Is China heading towards stagflation?

China’s consumer price index rose by 2.5 percent in September from a year earlier, a seven-month high and up from a 2.3 percent growth in August. The producer price index increased by 3.6 percent, after a 4.1 percent gain in the previous month.

Some believe the CPI rally was due to rising food and oil prices. The weakening yuan also played a part.

The country's money printing has become a serious problem. Currently, its GDP is only two-thirds that of the United States, while its money supply (M2) is double that of the US.

The yuan would slump even more if China achieves full convertibility of its currency. Asset prices have also spiked amid the excessive money supply.

An overvalued currency and inflated home prices are signs of an asset bubble. The authorities can support a high exchange rate and rising home prices when economic growth is robust. But they may have to let go of one if the market turns.

Hong Kong allowed a free fall of housing prices and wages during the 1997 financial crisis. Beijing may also let the yuan or home prices slide.

The Chinese currency has plunged 10 percent since the start of the US-China trade war. We’ve already seen what Beijing wants to let go. Hong Kong had a miserable six years in the wake of the home price crisis.

China may mainly use the exchange rate to cushion the impact of an economic downturn. As such, inflation may pick up further if food and oil prices stay high and the yuan slumps another 10 percent next year.

Oil price increases are generally thought to fuel inflation. Crude has quietly surged to US$80 a barrel from a low of US$40. Two years ago, Saudi Arabia pledged to ramp up production to tame the oil price and weigh on the US shale gas industry. But why is it not working?

The oil price rally this time is mainly due to political factors. The United States has resumed sanctions on Iran and joined hands with Saudi Arabia in capping oil supply. That has helped the oil price to recover.

Some speculated that US President Donald Trump is close to American oil producers, while others suspected that the US wants oil prices to stay high in order to contain China.

We can find some historical precedents. The US deliberately kept oil prices low during the Cold War more than three decades ago. That had brought a heavy shock to the oil exports of the then Soviet Union and eventually contributed to its breakdown.

Currently, China’s two largest imports are chips and oil. Is it possible that the US intends to increase China's inflation and contain the nation's economic growth with higher oil prices?

An uptick in inflation does not necessarily mean healthy economic growth. It can come along with stagnant growth, which is called stagflation. Consumer prices are driven up not by strong demand but by rising costs. Stagflation could harm corporate earnings as much as deflation.

The US is the engine of global economic growth. If US economic growth falters, global inflation would be subdued. The core personal consumption expenditures (PCE) index in the US has already reached 2 percent.

This is not low historically; the last time it reached this level was in 2007. Back then, the federal fund rate was at 5.25 percent rather than 2.25 percent. If the PCE index maintains its current level, US inflation is likely to pick up.

The tax cut the Trump administration introduced last year has spurred corporates to ramp up investment in the country, which in turn has pushed up wages and put pressure on inflation. It’s rumored that US may launch a wave of large-scale infrastructure projects, which could further bolster the economy and inflation.

The exchange rate determines asset valuation, while inflation determines interest rates. To forecast the stock market performance next year, investors should first try to determine whether we are heading towards inflation, deflation or stagflation.

This article appeared in the Hong Kong Economic Journal on Oct 19

Translation by Julie Zhu with additional reporting

[Chinese version 中文版]

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