skills and other services internally, this price pressure finally comes through and translates in their operations. The effect, therefore, can become quite costly: specifically as the money supply has become so cheap and so skewed towards a particular industry, then so have inflation pressures built across and throughout the domestic economy. Indeed, the cycle can become so ingrained, and the expectations of ongoing cheap money supply so severe, that inflation becomes not only a priced reality but actually a compounding expectation.
So any end to the endo/exo chinese fx macro price stupendo? Well, it is unfortunate to see that these inflationary pressures are becoming not only entrenched but dangerously widespread. It is all the more unfortunate to see that from a policy view point, focused on reducing uncertainty in global market has, finally, only really managed to translate into increased price instability locally. Oh, and in case you were wondering, there are few things more worrying economically than uncontrolled hyper-inflation…
That being said, the year has only started, and China is determined to confront this issue head, front and center. However, if change there will be, then FX rate revaluation there must. This could prove to be quite a turning point in global capital markets once the tipping point is finally reached.