I published this column on Executive Magazine:
The spectacular rebound of emerging markets after the recent recession was driven in no small part by China’s emergency stimulus package in late 2008, arguably the timeliest and the largest in the world (relative to gross domestic product). The pull of Chinese demand was powerful enough to revitalize international trade — severely curtailed by the crunch in trade finance — and to drag out of the hole many of the economies well integrated in the Chinese supply chain, from Malaysia to Korea, and Australia to Germany.
The flip side of this stimulus has been a worrisome boom in real estate prices (which has led many to scream “Bubble!”) and persistent inflationary pressures which have extended across Asia (excluding Japan), complicating the macro picture at the national and global level. Asian central banks (and also Latin American ones) until late last year were reluctant to aggressively raise interest rates, lest they clip the green shoots of recovery. But with the upturn in emerging markets, food and commodities prices worldwide resumed their surge; since the beginning of this year this surge has been exacerbated by oil price reaction to the turmoil in North Africa. Amplifying this effect is the premature end, after Japan’s Fukushima disaster, of the much touted “nuclear renaissance” that was supposed to substantially curtail hydrocarbons in the world energy mix.
China remains to-date the epicenter of inflationary pressures, despite the fact that authorities were the first to react decisively by increasing reserve requirements up to 20 percent for top lenders, restricting credit to the real estate sector and hiking interest rates four times since October. Nevertheless, in March, Chinese inflation hit a three-year record of 5.4 percent per annum, while in India, which is also experiencing a generalized price surge, it reached almost 9 percent; across the emerging markets generally, from Korea to Brazil, price levels are overheated.
Conventional wisdom and mainstream policy advice suggests that the Chinese authorities should act even more aggressively to counter further price hikes, and indeed solemn pledges to this effect figure prominently in public statements by senior politicians. But China generally defies conventions and an alternative course of action appears to be gathering consensus within policy circles. The new five-year economic plan sets a 4 percent inflation target for this year, and Chinese authorities have signaled that in the medium term they would be comfortable with inflation between 4 percent and 5 percent, which represents a substantial increase compared to previous years.
Furthermore, national and local governments have enacted a spate of hefty salary increases: since the beginning of the year, 12 Chinese provinces and provincial-level municipal cities have raised their minimum wages. The average adjustment over the 12 provinces was 21 percent with the highest hike, 28 percent, being decreed in Chongqing, in central western China (outside the coastal belt where manufacturing is concentrated). Incidentally, thanks to a 20 percent rise, Shenzhen replaced Shanghai to become the city with the highest minimum monthly wage in China (approximately $203). If we consider a longer horizon, since last year 30 provinces raised the minimum wage, often by double digits.
These measures were justified by the need to attract labor from the inner regions and to improve living standards, an issue that had taken center stage in domestic politics after strikes and workers unrest spread across the country, threatening to become a widespread phenomenon.
Whether by happenstance or by design, it seems that an unorthodox policy recipe is emerging. One of the foremost issues confronting the Group of 20 countries is the rebalancing of the current-account surplus by China and Germany and other mercantilist oriented countries. The most vocal critique of China’s export-led strategy has been the United States, which (stirred by Congress) has used such criticism to push for a revaluation of the yuan.
The Chinese government and central bank are aware that an ever-increasing current-account surplus is not sustainable (the foreign exchange reserves have reached a walloping $3 trillion), but might be contemplating an alternative route; instead of revaluing the nominal exchange rate (as demanded by the US and others) they are increasing the real exchange rate.
By raising domestic wages they boost domestic inflation, thereby losing competitiveness, but Chinese workers feel the benefits more than foreign competitors. In essence, the Chinese government seems to be pursuing a redistributive policy in favor of the domestic population with the aim of boosting internal demand and reducing the current account surplus.
It is hard to say how this policy will turn out; it certainly carries risks, as once a price/wage spiral is triggered it becomes hard to control, but a few implications for the global economy and the Middle East are clear.
Over the past three decades China has become the world manufacturer and has been the most powerful force behind a relentless deflation in traded goods — reveled in by the rest of the world — thanks to an almost inexhaustible supply of cheap labor. This process is reverting, and with China’s inflation on the rise it is only a matter of time before a global reverberation is felt.
If one adds the effects of money printing in the US and the need to monetize at least in part public debts in mature countries, foremost in the Eurozone, the next few years will present serious challenges for monetary policy; the word ‘stagflation’ is likely to make a comeback in everyday parlance.
This change will not be a temporary adjustment, but will represent a structural shift in the global economic environment, affecting greatly the smaller economies in the Middle East and elsewhere. In particular, the Gulf Cooperation Council countries will find themselves again ensnared, like in 2006-2008, in a monetary policy determined by the US Federal Reserve to serve its domestic goals, but utterly inadequate for the conditions of GCC economies.
Furthermore, the central banks and the sovereign wealth funds that manage the accumulated export revenues are typically exposed to fixed income securities denominated in US dollars. At present, the safe haven status and the anemic credit conditions have held bond prices remarkably stable (excluding of course troubled countries such as Greece or Portugal). But when markets realize that higher inflation is not a blip, the adjustment could be traumatic for fixed income securities. There are no simple solutions to this kind of tectonic shift, but a revamping of the GCC’s common currency project could not be more timely. A degree of flexibility in monetary policy and a new strong international currency would be in the best interests of the oil exporters and also indirectly, those of other countries in the region.
The surge in Chinese wages will also lead domestic consumption to replace exports as an engine of growth. This swing has a long course to run as private consumption represents a remarkably low percentage of China’s GDP. The effects of the Chinese boom have thus far benefited countries and companies embedded in China’s supply chain, but from now on the effects of the stimulus could reach those countries and companies that cater to Chinese consumers, in particular in the provision of durable goods for the expanding middle class — washers, cars, furniture and high end services, such as tourism, healthcare and financials.
A benevolent interpretation posits that, far from being a serious worry, inflation spurred by the loose wage policy tolerated — and often encouraged — by the Chinese authorities could be another step in the long march toward better quality of life within China and the harbinger of a great leap forward for the world economy.
