Comments from China and Germany about another round of quantitative easing (QE2) by the US Federal Reserve have a ring to them of someone caught with a hand in the cookie-jar.
Both nations have denied that the flood of their excess savings contributed to the sharp shift into deficits and dis-saving by deficit countries, notably the US, in the 2003- 2007 period. The irony now is that Berlin and Beijing are arguing that US liquidity creation is damaging because it causes inflation in the rest of the world. While they claim it’s possible for money to flow from the US elsewhere, both countries fail to acknowledge that savings in surplus countries also flowed into the US, driving up asset prices and reducing the apparent need to save. Is Wolfgang Schäuble, Germany’s finance minister, “clueless” (as he labelled the Fed) – or just a hypocrite?
When it comes to the pillorying of other countries’ behaviour, Beijing generally yields to no-one, yet today it overlooks Germany’s obstinacy. US QE2 is likely to prove counterproductive for the US in the short term, but highly effective in bringing home to Beijing the downside of the yuan-dollar peg.
Chinese currency undervaluation and US dollar overvaluation is already doing the inevitable: driving the US towards deflation and China towards inflation. Chinese CPI inflation has shot up more than 6% in just over a year – a dramatic shift which would have been worse without numerous price controls and other administrative measures. This picture is likely to deteriorate for China, given an already overheating economy and, now, the double-whammy of extra inflation from QE2.
By linking its currency to the dollar, China joined the dollar economy, where currency issuance is under the ultimate control of the US Fed. QE2 creates more liquidity in the dollar economy which, in effect, flows downhill – in this case to the low-value part of that economy, namely China. Protests about US money-printing ring somewhat hollow from a country whose 25% gain in nominal GDP in two years (from 2008 Q3 to 2010 Q3) has been overshadowed by a 53% gain in broad money (M2). The pipeline of Chinese inflation was already dangerous well before US QE2.
Higher inflation in China because of QE2 is both cost-push and demand-pull. Rising food and energy prices will cut into US real incomes and deflate real demand in the coming months, but the cost-push effect will be more severe in China, where food is one third of CPI versus 14% in the US. Food prices are up more than 10% over 12 months.
China’s yuan, though it has edged up slightly against the dollar, has shared most of the latter’s 5% effective devaluation, giving China’s exporters yet another leg-up relative to Japan, Korea, Taiwan, Germany and others, exacerbating already overheated demand in China’s economy.
Domestic demand must be kept under control in order to get rid of existing overheating, offset cost-push inflation, and to mitigate the inflationary impact of the dollar-peg. Interest rates have inched upwards, but remain more negative in real terms than a few months ago. The negative real cost of capital raises the risk of further wasteful investment. This means that consumer spending and investment demand will need to be restrained.
The true cost of the yuan-dollar peg is inflation, which will lead to an aggressive clamp-down on China’s economy. This week’s small increase in banks’ reserve requirements was a tiny token of what is needed to keep prices in check.
Yet China now has a shot at a “win-win” deal: to trade an appreciation of its currency for something it wants from the US. Currency appreciation will limit the impact of inflation and the coming cuts in domestic demand. And China can trade a currency move for something it wants. The talk in Beijing three weeks ago was that a 3-5% appreciation was acceptable, but a sizeable revaluation remained a non-starter. The Seoul G20 would be the natural place to cut that deal.
Charles Dumas is chairman and chief economist of Lombard Street Research and author of Globalisation Fractures: How major nations’ interests are now in conflict (2010)