Forecasting Inflation in China

Inflation in China is something of a hot topic to the extent that the blog and newspaper coverage of this topic is seemingly endless. China Financial Markets for example has long detailed posts on inflation and its cures and consequences daily.

This academic paper from the Bank of Finland is either very timely or completely out of date already. I find it hard to believe the forecasts from a month or two ago can be in any way accurate even a few months later.

The methodology may be of more interest.

Judge for yourself.

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Forecasting Inflation in China

AARON N. MEHROTRA
Bank of Finland - Institute for Economies in Transition (BOFIT); European University Institute - Economics Department (ECO)
JOSÉ R. SÁNCHEZ-FUNG
Kingston University January 27, 2008

BOFIT Discussion Paper No. 2/2008

Abstract:
This paper forecasts inflation in China over a 12-month horizon. The analysis runs 15 alternative models and finds that only those considering many predictors via a principal component display a better relative forecasting performance than the univariate benchmark.


Keywords: inflation forecasting, data-rich environment, principal components, China

JEL Classifications: C53, E31

Earthquakes and monetary policy

China Financial Markets looks at the monetary implications of the earthquakes. Economics does not stand still.

The devastating earthquake is also bad for monetary policy [China Financial Markets]

This has been a sad week for China, and it has certainly not been easy to watch on television the heartbreaking scenes of the effect of Monday’s earthquake. Sichuan is a heavily populated province, and many of my students have friends and family in the affected areas, so the disaster has hit us very hard. The fact that so many of the victims were schoolchildren makes it all the more horrifying. Bless China, as my student Gao Ming wrote me earlier today, a phrase many worried and dismayed students around campus have been repeating. Next week my friends and I will organize a concert to raise money for the earthquake victims. It’s not much, but everyone feels helpless and wants to do something to help, however small.

Unfortunately the earthquake and its corresponding devastation are almost certainly going to complicate matters horribly for the PBoC in its attempt to manage monetary policy and fight inflation.

Things are likely to get very tricky indeed.

Clearly the earthquake in Sichuan will not only impact agricultural production and the ability to deliver products to the market, but its reconstruction will fuel a boom in demand for energy, materials, and a wide variety of related goods and services. Recognition of the impact of the earthquake both on loosening monetary policy and on increasing the demand for a variety of goods seems to have powered the stock market today. It closed up 2.73% today, driven by smelters and banks.

The government’s automatic response to this potential surge in demand is to clamp down even tighter on price increases, but this cannot possibly have any but the most adverse effect. After all it is one thing to freeze prices in order to drive out inflationary expectations, but the earthquake has caused a real increase in demand and a real decrease in supply – and the stock market immediately recognized that fact. How can price freezes possibly eliminate the disequilibrium?

In fact yesterday’s China Daily had a very long article on the difficulty of maintaining existing price freezes. The article is called “To raise oil prices or not, that is the question” and starts out very bluntly with: “Diesel sold out. This notice can be seen at many gas stations in the country.” It explores both the difficulty of keeping prices at current levels – shortages and an increasing fiscal subsidy – and the difficulty of letting prices rise – the inflationary impact. People like me of course will point out that price freezes simply convert inflation from one kind, the kind that’s measured in CPI, to another, the kind that shows up as shortages and higher taxes, but the idea that China does not have monetary inflation, simply a temporary food-supply problem, has become so ingrained in policy, even though fewer and fewer people believe it, that its impact will stay with us for a while.

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"Wrong number": On the reliability of Chinese Data

Following on the heals of the last post and thanks to Chinalawblog for the pointer.

As an economist who works with large amounts of Chinese data this issue has arisen many many times without a satisfactory solution. The Economist discusses this issue at length. I tend to use province level data - this raises a set of problems that this article also covers.

An aberrant abacus

AS CHINA'S importance in the global economy increases, investors are paying more attention to its economic numbers. Yet the country's official statistics are notoriously ropy. Some commentators accuse China's government of overstating GDP growth for political reasons, others complain that the official inflation rate is fraudulently low. So which data can you trust?

