China is witnessing something most of the world’s major economies haven’t seen in quite some time: rising prices. With growth strong but debt at perhaps 300 percent of gross domestic product, that’s a welcome sign. The danger is that China’s government now hopes inflation will solve its other problems.
From 2013 until this year, the GDP deflator, a broad measure of prices, never rose by more than 2.3 percent. Most of the time, it hovered just above zero. This pushed up the real cost of China’s debt and raised the specter of Japan-style debt deflation. In the first quarter of 2017, however, the measure shot up by 4.6 percent. It’s set to finish the year above 4 percent for the first time since 2011, when China was exiting its post-crisis lending binge.
So what happened?
We know that this price increase wasn’t driven by consumers. Consumer price inflation remains below 2 percent, and the factory prices of consumer goods have risen by just 0.7 percent so far this year. During China’s recent Golden Week holiday, per-capita spending was up only 2 percent over the same period last year.
Instead, prices are being pushed up entirely by basic industrial and construction inputs. Industrial producer inflation has accelerated by 6.9 percent this year, while coal prices are up 33 percent and metallurgy prices up 23 percent. The cost of other basic inputs, such as petroleum and chemicals, is also rising fast. All this is more or less by design: China’s government has kept credit loose, encouraged capital to flow into financial products that trade commodities, and forced some factories to shut down temporarily to reduce capacity.
The resulting price increases have affected a broad range of economic metrics — and in some cases distorted them.
Non-performing loans peaked in 2016, for instance, shortly after commodity prices started rising. Because mining and manufacturing companies — including steel firms — have some of the highest rates of bad loans, any change to their profitability has an outsized impact on the bigger picture. While profits at China’s A-share companies were up 20 percent in the first half of 2017 over the same period last year, coal company profits rose by 319 percent and steel firm profits surged by 508 percent.
Inflation has also altered China’s broader debt outlook. By some measures, debt levels relative to nominal GDP may have even started falling. However, this is almost entirely due to rapidly rising commodity prices pushing up nominal GDP. If the GDP deflator had risen by 2 percent instead of 4.2 percent through the first three quarters, the ratio of total social financing to GDP would’ve risen by another 4 percent. This doesn’t change the official data. But it does illustrate how one small change can ripple through a range of closely followed variables.
It’s also important to recognize how narrow this shift is. The economy as a whole isn’t deleveraging: New total social financing is up 16 percent this year, and household borrowing has risen by 23 percent. That basic commodities can nonetheless have such an impact reveals just how much China still depends on them for growth, whereas these price increases have barely registered in other major economies.
China’s government may hope that inflation is the path of least resistance in reducing debt levels. And under some conditions, that might be true. But this approach comes with significant risks. Although inflating away debt may work for certain industries in a controlled economy, it is dangerous for a country running a fixed exchange-rate regime where asset prices — such as housing and stocks — are already elevated. Rising prices will eventually place serious pressure on the exchange rate, and a significant acceleration in consumer inflation could lead to social instability.
More to the point, commodity prices can’t keep rising by 50 or 100 percent a year forever. Analysts are already predicting a decline in the Producer Price Index, as the “base effect” that sometimes distorts inflation figures starts to kick in. Meanwhile, for all the talk of deleveraging, debt is growing faster across a range of measures compared to last year, meaning that substantially faster inflation would be needed to really make a dent.
Ultimately, trying to inflate away debt sector by sector is a losing battle. Rebalancing China’s economy in a sustainable way will require substantially reducing credit and tolerating more corporate bankruptcies, slower growth and higher unemployment. There’s no easy way out.