The new year is off to a steady start in China. Data from the manufacturing, services and construction sectors continue to point to strong growth, but not overheating. This reinforces my view that no broad tightening measures will be introduced until the second half of 2010, when concerns about asset-price inflation will likely prompt Beijing to make small rate hikes.
The seasonally adjusted purchasing managers’ index (PMI), published by Markit, was in expansion for the ninth consecutive month in December, rising to 56.1 from 55.7. It has been in the 55-56 range for five months and, while I expect the index to remain in expansion territory this year (i.e. above 50), the current level may soften a bit as inventories recover.
The December figure was the second-highest in the more-than-five-year history of the survey, but production is not getting ahead of itself: Stocks of finished goods contracted for the second consecutive month, and in five of the last six months.
There have also been signs of improvement on the corporate profits front, with Beijing announcing in January that profits at larger industrial firms rose 69.9% year-on-year during the September-November 2009 reporting period. For the first eleven months of 2009, industrial profits rose 7.8%.
Performance has been aided by a weak base and companies will continue to benefit from this through the first half of 2010, after which the base strengthens. There are already signs that firms will struggle with rising input costs in the second half. The Markit PMI index for manufacturing input prices has been climbing steadily, to 69.9 in December from 44.3 in May.
Rising input prices are a serious concern because overcapacity and competition in almost every manufacturing sector severely limits the ability of firms to raise final goods prices. When, for example, the PPI rose to 115.4 in July 2008 from 103.6 a year earlier, it had almost no impact on the core consumer price index (which excludes food and energy).
With the global economy likely to remain anemic next year, energy and raw material prices will not return to mid-2008 levels. But I am concerned that rising input prices may dampen profit prospects in China’s industrial sector in the second half of the year.
It is logical to assume that the massive increase in credit and liquidity will generate serious consumer price inflation in China, but the equation is actually a bit more complex. A rise in the quantity of money in an economy can have three consequences: a rise in prices, a rise in quantity of output, or a fall in the velocity of money.
Milton Friedman wrote that "inflation is always and everywhere a monetary phenomenon," but he qualified this by adding, "…in the sense that it [inflation] cannot occur without a more rapid increase in the quantity of money than in output." Although output in China is clearly rising, it trails the 30% growth in the M2 money supply, which partially offsets the impact of liquidity expansion.
As for the velocity of money, economists usually expect it to remain stable when evaluating the impact of money supply growth on prices. But not this year in China – the velocity of M2 was at its slowest pace in a decade in December.
The slower pace of money changing hands is reflected in Chinese bank accounts. The amount of money in household savings accounts grew by 19.7% in 2009, while corporate savings rose 37.7%. This means that much of the new money supply is not chasing goods and services; it is resting in the bank.
As a result, M2 growth has not, in most cases, led to higher prices. The CPI rose 1.9% year-on-year in December, but 92% of the increase came from food (non-food prices rose 0.2%), and this is due to seasonal factors, not increased demand. With output rising and the velocity of money falling – and firms unable to raise final prices due to overcapacity and competition – consumer prices should stay in check.
Two areas where rising money supply has led to price increases are real estate and equities: The National Development and Reform Commission said property prices in 70 cities were up 7.8% year-on-year in December, and the Shanghai Composite Index gained 80% in 2009. When Beijing does turn to interest rate hikes, it will be to rein in these two asset-price inflation cycles, not consumer prices.
The CPI is likely to rise 3% this year, from an average of -1% in 2009, but the key driver will be pressure on the food supply, not rising demand.