One reason to be suspicious of GDP figures is that China is always one of the first countries to report them, usually only two weeks after the end of each quarter. Most developed economies take between four and six weeks to produce them.

So which data to trust. From Statistics that Don’t Add Up [China Business Services]

The Economist also provides a guide (developed by Goldman Sachs) to the reliability of official Chinese numbers. It gives a score to different sets of stats, 5 being the most reliable, and 0 the least:

• Foreign Trade: 5
• Money Supply: 5
• Industrial production: 4
• Consumer Prices: 4
• GDP: 3
• Retail Sales: 3
• Fixed Investment: 2
• Employment: 2
• Average Earnings: 1
• Unemployment: 1

On the issue of province versus country level data:

Chinese provinces independently report GDP, and a weighted average of their figures consistently gives higher rates of output and growth than those reported by the central government (see chart). True, local officials have an incentive to inflate growth numbers because promotion depends upon economic performance; however, experience suggests that number crunchers in local government are more accurate than Beijing's. For instance, the figures first published for 2004 showed that the sum of the provincial GDPs was 19% bigger than the reported national figure. Lo and behold, in 2005, after a national economic census picked up more services, the NBS revised its GDP up by 17%; it also lifted the annual growth rate over the previous decade.

Finally, as someone who uses a lot of trade data here is the good news:

Foreign trade is perhaps the most accurate economic indicator. Critics accuse China of fiddling its trade figures, because the value of its exports as measured by the importing country is always much bigger than what the Chinese report. This discrepancy reflects the fact that China's bilateral trade figures exclude goods shipped to Hong Kong before being re-exported. But this should not affect total export figures and detailed Hong Kong data are available to adjust bilateral trade flows.

An interesting topic.

"Huge wealth; huge misery": China by numbers

The Independent on the 10th May had a China special. The numbers at the end of the article are worth posting to have on record.

Whilst the writing style is "sensationalist" it is well written and does paint a good picture.

The dragon awakens: China, how did it happen? [Independent]

What is happening in China is the greatest economic story on the planet. It is the world's biggest boom – and not just the biggest boom right now, but the biggest boom that has ever occurred in history.

As an economist I like numbers. For anyone in the US or Europe these numbers are astonishing. It takes many years to get agreement for just 1 runway in the UK let alone a whole airport (or 97 of them).

The statistics of the boom are astounding. China consumes nearly half the world's cement and produces 40 per cent of its socks. It commissions a new power station about every four days and last year built as much power generating capacity as the entire output of France. It plans to build 97 regional airports in the next decade. And so on.

This comparison with the UK over 100 years ago is a good one.

The other occasion was on the train pulling out of Shanghai. We were passing a wasteland, a site that had been cleared for new building. I glanced out of the window just as we were passing one of the last of the buildings left standing and for an instant saw a group of concerned people carrying out an elderly woman, who was clearly in some distress. I am pretty sure she was being taken from her home prior to its demolition. Then the train picked up speed and we were gone.

Victorian England must have felt like this. Visitors to Manchester were equally appalled and in awe of the stream-driven cotton mills. Huge wealth; huge misery. People ran to the city not because there were good jobs in the mills but because it was a better living than they could have had in the country. At least there was food to eat and there was money to be sent home. And so the workers flock to the cities in China, to what we would call sweat-shops, to produce the toys, clothes and furniture for the shops of the West.

As economists we should not pretend that things in China are any different but as happened in the UK and US these are growing pains that all economies need to go through. China will grow out of these pains a lot quicker than the West ever did (using and adapting Western technologies).

Before China reaches this position these growing pains could get out of hand - can the government negotiate the line between growth and social unrest:

Social tensions and economic inequalities may be even harder to tackle. You can really only catch a feel for that from the Chinese people themselves. A young Shanghai woman told us how she and another friend had spent their last holiday travelling round the deep country: they wanted to see the other China. She described houses where the animals lived on the ground floor, the family in the middle and the fodder was stored in the loft. She realised that these farmers had never seen people like her, the foreign-educated, new middle class of the cities, just as people like her never saw life in the countryside. They could not communicate for there was no common language. The division is even more stark than Disraeli's two nations: at least we could talk to each other.

