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Why Inflation in China Could Lead to Another Global Recession

Inflation in China is far more intractable than official headline statistics reveal.

That's potentially bad news for global growth and toppy stock and commodities markets.

If China effectively dampens dangerously high inflationary expectations and real, rapidly rising food, property and fixed-investment assets by hitting the brakes too hard, global growth could skid and potentially stall out.

The resulting sound of breaking glass would likely be clear support levels enjoyed by rising stock and commodity markets as they finally correct, along with theories of China's infinite growth trajectory.

Even China's Statistics Bureau has said consumer inflation growth is "too fast." And, Vice Premier Wang Qishun recently called inflation "China's biggest problem."

April's headline consumer price index (CPI) reading just came in at 5.3%, well above the official target rate of 4%. The CPI compares current price levels with year-ago levels.

Even though April's CPI number came in above Wall Street's consensus estimate of 5.2% and higher than Beijing's official projection, a sigh of relief was breathed that the rate was lower than March's 5.4% level, which itself was a two-year high.

Still, looking at inflation statistics through a short historical prism indicates much deeper problems.

In 2008, rapid growth in China and rising commodity and food prices around the globe pushed consumer inflation in China to 5.5%. The rate subsequently fell to an approximate rate of -1% at the depth of the credit crisis in March 2009. However, it has since risen steadily, and is once again nearing 5.5%.

Food price inflation (FPI) is far more chilling. Chinese food inflation reached 22.5% back in 2008. And like the overall trend of inflation in China, FPI has been on a steep trajectory higher since bottoming out in 2009. In fact, it just reached a worrisome 11.5% in April, making for the sixth straight month of double-digit gains.

Non-food CPI was up 2.7% in April, the same as in March, and the highest it's been in five years.

And there's even more bad news.

For the January-April period of this year, fixed-asset investment growth was 25.4% higher than the same period a year ago. Additionally, residential investment rose a staggering 38.6% over the same four-month period, according to Moody's Analytics.

The problem facing China is how to foster growth robust enough to keep its huge and growing workforce employed without stoking dangerous levels of inflation. A failure to succeed in either respect could trigger civil unrest.

Inflation in China and the Global Economy

It's important to remember that the global economy is still largely dependent on China.

China for the past few years has been a powerful engine of economic growth that's helped both emerging markets and developed nations rebound from the global financial crisis. If its economy stalls, the impact will be global.

Indeed, Chinese growth is what's truly been driving the world's equity and commodity markets, as well as many bond markets.

With stimulus packages being reined in around the globe, the U.S. Federal Reserve slowly backing off from quantitative easing, and central banks around the world raising interest rates, China's continuing growth is the only fuel still feeding hope and speculation.

If China makes one wrong move, the interconnectedness of economies and overly correlated market plays could quickly test the one-world economy.

The Chinese government's approach so far has been – and should continue to be – targeted and broad-range attacks on the inflationary menace. And so far they've been measured.

On the "targeted" front, reserve requirements have been raised. The theory is that by forcing banks to hold more reserves, less money will make its way through the system to feed rising prices.

Additionally, the key interest rate has been hiked four times since October. By jacking China's one-year benchmark interest rate up to 6.31%, the central bank is essentially throwing a wet blanket over the entire economy. Higher interest rates are more of a blunt instrument than a targeted smart-bomb.

Still, inflation seems to be entrenched.

There is another weapon the government has, but it would have the effect of a sledgehammer on China's vibrant export industry. That would be allowing China's currency, the yuan, to appreciate more than the piddling 5% rise it's had against the dollar over the past year. That would certainly dampen inflation – both in real terms and expectations.

However, the cost of such a move would be difficult to absorb. So that hoped for approach isn't really in the playbook, and won't be for a year or three.

We're already seeing fallout from a mere perceived slowing in China. Oil has dipped on expectations that China might raise rates again. China's imports of iron ore were down 11% in April from March, and were 4% lower year-over-year. Copper imports were down 14% from March to April and down a whopping 40% year-over-year. So is it any wonder that iron ore and copper prices have fallen?

Trillions of dollars have flowed not just into China, but into the raw materials and commodities that have fueled the country's growth and the stocks of corporations that have benefited from its increased consumption.

Now, its capital flows will have to be closely watched.

The minute large capital flows start to move, as they do rapidly in the new world economy, investors need to be watching where money is coming out and where it's being repositioned.

Right now, all eyes should be on China's inflation-fighting policies and actions. With markets bumping up against recent highs and leveraged speculation rampant, any attack on inflation that takes too much air out of China's pumped-up growth rates could flush out weak hands in a matter of weeks, if not days.

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About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Short-Side Fortunes, Shah shows the "little guy" how to make massive size gains – sometimes in a single day – by flipping large asset classes like stocks, bonds, commodities, ETFs and more. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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  1. Jeff Pluim | May 13, 2011

    It would be interesting to know some of the numbers regarding China's, up-to-now, commodities stockpiling. Is it possible that the decrease in the purchasing of these commocities is because China is now starting to consume these huge stockpiles of commodities, and not because the Chinese economy is slowing?

  2. jj | May 13, 2011

    You are correct that this is a major worry.I remember, in past decades,what the U.S. did,economically, had the largest effect on the world economy.Today,it's China that leads the world's growth.So,even if the U.S. Fed keeps an easy money policy,if the rest of the world,and especially China stay tight,we could see a worldwide recession.I think China should adopt an honest currency,like the U.S. had when it was the global engine and had a gold backed currency,a hundred years ago.Dishonest fiat currencies always cause inflation problems.

  3. Pieter Stek | May 14, 2011

    China is caught between two sources of potential social unrest: retail-price inflation and inadequate job creation. Striking a socially acceptable balance between these two with only monetary policy as an instrument is not plausible over the longer term. However, within monetary policy it would appear that more forceful appreciation than the 5% vis-à-vis the dollar is a better instrument than monetary tightening. Why not 6% or 7% or more per annum and why did you not discuss an appropriate trade-weighted rate of appreciation vis-à-vis the rest of the world in stead of only the US dollar? I believe China's leeway for appreciation is much larger from that, more relevant, point of view.

  4. mark chan | May 14, 2011

    If inflation in China is so serious and detrimental to the global economy, the America-led West should stop criticising China on human rights, democracy, rfeedom, etc., and work with China to find ways to tame Chinese inflation. America is too big to fail. So is China.

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