A reminder from China about how inflation can hurt stocks

Most people think China will keep expanding its economy much as it is now. And they think that this will mean it will soon have a bigger economy than that of the US. Indeed, the consensus thinks this will happen at some point in the next 40 years.

But how likely is this really? Let’s not forget that economists have a horrible record of forecasting this kind of thing. As James Mackintosh points out in the FT today, if the economists of the 1970s had been right, the Japanese economy would have been bigger than America’s for well over a decade by now. And if the economists of the 1960s had been right, the Soviet Union would still exist intact and its economy would have been bigger than America’s for a good 20 years.

China has a good story – one of a huge population that both works hard and improves productivity as it goes. But history tells us that however good the story might be, really high growth can’t be sustained for much more than 30 years. After that, productivity of the industrialising economy will have caught up with the developed world, and it just can’t keep rising at the same rate.

Then, as it slows, imbalances in the economy come to the fore – the way corruption or loose lending has led to capital misallocation, for example. You mostly get a crisis of some kind next. It is impossible to tell when this crisis will come. But here are a few things for those interested in it to note.

First, the Chinese appear to have all but lost control of the money supply. The government has been trying to make the banks cut back on loan growth. But, despite the much-feted command nature of the Chinese economy, it isn’t working very well. Note that last year the government set a full-year lending ceiling of ¥7.5trn, but the banks still lent out nearly ¥8trn. Lending is also thought to have hit ¥1trn in the first two weeks of this year alone. That raises the risk of policy overreaction of some kind.

Next is the effect of inflation. The Chinese economy may have grown at extraordinary speed, but the population has come from a very low income base. So food still takes up a huge part of most people’s cash. That means that commodity-price-driven inflation could very easily lead to social unrest.

Another thing those who assume super-fast growth forever might like to note is that China’s work force will peak in about three years. There’ll still be plenty of labour around, but if worker numbers aren’t rising, you can bet that the demands of those still toiling will.
Still, while we can’t tell how or when China’s crisis will come, what we can remind ourselves of, from the current state of the country, is just how much markets hate inflation once it gets above 4%-5%. The Shanghai Composite is down around 15% in the last year and the market lost 3% last week when new releases showed the economy growing just as fast as ever.

Jonathan Allum of Mizuho has plotted a chart of inflation and returns in emerging markets for the year to date and it is notable, as he says, that “the higher the inflation, the worse the performance.” Something to remember as our own CPI heads towards 4%.