Perhaps a recession is the only option for China

The problems of inflation and asset bubbles in China are now on the back of every investor’s mind. The recent series policy tightening has certainly heightened the perceived policy risk in China, which has weighed on stocks and commodities markets.

Photo by Jakob Montrasio

Despite a “low” inflation number of 4.4% (compared to 13% in the United States back in 1979), the problem is actually hard to control. As I written previously, to avoid the Chinese Yuan appreciation, the Chinese authority has allowed the money supply growth to go out of control:

M2 Money Supply, China vs. US (Rebased: Year 2004 = 100)

I am perfectly aware that the situations in China in 2010 and in the United States in 1979 would not be directly comparable, it might be instructive, however, to take a look at how the Federal Reserve back then effectively engineered two recessions to bring inflation under control.

The former Fed Chairman Paul Volcker was widely credited as the one who ended the period of high inflation. Although the money supply growth in the United States was relatively fast in the 1970s (roughly at a low double-digit rate), it was still much slower than that of China in the past few years (e.g. the year-on-year change of M2 money supply hit almost 30% on November 2009). Nevertheless, Inflation was a serious problems back then as increasing oil prices fuelled a double digit inflation. On 6 October 1979, an emergency FOMC meeting was held, shifting policy focus from the Fed funds rate to money supply growth and allowing the Fed funds rate to swing in a much wider range in order to stop money supply from growing too fast. On 22 Oct 1979, less than a month after that meeting, the effective Fed funds rate hit 17.60%, 5.99% higher than the day prior to the meeting. Later in 1980, the Fed also imposed control on credit expansion by restricting banks’ loan growth. This made the Fed funds rate rose further to 19.85% on 31 March 1980. A short recession was engineered.

Effective Fed Funds Rate Source: St Louis Fed (recessions shaded in gray)

The Fed continued to get tough on inflation after the first recession, making interest rates swung even higher. It eventually created another recession, which was even longer and deeper. After this deep recession, however, inflation finally dropped to a low single-digit level, and never quite returned for the next 2 decades. So the period of high inflation ended after a period of restraint in money supply growth (among many other reasons, such as drop in oil prices).

CPI (All item) % Change YOY Source: St Louis Fed (recessions shaded in gray)

So the Fed’s focus on money supply growth made large swing in interest rate, and upswing of it caused two recessions. Truth be told, the money supply growth before Paul Volcker’s tenure was rather slow relative to what we see now in China, and the decrease in money supply growth rate in the United States was not very dramatic. But you may need to expect something more drastic if China wanted to learn from Paul Volcker.

If the Chinese authority is really serious about inflation and bubbles, there will be tough decisions to make. Given the large increase in money supply and expansion of credits over the past years, we have good reasons to believe that inflationary pressure is enormous (so enormous that we may doubt if the government is understating the number). Given the latest year-on-year change of M2 money supply at almost 20%, if the government is serious about inflation, they probably have to slow the growth rate at least to low double-digit rate, which is a sharp deceleration of growth.

To tighten that much, it will mean that Chinese Yuan has to be allowed to appreciate much more quickly, and interest rate has to be allowed to increase sharply. There will be, however, serious repercussion. Exporters will be hurt, credits conditions will deteriorate, home prices will drop… I trust I don’t need to continue describing it, and you know what I mean. Yes, recession. A very deep one indeed.

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About Zarathustra

Zarathustra: Founder and Managing Editor of Also sprach Analyst. Once an analyst, now an investor and entrepreneur. Based in Hong Kong, but Londoner at heart.