The Global Economy and The China Effect

The aim of this entry is to take you through what has been termed by many the 'China effect' and how this effect may or may not be on the decline. Before we move into the nitty gritty of the argument we migth want to contextualize this a bit more. So first off; think about the global economy and how best to describe this over the past 5-6 years the current central banks rate hikes and subsequent market wobbles notwithstanding. The first concept to think about here is the 'globalimbalances' which are well accounted for in this Economist survey from 2005. The survey's aim is to examine what is called the 'saving glut' argument which, with a little quote hazzling, states the following ...

(From the Economist)

The idea's (i.e. the 'saving glut' argument) appeal lies in the way it ties together two of the most vexing questions about today's economic landscape: why are interest rates so low? And why can America borrow eye-popping amounts from foreigners with seeming impunity?

(...)

A “global saving glut” could explain both oddities. If savings are somehow super-abundant, the usual relationship between a strong economy and higher interest rates may no longer hold. And if the spare cash is mainly abroad, that should allow America to finance its deficit with ease. Rather than signalling American profligacy, the current-account deficit might simply be the counterpart to foreign thrift.

Yet, the argument above is merely one side of the story. Another point and argument which we need to address is the argument of 'excess liquidity' (hat tip Edward Hugh) which also tells an important tale about the global economy.

(From Joaquim Fels at Morgan Stanley)

"According to our calculations, global excess liquidity has been on a steep upward trend since about 1995. Between 1995 and 2005, the credit-to-GDP ratio has risen by 25%, broad money-to-GDP by 32%, and narrow money to GDP by no less than 55%. The steep rise especially in narrow money reflects the fact that this aggregate is particularly sensitive to short-term interest rates, which were reduced sharply following the bursting of the equity bubble in 2000. Thus, monetary easing has produced an unprecedented amount of liquidity not needed to finance transactions in the real economy and available to chase bond, equity and other asset prices higher."

So what do we have here? What scenario best to describe the global economy - excess liquitidy or a saving glut? Well, dear reader as portrayed by this excellent Economics Focus article from The Economist, the two are not necessarily mutually exclusive.

(From the Economist - note that knowledge about the IS/LM schedule is nice in order to understand The Economist's conceptualization)

'In fact, the two theories are not mutually exclusive. Too much saving relative to investment may well have gone hand in hand with excess liquidity, ie, both the IS and LM curves have shifted downwards. Central banks' monetary easing was, after all, partly in response to a fall in investment after share prices slumped. However, the current rapid pace of global growth suggests that excess liquidity is the prime cause of low bond yields.

The snag is that central banks will eventually have to mop up the overhang of liquidity and bond yields will then rise.'

This last bit is obviously what is happening now but we will leave that for just a bit. Let us in stead return to one of the questions initially raised in the context of all this; why has interest rates been kept so low for so long or put in another way; why has not all this excess liquidity spilled over into inflation pushing rates up?

Enter the China Effect and its Reversal?

Quite simply put, China and other emerging markets have been exporting deflation in manufacturing and consumer goods which has gone right smack into the heart of Western countries' CPI indexes; or put in an IS/LM context.

'Why isn't excess liquidity generating inflation? The basic IS-LM model assumed that the price level was fixed, and thus its inability to explain high inflation rates in the 1970s and 1980s hastened its fall from grace. If an economy is at full employment, an increase in money leads to higher prices, not lower bond yields. Today, however, the model may be more relevant because the entry into the world economy of cheap labour in China and other emerging economies is helping to hold down inflation. In a world of low inflation, IS-LM rides again.'

Another way to explain this comes from Chris Dillow over at Stumbling and Mumbling as he explains us why deflation matters?

'Goods price deflation is a sign that the economy can grow quickly without stoking up inflation. And if stock markets can look forward to non-inflationary growth, share prices should be high, as investors anticipate profits growth and low interest rates. (...) You can think of goods price deflation as a sign of a positive supply shock.'

But the global economy as it is described above might very well be a story of the past as all major central banks have embarked on a raising hike in order to scoop up all this excess liquidity and hold down inflation. But wait a moment; this must mean that one of the premises of the low inflation environment is changing and incidentally there is much data pointing to a reversal in the so called 'China Effect'. Actually there is a lot of data pointing to this and I won't go into all of it here (please see my list of references below); the point is well summarized by this Economist article in the recent print edition.

China's excessive growth is not only of domestic concern. With much of the world increasingly worried about inflation, questions arise about what an overheating Chinese economy could do to global prices. It seems strange to worry about China exporting inflation—as Mervyn King, governor of the Bank of England, did recently—when the country's consumer-price inflation is less than 1.5% and its vast manufacturing (over)capacity has led to a steady drop in global goods prices from shoes to electronics. For the past few years, China's deflationary impact on manufactured goods—known as the “China price”—has outweighed its inflationary effect on commodities and capital goods.

But that balance may be changing, argues Jonathan Anderson, an economist at UBS in Hong Kong. “Current data [in China] show that we are on the verge of an inflationary correction that will have a cyclical impact at home and abroad,” he says. After being squeezed between rising input costs and falling factory-gate prices, China's manufacturers are starting to raise prices to rebuild margins—and getting away with it because both domestic demand and exports are still far stronger than they were two years ago. Add in higher domestic food and energy prices and surging labour costs, and the China price may soon be a good deal higher.

List of references

References cited above

Dillow, Chris - Why Deflation Matters; June 13th 2006.

Economist, the - Excercising its pricing power; June 22nd 2006

Economist, the - The Great Thrift Shift; September 22nd 2005

Economist, the - A Working Model; August 11th 2005

Fels, Joaquim - Is Global Excess Liquidity Drying Up?; November 8th 2005

General References related to the topic and the 'China Effect'

BusinessWeek - How Rising Wages Are Changing The Game In China; March 27th 2006.

Financial Times, the - Globalisation could 'raise inflationary pressure'; April 14th 2006. See one of my previous post for a lenghty quote.

Financial Time, the - China's competitiveness on the decline?; March 22nd 2006. See also Edward Hugh and Mark Thoma for quotes and comments and my own post as well. Finally this post by Brad Setser also touches upon the topic from the perspetive of the US' structural trade relationship with China.

IMF - World Economic Outlook 'Globalization and Inflation'; April 2006. See also this post by New Economist.