PPI and CPI dropped despite a windfall of new credit issued in January and February. The answer to why lies in the type of loans issued.

By Caijing Economist Lu Lei

 

(Caijing.com.cn) Inflation is always and everywhere a monetary phenomenon, claimed Milton Friedman. But he might not be so sure if he saw today’s China.

While China’s new loans skyrocketed in the first two months of this year – new credit in these two months alone amounted over 70 percent of last year’s level – prices for consumer goods and production alike dropped in February, something not seen in six years.

 

Why is there such a striking contrast between China’s current market and the classic theory that price goes hand in hand with overall money supply? Right now it seems that slumping prices and the spate of credit have formed a vicious cycle and are reinforcing each other.

 

First of all, the falling price, or “deflation” as some may be reluctant to call it, reflects a shrinking aggregate demand.

 

Seeing a decline in the producer price index (PPI), which is regarded as a leading indicator for future investment and production, it seems Chinese factories might have already cut capacity or withdrawn investment. Weakening external demand might also force firms to either shut their plants or dump their excessive products in the domestic market, further dragging down prices.

 

This hypothesis might seem contradictory with the 26.5 percent increase in fixed investment in the first two months of 2009, but it is worth noting that this growing investment was largely attributed to China’s stimulus package announced last November. Thanks to that, state-owned and state-controlled companies increased their investment by 35.6 percent in the first two months, and projects funded by the central government saw a 40.3 percent growth compared to last year.

 

By contrast, sectors more capitalized by private investors, such as real estate, have enjoyed little additional investment. Funding from overseas also tapered. This means, unless the government is willing and able to draw on more resources for investment, these privately invested industries are very likely to trend downward.

 

The second major reason for the anomaly is, despite soaring credit, smaller companies are still having difficulty borrowing from banks.

  Note that the loan-to-deposit-ratio has remained at around 66 percent since last year. The implication is that banks were lending in order to maintain a certain ratio as deposits were accumulating. This let them take in more interest payments to offset the increasing interest paid to depositors. In this case, they might have undergone sort of “fire lending.”

 

In order to reduce risk, banks elected to issue short-term credit rather than granting long-term loans. (In February, banks issued 487 billion yuan of notes, compared to 158.2 billion of short-term loans and 367.8 billion yuan of longer-term loans.) But unlike long-term loans, notes and short-term loans won’t spur investment or boost consumption. Therefore, the credit surge is little more than rolled-over debts, and is very unlikely to materialize in the real economy.

 

If banks continue to extend credit into channels that won’t help the real economy, and if companies stick to their over-capacity instead of downsizing production, it is almost certain we will see even lower prices due to excessive supply.

Although we might not see a banking crisis in the near future, the possibility cannot be ruled out in the long-term, especially if China’s monetary authority fails to stabilize the Yuan’s exchange rate. What’s more, expectations that the Yuan will depreciate might be self-fulfilling if people believe China’s trade will continue to contract.

 

The implication for policy is that the China should maintain the current interest rate, the required reserve ratio and the exchange rate, so as to avoid even more inefficient credit and ensure a safe level of capital. It should also use its foreign reserves as a stabilizer and buffer for Chinese banks.