As someone who writes academic papers on China this final paragraph reveals that there will never be a shortage of research ideas. This is an excellent finish to a very interesting article.

I am not sure we in the West fully grasp the magnitude of what is happening. Intellectually we can see it affecting us but emotionally it is hard to understand that we are moving towards a world where Western ideas, our ideas, will no longer hold sway. China has other ideas. Those will increasingly co-exist alongside ours in shaping global economic and political development. You can see that most obviously in Africa now. If a country seeking inward investment does not want to submit to the guidelines of the World Bank or Western donor agencies it can, if it has something to sell, get China to supply the funds or build the infrastructure instead. This is just an early sign of the shift in power that will go much further.

We will not find this comfortable. What we think will matter less and less. But we cannot do anything about it, and in any case, consider the alternative. Would we really want a China that was failing in economic terms, with all the misery that would cause? That would surely be far more dangerous and disruptive to the world than a continuation of China's thrilling but terrifying success story.

Here are some of the famous numbers:

30,000: The expected number of Chinese MBA graduates in 2008. The number in 1998: 0

5.7 million: Students graduated from Chinese universities in 2007 (compared with 270,000 in 1977)

30: Number of nuclear power plants being built in China

500: The number of coal-fired power plants China plans to build in the next decade

10 million: The estimated number of Chinese people who have no electricity

97: New airports to be built in the next 12 years, bringing the total number to 244 by 2020

540 million: Number of mobile phone users in China, with an increase of 44 million in the past six months

95: The estimated percentage of DVDs sold in China that are fake. Uncensored foreign films are widely available from 50p

160: Cities in China with populations that exceed a million. In the USA there are nine; in the UK just two

80: Percentage of the world's zips produced in factories in the Zhejiang Province city of Qiaotou (amounting to 124,000 miles of zip each year, or enough to stretch half way to the moon). Qiaotou also produces 60 per cent of the world's buttons (15 billion a year), while nearby Datang makes a third of the world's socks. As many as 80 per cent of the world's toys are made in China, which boasts more than 10,000 toy factories

21 million: The number of Chinese-made toys recalled last year by the US toy company Mattel

0: Miles of motorway in 1988

30,000: Miles of motorway today

6.3 million: The number of passenger cars registered in 2007 (compared with 2.3 million in 2004). More than 1,000 new private cars hit the roads every day in Beijing alone

350 million: The number of Chinese people who smoke (a third of the world’s smokers). Around a million people a year are thought to die from smoking-related diseases

240bn yuan: (£17.3bn) The estimated amount earned by the Chinese government in tobacco taxes in 2005

1.3 billion: China’s population. The country accounts for one in five people in the world 400 million

The estimated number of births prevented by China’s one-child policy, introduced in 1979

22: The number of suicides per 100,000 people, about 50 per cent higher than the global average. Suicide is the fifth most common cause of death in China, and the first among people aged between 20 and 35

700,000: The number of people living with HIV or Aids in China. The UN has warned China it could have 10 million cases by 2010 unless action is taken

Tougher stance on inflation

On the back of the steep rise in prices of 8.5% in April China announced further monetary tightening.

What is more worrying is the suspension of the appreciation of the RMB. This may prove to be counter-productive.

The story is covered expertly by the FT (saving me the time).

Beijing takes tougher stance to combat steep rise in prices [FT]

China announced fresh monetary tightening measures yesterday after inflation data showed price rises of 8.5 per cent in April, the second highest monthly figure for 12 years.

The People's Bank of China lifted the share of funds that commercial banks must leave on deposit with the central bank by 50 basis points to 16.5 per cent, the fourth increase this year.

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While Beijing is maintaining an official monetary tightening bias, it appears to have suspended the appreciation of the Chinese currency - regarded by economists as another key instrument for fighting inflation.

The renminbi has stalled in recent weeks against the dollar, after appreciating at an annualised rate of nearly 20 per cent in the first quarter of this year.

Beijing-based economists and government officials, speaking on condition of anonymity, said the PBoC, long known as a supporter of faster currency appreciation, was now being blocked by other ministries.

