CHINA & INFLATION

The China conundrum

May 16th 2006

From Economist.com

With an inflation scare in America, what of the prospects for Asian markets?

OH, WHAT a happy few days it has been for the miserable little commentating class. Too wise to have thrown their own money with the hedge funds’ at Turkish lira, long-dated copper derivatives, Japanese titanium processors or indeed American blue chips, the scribblers have long been giving warning of dire things afoot: of mounting global macroeconomic imbalances, of vertiginous rises in the price of commodities fed only by the rises that preceded them, and of doom to come. Then, late last week and early this, almost everything seemed to fall at once: the dollar, world equities and, with a vengeance, commodities. Money was said to be seeking safe havens, but where to find one? With the financial elite in a panic, cancelling dinners at Nobu, rarely can the scribblers have so fondly patted the pockets containing their piddling pay-cheques.
Things turn fast. The most recent edition of The Economist reported a new high for the Morgan Stanley Capital International global stockmarket index and new records for the prices of copper and platinum. It noted that stockmarket volatility was abnormally low—a mark, very possibly, of investor complacency—but that the breeze was now starting to lift the corners of the picnic blanket. In very swift order, winds have given the blanket a thorough shake.
And already this columnist, sitting in Asia, detects the start of niggling worries among those who believe in the merits of a stiff breeze that they are about to get more than they wished for. A nice easy gentle fall in the dollar is all well and good; a soft popping of the commodity bubble followed by a drawn-out wheeze, all fine and dandy. But a rather-too-precipitous slide in the dollar and some commodity prices? More of the same will not be good for anyone, least of all investors in Asian equities, which have risen handsomely since 2003.
It is of course a dangerous game to separate the deep from the proximate causes of the fear that suddenly stalked the world’s markets, but it is a fair bet to think that America’s Federal Reserve has something to do with both. Ever since his testimony before Congress in late April, financial markets think they may have detected in Ben Bernanke, the Fed’s new chairman, a wavering commitment to fight inflation, despite last week’s quarter-point rate rise, the 16th in a row. The markets are now perhaps inclined to pick and probe.


It is probably too unkind an assessment of Mr Bernanke; the Fed, not yet having perfected its divination of the future state of the economy, is for the moment understandably unsure what to do next. Still, in the currency markets this past week, there were more inflation hawks than doves. The American economy is rollicking along, and so is global growth. Labour markets and capacity utilisation in the United States are tight and, with commodity prices high, inflation is knocking at its acceptable upper bounds. If markets don’t trust Mr Bernanke to take action to slow the economy by raising rates again soon, then they might act first by dumping dollars.
The fear rippling through Asia this week, in other words, was that the Federal Reserve might find itself with a classic inflation scare: faced with a tumbling dollar and rising bond yields, it might have to raise rates higher than it would otherwise have done. That, in turn, could have all sorts of consequences for Asia. Higher rates would floor an American housing market that has done so much to date for American demand, and Asian exports would be the first to feel the slump. Nor would Asia’s long stockmarket rally be able to ignore any sharp corrections on Wall Street.
Will Asia’s current fears play out? This columnist will merely point to a tiny inconsistency in them. The coming supposed trial and torment of Mr Bernanke is predicated on an inflation scare, one driven in big part by recent giddy rises in commodity prices. Yet in the past few days, commodities have fallen with other markets. It seems to suggest that, among those scared about an inflation scare, less value is attached to recent falls in commodity markets than to falls elsewhere.
At any rate, the notion that commodities in the long run can only go up is a remarkably stubborn one in this part of the world, and probably has something to do with the proximity of China, a country with a pattern of growth supposedly built upon the intensive use of commodities. It is a dangerous notion, and here are two reasons.
First, whatever the Fed does next, it has done much in the past two years to normalise a loose monetary policy in which commodities are merely the latest (and possibly the last) asset class to have revelled. The European Central Bank has also been tightening policy, and the Bank of Japan is about to follow. Soon, much less global liquidity will be around to slosh its way into commodity markets.
Second and more important for the region, China’s commodity boom has limits, which it may already have reached. Much is made of China’s appetite for commodities: the country accounts for 5% of the world’s GDP, for example, but one-third of its demand for iron ore, coal and steel. Less is made of how inefficiently China uses its inputs. The country, for instance, uses several times as much oil for each unit of GDP as does Japan: in its rush to develop, as Morgan Stanley points out, it ignored the use of energy- and commodity-conserving technologies. That is now changing. Partly because of the high price of inputs, China’s official strategy is to move away from commodity-intensive manufacturing, which could be done by adopting existing conservation technologies.
At any event, China is attempting to deal urgently with a grossly overheated economy. In a surprise move, it raised interest rates late last month. It is taking measures to cool rampant property development, a key source of commodity demand. And it is trying to rein in bank lending, much of which has merely added to industrial excess capacity. If the measures are even faintly successful, it does not bode well for the commodity bulls. Oh, and if you wanted a signal that commodities were due to fall, the state copper-trading body recently closed out all its short positions.