US inflation spreads like wildfire to China
The world’s top two economies haven't decoupled much at all when it comes to fast-rising inflation risks
TOKYO – On any list of things Xi Jinping feared might spoil his desire for a third term as Chinese president, runaway inflation probably didn’t warrant high placement.
But now, the fastest factory inflation in 26 years is complicating Xi’s best-laid plans. And there’s an even bigger complicating factor: signs of overheating in the US, where consumer prices are rising at their fastest clip since 1990.
China’s inflation troubles are one thing. But a 6.2% jump in consumer costs in the US, the issuer of the reserve currency, is a far bigger threat to China given the symbiotic nature of the world’s two biggest economies.
And a dearth of optimism about smoother Group of Two relations with Joe Biden’s White House hardly helps.
The latest inflation numbers belie arguments by US Federal Reserve Chairman Jerome Powell and Treasury Secretary Janet Yellen that inflation pressures are “transitory.” Indeed, they could end up being right. But the trajectory of prices throws cold water on the theory that base effects from last year’s Covid-19 recession tell the full story.
“The inflation overshoot will likely get worse before it gets better,” argue economists at Goldman Sachs in a research note.
At the very least, Fed “tapering” risks are no longer theoretical. Nor is the specter of an actual interest rate hike a distant threat. It’s one thing for the Bank of Korea and Reserve Bank of New Zealand to hit the brakes. The Fed, with a balance sheet topping Japan’s gross domestic product (GDP), is another story.
The problem the Fed faces is lost credibility. Over the last 25 years, traders have come to trust the Fed, the Bank of Japan and the European Central Bank to a near-irrational degree. Powell’s predecessors Yellen, Ben Bernanke and Alan Greenspan all kept inflation under wraps, earning the Fed an immense benefit-of-the-doubt privilege.
So did their counterparts in Tokyo, Frankfurt, London and beyond. This fed a collective complacency — a misplaced belief that global institutions had tamed the inflation monster of old. That spelled “risk-on” for punters everywhere.
Until now, perhaps. The last 18 months produced a perfect financial storm of sorts: demand surges as economies reopen from Covid-19, supply-chain disruptions, scarcity among vital commodities and 13 years of ultralow rates acting like monetary gasoline to accelerate and feed the blaze.
The problem with today’s inflation flames “is that they’re unlikely to ease up any time soon so the pressure on the Fed is going to be intense,” says analyst Craig Erlam at trading platform OANDA. “With gold prices soaring as investors seek inflation hedges, the dollar and US yields on the shorter end of the curve jumping and equities falling, it’s clear the Fed has some questions to answer. The markets and the central bank are not on the same page.”
Adds economist Robert Frick at the Virginia-based Navy Federal Credit Union: “We expected inflation would get worse before it got better, but not this much worse. Particularly painful is the increase in food prices as we approach the holidays, and the rise in energy prices as we plan to travel more to family get-togethers.”
The hope, Frick says, is that “both those increases are likely to be temporary, and the forecasts that inflation overall will drop early-to-mid-next year still seems credible.”
A rich platter of risk
Or not. The risk is that markets grow impatient and take matters into their own hands. The reference here is to the so-called “bond vigilantes” – punters who band together to punish wayward governments and risky central bank policies by bidding up yields.
These debt-trading activists sprung to action in the early 1990s when US budget deficits surged. In 1997 and 1998, they chastened over-leveraged authorities in Bangkok, Jakarta and Seoul manipulating currencies. In 2008, they punished Wall Street for its addiction to subprime loans and other toxic assets.
An attack today by activist traders could have exponentially great effects if they push US yields higher. That would precipitate a repricing of corporate, asset-backed and municipal debt and unnerve stock markets everywhere. It also could undermine the dollar, the linchpin of global trade and finance.
Asian central banks are sitting on roughly $4 trillion of US Treasury debt. Japan alone holds $1.28 trillion and China is sitting on $1.1 trillion. This puts considerable state savings at risk. Yet that pales in comparison to the damage to China’s GDP if surging US debt yields slam global demand.
China, of course, isn’t ending 2021 at its most stable. Its return to growth as Covid infections wane — north of 6% — is surely supporting demand in the US, Japan and Europe. Yet the default dramas at China Evergrande Group and Fantasia Holdings speak to the cracks spreading underneath Asia’s biggest economy.
This has investors waiting for the next proverbial shoe to drop.
