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We think that China is an indestructible economic juggernaut but its economy is very fragile and it is sitting on a property bubble which will burst. What China does in response has major implications for their economy and the rest of the world. This is the third part of a three-part series on this topic

Inflation is on the Rise

I think they will panic if they see western economies weaken. They will panic further if real estate prices start to collapse as a result of tightening policies and western economies weaken. The panic will result in more fiscal and monetary stimulus.

This is right out of the Keynesian playbook and the result will feed the bubble, create inflation, and result in more debt. And, since a substantial part of their official “growth” comes from quasi-government entities (local  and regional governments, Red Army and other State-run enterprises) which are highly inefficient as a result of top-down dictates from Beijing, much of this spending is just a waste of capital. Japan tried the same thing and it didn’t work for them either.

It is remarkable that Premier Wen can get up and say that China will have 8% growth this year. In light of poor exports, a financial bubble, poor internal demand, and the severe risk from  the quasi-government and local government debt bomb, it is unlikely that China will see real economic growth this year approaching that number. Understand that they can claim to have such growth because of how they measure GDP, but it isn’t real.

And they are already seeing  inflation. In February consumer prices rose 2.7% YoY, a 16-month high. Producer prices rose 4.3% in January and 5.4% in February. In light of money supply targets, inflation can only grow. The fact that there is an “output gap” has nothing to do with inflation; idle capacity and high inflation are compatible (remember stagflation). The government’s target is to keep it under 3%. No one believes that.

It is clear that, officially, the CPI won’t exceed 3%, but unofficially? There will be no way to know for sure. I doubt they will announce price controls to achieve their goal, but they have the power to do it unofficially by either fudging the numbers or “jawing” prices down, or both. If they attempt de facto price controls, the evidence of such will be shortages of certain commodities.

The Consequences to China and the World

1. China will lead no one out of the recession. Despite what many commentators tell you, China has weak internal consumption and lives on exports. We cannot look to them to be a leader of the world’s economies because they live off of the U.S., Europe, Japan, and other buyers of Chinese products. The U.S. will lead them out of the recession, not vice versa. The only way they can rapidly spur internal consumption is for them to abandon their wasteful planned economy, fully embrace capitalism, and let those who know how to create wealth and jobs do their thing. … Continue reading China’s Fragile Economy, Its Housing Bubble, and What It Means To Us: Part III