Asset Allocator's Soapbox: China troubles

Jason Hepner, investment director for global strategy at Standard Life Investments, looks at the implications of rising inflation in China.

There are many issues worrying investors in the world today, such as the situation in the Middle East and the tensions in Europe. However, the inflation path in China, and how well the authorities there cope with a slowing economy, come high up the list.

Recent news has not been good. In May, China’s consumer price inflation (CPI) reached a new cycle peak of 5.5%, its highest since July 2008. Back then the inflation surge forced Chinese policymakers to tighten policy aggressively. Its timing was very unfortunate, coinciding with the credit crunch beginning in earnest in the US, leading ultimately to the collapse of Lehman Brothers, and helping to send the entire global economy into a tailspin.

Could the same happen this time? The parallels are clear and causing consternation for global financial markets. Commodity prices are rising in a broad based fashion. In particular, food prices have risen very quickly – something that is difficult for Chinese households to tolerate. Hence, the Chinese have been tightening policy in earnest – just as sovereign and financial sector difficulties elsewhere enter full swing.

Deep cracks

The fear is that just as China withdraws liquidity and slows its powerhouse economy, deep cracks may reveal themselves in the Eurozone. The market is presently very unsure how the Greek situation can resolve itself. Will Greece have to restructure its debt? Can they enact the kind of fiscal austerity measures that will placate the market, and bring yields on their debt down from the heady levels where they stand today?

Will Germany and France bail out Greece, and what are the knock-on implications for the larger ‘peripheral countries’ of Spain and Italy? The truth is that no one presently knows the answer to these questions – not even the politicians. Hence, these issues represent significant risks for financial markets.

This is all relevant to China in that there is a big difference between China tightening its policy in an appropriate manner at the same time as we see a reassuring solution applied to the Eurozone situation, versus China tightening and slowing its economy, just as we see a severe wave of market turbulence stemming from the Eurozone situation.

It is of paramount importance that policymakers in Europe come up with a credible solution to the Eurozone area problems in order that we do not see a repeat of the difficulties witnessed in 2008. Relating to this, of course, is the key variable of Eurozone demand for China’s export produce. That is to say, the worse the Euro area’s growth slowdown that results from any crisis, then the harder hit China’s exports will be. China’s policymakers will be watching the European situation very closely – once bitten twice shy.

Fortunately, detailed examination of Chinese inflation shows it is by no means all doom and gloom. Core inflation has risen steadily to 2.9% in May, but this is not a serious problem for an emerging economy that is growing at close to 9% a year in real terms. The expectation is that favourable base effects will come into play later this year, and then the year over year impact of higher food and energy prices will lessen in terms of the overall headline inflation level.

The hope is that this will happen before we see too large a further contamination of ‘headline pass through’ into core inflation. China started tightening its monetary policy back in early 2010, hence the lagged impact of a whole range of measures enacted, including property tightening measures, reserve requirement ratio hikes, and some interest rate increases, are starting to bite.

China is the world’s second largest economy, the world’s largest consumer of commodities, and overall it is the preeminent global emerging market. The monetary policy tightening seen in China and some other emerging markets, has been a major factor in the recent underperformance of emerging market equities versus their developed country counterparts.

An easing in terms of Chinese monetary tightening tensions is likely to be an important precondition to allow stronger performance from equity markets sensitive to China’s growth, later this year and into next – as long as there are no policy errors in Europe or the US to damage investor confidence.