Opacity feeds fragility
Many are now scrutinizing Kaisa Group Holdings, China’s third-largest dollar debt borrower among developers. This week, Fitch Ratings cut Kaisa further into junk territory, citing increasing risks of the company missing bond payments.
“The downgrade reflects our view that Kaisa’s liquidity has further deteriorated,” says Fitch analyst Edwin Fan. “We believe Kaisa’s credit risk is high due to tight liquidity, undisclosed debt from wealth-management products, potential pressure to address non-capital market debt, declining contracted sales and limited progress on asset disposals.”
Kaisa matters because in 2016 it was the first Chinese developer to default on dollar bonds. That it’s still in trouble speaks to the deeper rot in an industry that generates at least one-third of Chinese growth.
And because Xi’s presidency since 2012 has increased opacity across economic sectors, it’s now harder to know where the next cracks might appear. All this puts the People’s Bank of China (PBOC) in a tough position.
Its mission these last 18 months was to reduce leverage in the property sector and deprive shadow banks of excess liquidity. But the PBOC’s actions, and those of Xi’s regulators, pushed developers to the brink just as the pandemic hit the economy.
Rising inflation limits PBOC’s ability to soften the blow should Covid inflation rates spike anew across the most populous nation. At the same time, the fragile state of China Inc’s foundations makes it hard for the PBOC to close the monetary spigots.
This puts PBOC Governor Yi Gang in a precarious position: hoping the Powell-led Fed knows what it’s doing.
There are steps Xi and Biden could take to calm inflation fears. One is for the US to scrap Donald Trump-era trade tariffs. These taxes on nearly $500 billion of Chinese goods did zero to narrow the US trade deficit with China. Former president Trump’s taxes did lots, though, to increase costs for US businesses and consumers.
In his virtual summit with Xi next week, Biden could use a scrapping of Trump’s taxes both as a geopolitical olive branch and pressure valve for the global bond vigilantes. Until now, Biden has been reluctant to do so, not wanting to appear soft on China. Surging inflation gives Biden the political cover to act.
Xi knows well that the recent $1.2 trillion infrastructure bill passed in Washington is a boon for China. In the depths of the Covid crisis in 2020, mainland machinery companies saw international sales crater. In October, say analysts at Daiwa Capital Markets, exports of China’s excavator machines surged 85% to a record high.
The snag, of course, is how this burst of demand collides with global delays and shortages of everything from chips to raw materials to parts for construction machinery and other related goods. Taking Trump’s tax off prices is a good start.
“Inflation hurts Americans’ pocketbooks, and reversing this trend is a top priority for me,” Biden said Wednesday. “I want to reemphasize my commitment to the independence of the Federal Reserve to monitor inflation and take steps necessary to combat it.”
Yet the problem for Biden, whose poll numbers are already slipping, is that “the latest inflation reading shows that price gains are picking up steam,” says Erin Doherty at Washington-based news and analysis portal Axios.
China’s price perils
China faces enough inflation risk without the US. In October, mainland producer prices jumped 13.5% from a year earlier, topping a 10.7% rise in September. That’s the fastest pace seen since July 1995. For example, costs of coal mining and washing prices are up 103.7% from a year earlier. Costs in the oil and gas extraction industry rose 59.7%.
So far, consumer price increases have been more contained, rising just 1.5% in October year-on-year. But some analysts worry it’s only a matter of time.
“We are concerned about the pass-through from producer prices to consumer prices,” says economist Zhiwei Zhang at Pinpoint Asset Management. As Chinese growth slows and companies face depleted inventories and pass higher costs onto customers, “the risk of stagflation continues to rise,” he adds.
Inflation is rising in China as input prices surge. Photo: AFPIf past policy-making is a guide, there’s reason to hope Xi’s government can intervene across industries fast enough to avert disaster. “Factory gate inflation is probably close to a peak,” says Julian Evans-Pritchard, senior China economist at Capital Economics.
Still, every inflation report indicator in the days and weeks ahead, no matter how minor or obscure, has scope to send world markets into sudden tailspins. Measures of supply-chain cost dynamics could be especially explosive.
“I think that all legitimate leading indicators should be watched,” says currency strategist Thierry Wizman at Macquarie Group. “Shipping rates will measure the tightness of seaborne freight markets, which are an important bottleneck in the supply chain.”
With any luck, the leading indicators emanating from the US will trend in a less disastrous direction. The last thing Xi needs as 2022 approaches is a 1970s-like inflation crisis in the globe’s biggest economy.