They said that the slowing rate of the growth of China's exports had prompted some ministries to press for a pause in renminbi appreciation, in order to minimise the impact of the currency on export industries and employment.

China recorded a trade surplus of $16.7bn in Aprilbut the rate of growth of imports outpaced exports.

The PBoC has generally argued that currency appreciation is essential to stemming the growth of the trade surplus and the unchecked flow of speculative funds into China. Rising food prices continue to be the largest contributor to inflation, with year-on-year price increases in this sector hitting 22.1 per cent in April, compared with 21.4 per cent in March.

But economists say the underlying driver of inflation is the excess demand created by the huge flow of funds into China through the trade surplus and other avenues, as well as the velocity at which money circulates in the economy.

Beijing's efforts to talk down inflation by issuing headline-grabbing edicts that threaten price controls and other administrative measures do not seem to have borne fruit so far.

"As underlying inflationary pressures remain undiminished, it is vital for the government to keep its tightening policy stance to anchor inflationary expectations," Goldman Sachs said.

Inflation picking up speed

From Bloomberg.

This article sums up nicely the inherent dangers when inflation begins to rise at rates like this.

China Inflation Quickens; Close to Fastest Since 1996

May 12 (Bloomberg) -- China's inflation accelerated to close to the fastest pace since 1996 as food prices soared and the government slowed gains by the yuan.

Consumer prices rose 8.5 percent in April from a year earlier, the National Bureau of Statistics said today, after gaining 8.3 percent in March. That topped the 8.2 percent median estimate of 22 economists surveyed by Bloomberg News.

Food prices jumped 22 percent, a threat to social stability as the world's most populous nation prepares to host the Olympic Games this summer. Faster currency appreciation, while reducing import costs, also risks attracting more speculative funds into an economy flooded with cash.

Zero Profit in China

An interesting article from Far Eastern Economic Review (thanks to China Game and Paul Midler for the HT and writing the article).

The arguments expounded in this article are fairly sound and provides a number of interesting insights. First, that economics is a long term game, second, that profits are not the only motives of individual firms (at least in the short run). Finally, he points out that many foreign economists (including myself) predicted non-performing loans would cripple the banking sector. Whilst I think this is still a potentially serious problem I think Midler makes a good point in this article.

This discussion on over supply and copyright issues is also interesting.

It is worth reading in full.

Why Profit Zero Works in China [Far Eastern Economic Review]

Profit zero scenarios are a product of Chinese business history. Back when state-owned factories acted in place of a social welfare program, manufacturing’s primary goal was not profitability, but job creation. Throughout the 1980s and into the 1990s, when the planned economy failed to stimulate enough job growth to approach full employment, the Communist Party looked to private industry, and entrepreneurs who could put people to work garnered a degree of political clout with government officials. Profitability was important, but it took a back seat to the achievement of political aims. Manufacturers consequently found themselves motivated to sign cross-border agreements with foreign companies.

While one benefit was the acquisition of new technologies, even more important was the opportunity to learn how business was done in a market-driven economy. It was in this environment that Chinese companies willingly gave up short-term profit opportunities. Some manufacturers viewed their first big contracts the way a college graduate looks at an unpaid internship—a sacrifice made with the understanding that it would pay off later. Labor in China was already cheap, and factories willing to forgo a profit margin made themselves even more attractive. With prices held artificially low, importers rushed into the market.

On the banking sector:

Of course the opportunity for profit zero would not have been made possible without help from the banking sector. Chinese banks loaned money to manufacturers for years without pressuring them to make payment, and, while foreign economists suggested that nonperforming loans would cripple the economy, China ultimately proved the value of a profit-zero strategy. Some of the bad lending that went on was occasionally the result of corruption, but the average loan made to a manufacturer was legitimate. Industry in China has long been in the habit of building production capacity well in advance of any actual need. Importers hesitated to place orders unless they saw a factory that at least on the surface looked capable. Manufacturers and bankers understood that a shining new factory was like a billboard. In most economies, an entrepreneur must prove a need for a capacity expansion before money is lent.

An excellent article.