[Viewpoint] China’s asset bubbles keep growing

Money, money everywhere. At least that’s what it feels like at the moment in China. Awash in luxury cars, condos and expensive jewelry, the Chinese are enjoying what looks to be an unstoppable boom.

But inflation figures, due to be released tomorrow, should give pause to those who assume China’s economy is on sound footing. China’s astonishing growth rates these past two years have been fueled by an even more astonishing expansion of its money supply, by more than 50 percent. Until now, the inflationary consequences have been largely camouflaged in the form of rising asset prices.

High-end property prices in dozens of Chinese cities have doubled during the global financial crisis. Sales of gold bars have done the same this year. Fine pieces of jade are selling at $3,000 an ounce, up 50 percent in the past couple of months, while packets of certain types of dahongpao tea are going for $30,000 a kilogram ($13,635 a pound). Art and wine auctions in China are pulling in record prices, while the Shanghai stock market surged 8.5 percent last week to its highest level in almost six months.

Now there are signs that inflation is spilling over into consumer prices. China’s Consumer Price Index has been climbing steadily all year, and Chinese officials are making noises about raising their CPI target to 4 percent or even higher. Food prices gained 7.5 percent in August, from a year earlier. Economists estimate wages are rising about 8 percent. HSBC Holdings’ Purchasing Manager Index survey for August reported a marked increase in input costs being passed along in higher output prices.

If it seems like there’s a lot of money sloshing around the Chinese economy, that’s because there is. Over the past two years, M1 expanded by 56 percent and M2 by 53 percent. Currently, even with much-touted “cooling measures,” both are still growing at an annual rate of about 20 percent.

Unlike the U.S., China never really had a fiscal stimulus, where the government spends its own money directly. The funding for infrastructure and other projects to juice up the Chinese economy came almost entirely from a boom in lending by the state-run banking system.

In 2009, those banks made almost 10 trillion renminbi ($1.5 trillion) in new loans - more than double any previous year - expanding the country’s loan portfolio by a third. This year, they will probably lend 8 trillion renminbi.

Where did all that money come from? It came from Chinese banks being allowed to draw down on their reserves, which opened up a cascade of new lendable funds throughout the entire system. China’s lending boom was, in effect, a massive monetary stimulus or “quantitative easing.”

The pressure behind this monetary eruption had been building for some time. For years, China has been running big trade surpluses. To maintain the renminbi’s peg to the dollar, its central bank must buy up the excess dollars earned by Chinese exporters, to be stockpiled as foreign-exchange reserves, and issue renminbi in exchange. Normally, that newly issued renminbi would add to China’s domestic money supply and fuel inflation.

To prevent that, authorities try to “sterilize” the monetary expansion by forcing banks to hold higher levels of reserve deposits and buy special central-bank bonds. In short, there was a huge reservoir of liquidity bottled up in China’s banks, just waiting to be let out. The low loan-to-deposit ratio of Chinese banks, often touted as evidence of their financial solidity, is really a product of pent-up inflation.

The main tool used to boost bank reserves was the annual lending quota imposed by the central bank. Since banks could lend up to the quota, but no more, most had no choice but to hold excess reserves beyond their reserve-requirement ratios. Then last year, the lending quota went out the window. Actual reserve ratios fell from 21 percent to about 17 percent.

China’s central bank issued more “sterilization” bonds, but effectively, it stopped sterilizing. Trillions of renminbi, formerly locked up in bank reserves, flowed into the economy. The amount of renminbi created far exceeds even China’s nominal, stimulus-fueled GDP growth for the period.

When money is created at a faster rate than real economic growth, the result is inflation. However, China’s official statistics show consumer inflation at barely over 3 percent. Those figures have many economists scratching their heads, wondering where the inflation went, while most people in China seem content to believe their country has found a wonderful new formula for prosperity.

In reality, there is rampant inflation in China. It’s just showing up in asset prices. The new money that was created entered the economy as loans, mainly to fund investment in fixed assets. When it finally reached consumers, they bought tangibles instead of spending on consumer goods.

Asset-price inflation is tricky because it doesn’t feel like inflation. But it’s only a matter of time before asset inflation starts working its way through the rest of the economy as broader price inflation - and puts China’s policy makers in a serious bind.

*The writer is an associate professor at Tsinghua University.

By Patrick Chovanec