Why does Beijing see “moderate inflation” as conducive?

By He Qinglian on September 5, 2012.

Recently, foreign financial institutions have been issuing warnings on Chinese economy, in particular the risks of its financial sector.


Warning Signs of the Chinese Economy

Goldman Sachs have always been highly positive about the Chinese economy. In their newly published macro-economic report, however, the Chinese economy has been included in the three major risk factors that affect the world's economy. By “three risk factors” they meant the Europe debt crisis, the sluggish U.S. economy and the “hard-landing” risk of the Chinese economy. Goldman Sachs pointed out that, compared to the other two factors—the U.S. economy is improving, the Europe debt issue is calmed somewhat at the moment, China's economic growth would be the one major uncertainty.

Kiyohiko Nishimura, vice president of Bank of Japan, stated on August 21 that property bubble, a change in demographic structure and a rapid growth in loans would increase the probability of a country experiencing a financial crisis, and China has entered the “danger zone” in this regard. Nishimura made his remarks based on the experiences of Japan and the U.S.. Both countries saw the formation of a vicious bubble that would lead to financial crisis when their labor force to total population ratio peaked, coinciding with high housing prices and rapid growth in loans.

That the Chinese economy has serious issues and bad debts in its finance system is nothing new to China. The Chinese government is not as worried about economic crises as Western governments because it knows that unlike in the West, such crises would not lead to political crises and it knows what to do with one as it has succeeded twice in tackling them before.

Solutions with Chinese Characteristics

In December 2003, China exploited the keen interest foreign investors had in entering the Chinese market and enticed 11 international investment banks, including Citigroup, JP Morgan, Goldman Sachs, Morgan Stanley, into buying bad debts of Chinese banks; in 2005, several state-owned Chinese banks became publicly listed in Hong Kong and mainland after “strategic investors”—foreign banks from the U.S., Britain, Singapore and other countries were found and their bad debts restructured and packed. Those staggering debts of 900 billion were thus shared among the investors and those banks got to greatly expanded their capital.

After 2008, the Chinese government used “moderate inflation” to boost the economy. Economist Wu Jinglian did the math on Chinese currency and figured that the currency totaled 1.53 trillion in 1990; in 2011 it was 89.56 trillion, a 58.53 times increase in 21 years. The American currency at the same period increased just 1.99 times.

According to the data of the People's Bank of China, the country's M2 was close to 90 trillion and has become the world's largest currency issuing country—an indicator that inflation in China has exceeded the tipping point of “moderate inflation”.

To this extent, both the Chinese government and its critics would realize the Chinese economy is driven by excessive issuance of currency, yet what has the Chinese government gained from this? And who is footing the bills for the Chinese government?



Through inflation, the Chinese government relieved itself of at least 20% of debts and enjoyed the benefits of seigniorage. Based on the calculation done by political economist Liu Jiabai, in 2010 the total amount of seigniorage in China stood at 4132.6 billion yuan. The total personal income tax in the same year was only 480 billion yuan.

Simply put, what the central government gains for excessive issuance of currency is that the economy could continue to keep growing rapidly and avoid the danger of hard-landing; and the local governments have their revenue guaranteed. The inflation resulted in a major reshuffle of wealth in China. The rich see their assets vastly appreciated as they invest in real property, the common people see their savings reduced to nothing and they have to put up with the most expansive housing prices in the world, the commodity price that would never go down and the burden of heavy mortgage.

The inflation has resulted in the marked worsening of the lives of the middle-class and the grass-root, the people's grievances could be noticed everywhere. Those specialists who spotted the danger came to believe that “hot starts” have too great a cost, the central bank should change its tendency of excessively issuing money.


Printing More Money

Deputy Primier Wang Qishan has vowed a few months back that “[the government] would hold firmly the bottom line that no regional financial crisis should emerge [in China]”. However, there are already signs of crisis in the Chinese economy: lots of enterprises have gone bankrupt, a huge number of people is out of work; foreign businesses are leaving gradually, local governments see their tax revenue decreasing, and their fiscal standing became tight. To solve these, local governments are finding ways to collect more taxes and boost their revenue, the businesses are complaining.

The only way to keep the economic growth above the rate the government expects is that the government makes investment to boost the economy. I noticed Zhou Xiaochuan, director of the central bank, said when answering questions from reporters that, “the possibility of using any monetary policy tools is not ruled out.”

There is only a finite number of monetary policy tools. When adjustment of both the interest rates and deposit reserve ratio do not work, the only option left is probably to issue currency in huge quantity and boost the economy in the form of government investment stimulus. The problem is, at the moment, the power struggle in Beijing has still not settled, this option has to be saved for the fifth generation of leaders or there is nothing they could do to boost the economy after they assume office.



If inflation becomes hyperinflation, what would its implications be for Chinese politics? For this problem, both government officials and the general public alike are deeply concerned. The recent publication of the translation of Niall Ferguson's Paper and Iron: Hamburg Business and German Politics in the Era of Inflation, 1897-1927 in China, a book that talks extensively on the adverse impacts of the “Weimar hyperinflation” is very much an indicator of how concerned the public is.

Throughout human history, there are several instances of hyperinflation. In Germany after the first World War, there was the “Weimar hyperinflation” that began in January 1919 and ended in December 1923. Within a few years, Germany's consumer index shot up 481.5 billion times, 1 dollar could exchange for 4.2 trillion Deutschmark. This hyperinflation is often considered the main cause of the collapse of the Weimar Republic and the rise of Adolf Hitler.

Another instance of hyperinflation took place in China in August 1948. At that time the Nationalist government carried out a currency reform. It issued a new currency, the Gold Yuan, to replace the rapidly devalued legal tender. Yet the Gold Yuan exploded even faster. In less than ten months, 130 trillion Gold Yuan were issued, 65,000 times greater than the 2 billion the government initially stipulated as the amount of issuance. The commodity price rocketed to 1,700,000 times higher than the early stage of the currency reform.

The currency reform that aimed to compete with the people for profit had dealt a serious blow to the credibility of the Nationalist government and has been considered a significant factor of the Nationalist government's retreat to Taiwan and its loss of mainland China.

Interestingly, it was revealed 6 decades later that Tse-ven Soong, then financial minister, decided to issue the Gold Yuan at the suggestion of a secret agent of the CPC.

There is yet another instance of hyperinflation in Zimbabwe a decade before the 21st century. Chinese media had run a report saying Zimbabwe has turned from a heaven on earth to a country that a single egg costs 100 million. The report mentioned specifically the 2,200,000% inflation rate the country saw in 2008.


“Moderate Inflation” is good

When China experienced inflation in the 1980s, the party elders recalled Gold Yuan and felt unsettled. They urged the Chinese authorities to control inflation and to avert what happened to the Nationalist government.

However, after the Chinese authorities had a taste of using “moderate inflation” to boost the economy and got some results in improving employment in 2006, and in particular after it learned from the Mugabe regime that remains in power after a decade of hyperinflation, I believe the high level in the CPC has forged a consensus that inflation itself is not a deadly factor that brings about the collapse of a regime. So long as there is no opposition, they do not have to worry even if there is “moderate” inflation.

The lives of the general public is currently not on the mind of those in power in China, though. 

Headings are added by translator.