International | Jun 15 2022
China’s recent lockdowns, coinciding as they do with the Ukraine War, are contributing to inflation in developed markets, but is this just the beginning of the China inflation story?
-Supply chain inflation wreaking havoc
-Is China really the bogeyman?
-China’s deflationary power a huge lever
-When will China’s lockdowns end?
-US Federal Reserve sharpens inflation knife
-ESG Short-Term Inflation Villain, Long-Term Saviour
-Technology holds the key
By Sarah Mills
Supply chain inflation has been dogging economies around the world, the United States last week announcing an eye-watering 8.6% annual rise in its May consumer price index (CPI), a 40-year high.
Covid was the primary culprit. The pandemic provided an excuse to unleash massive stimulus around the world; while lockdowns triggered supply disruptions to both manufacturing supply chains and labour markets, and a shift in western consumption patterns from services to goods.
The Ukraine War was another turn of the screw, sending energy prices and certain other commodities prices soaring.
Throw in demand for green commodities into the mix and we have our current dilemma.
Many are also pointing the finger at China, claiming that its lockdown policy is exacerbating inflation and that the policy is unnecessary given the new weaker covid variants do not justify such drastic action.
Others beg to differ.
Quick Backgrounder On China’s Role In Inflation
But first, it is important to note the major role China has played as a brake on inflation over the past few decades.
The western quest to outsource manufacturing to countries with cheaper labour, while simultaneously reducing the appeal of communism to poorer countries, found its Holy Grail in China.
The mobilisation of western capital through China’s centralised command and control economy acted not just as an inflationary brake but an important lever to global growth, spurring global demand as cheap goods flooded the world.
But China now accounts for roughly 35% of global manufacturing output but only 10% of global household consumption.
The unwinding of this disparity, as China seeks to raise its social scores in an ESG world, is likely to create massive ructions in global economies.
“Structurally, China’s role as a global disinflationary force is waning,” posits Morgan Stanley, as the potential to further depress western wages narrows.
Much of China’s rise, global growth and low inflation during the past three decades can also be traced to the unbridled rape of the environment, another trend which is forecast to reverse according to the ESG narrative (although there are few real signs of a significant reversal at this stage).
Morgan Stanley notes the green transition means the cost to the environment will now have to be accounted for, and this will increase the costs of China’s manufacturing.
These structural shifts are likely to have such dramatic impacts on global economies that it makes monetary policy solutions to modern problems appear archaic and more of a distraction than a panacea.
Short-Term Impact Of China On Inflation
Morgan Stanley notes that since the pandemic started (outside of the most recent lockdowns), China has been a major contributor to ameliorating the cyclical global inflation, managing to maintain supply of goods to the world for most of the two years of the pandemic.
China's exports grew by an average of 25% annually after covid’s initial onset, notes Morgan Stanley, relieving demand pressures while simultaneously allowing the country to increase its share of global export markets.
Many observers point out that this was not entirely altruistic, as it helped deepen China’s grip on global supply chains, just as geopolitical and ESG imprimaturs were pushing towards onshoring, and as Russia invaded Ukraine.
But that still leaves the most recent lockdowns, which coincided with the Ukraine War.
These have contributed to rising inflation within supply chains over the past six months, and, while the picture is far from black and white, most market observers pray for their swift end.
When Will China’s Lockdowns End?
Morgan Stanley notes that China’s exports rebounded in May and expects supply chains will start to normalise by end June or early July, as well as a normalisation in western patterns of consumption away from goods and back to services.
China finds itself in a very different economic position to the rest of the world.
Crackdowns on the housing infrastructure and gig-economy sectors triggered a sharp slowdown in the Chinese domestic economy, which is proving a drag on both domestic and global inflation.
China’s most recent consumer price index stood at 2.1% annually, with core inflation less than half that at 0.9%.
The country’s non-commodity producer price index (PPI) has already peaked and Morgan Stanley expects the retreat will continue, which should reduce prices for imports globally, particularly in the US.
“We think that supply chains will further normalise by end June/early July, bringing further balance to demand/supply,” says Morgan Stanley in its Asia Economics The Viewpoint: China’s Role In The Global Inflation Challenge.
Morgan Stanley also notes that despite the lockdowns coinciding with the Ukraine War, China has helped alleviate global inflation via non-oil commodity prices by boosting supply of exports such as steel and aluminium.
This again was achieved through its crackdown on the overheated housing infrastructure sector, which crushed domestic demand for those commodities.
Morgan Stanley expects this trend will continue into 2023.
FNArena last week asked the panel at the S&P Global Ratings’ Monthly Asia-Pacific Credit Focus webinar: when would China’s lockdowns end?
S&P Global responded that the unofficial consensus appears to be that lockdowns, and China’s zero-covid policy in particular, will end soon after the 20th National Congress of the Chinese Communist Party, in which roughly 90 million delegates from the Chinese Communist Party will vote on the nation’s leadership.
The congress is forecast to be conducted in Beijing sometime in the December quarter, ahead of which, and at, observers are forecasting a major political reshuffle.
This suggests that the lockdowns relate as much to Chinese domestic politics as any other imprimatur.
Roughly 45 cities were in lockdown during China’s spring. Shanghai’s full covid lockdowns ended at the beginning of June, but restrictions remain in place.
Just three days ago, reports that Shanghai and Beijing faced further lockdowns after dozens of new covid cases were reported, highlighting how shaky the situation is.
China’s Position Is Entrenched Despite Western Bids To Onshore
It is a combination of all of the above-mentioned factors that have allowed China to further entrench itself in global supply chains during covid and the more recent period of post lock-down inflation.
Morgan Stanley expects the relocation of supply chains as the West works to reduce its dependence on China to be “challenging, slow and expensive” and believes China’s economies of scale mean “there is no other single location that can match the scale and cost efficiency that China provides”.
S&P Global agrees saying it will take decades for the West to disentangle itself from China, positioning China well on the global stage.
But both the geopolitical and ESG imperatives to diversify away from China remain in place, so Morgan Stanley believes the medium-term risks to the goods inflation outlook are to the upside.
The Fed Isn’t Taking Any Chances
China’s covid lockdowns and geopolitical tensions, not to mention domestic challenges in China, and an ageing developed-market global demographic, are also weighing on global economic growth, raising the spectre of stagflation.
The US Federal Reserve is set to meet on June 14 and June 15, the question being: by how much to raise?
The Economist doubts the Fed will take any chances.
The magazine argues that comparing recent levels of inflation with past indicators may be misleading because of changes to the consumer-price-index methodology in the 1980s, largely due to estimates of the true cost of housing.
Using the present methodology and applying it to the 14.8% peak in March 1980, would instead yield a figure of 11.4%, which would suggest “current inflation levels are thus closer to historical peaks than the official data would suggest,” says The Economist.
Co-author of this research, former US treasury secretary Larry Summers, believes this tightening cycle will therefore be much more painful than the previous cycles (which were painful enough) and that taming the inflation beast will require the same amount of disinflation achieved during the Volcker years.
But Morgan Stanley believes much of the current inflation is transitory (as opposed to its view of upside risk in the medium term outlined above), particularly in the goods component.
This is a view shared by many in financial markets, most expecting US inflation will over the rest of 2022, stabilise between 3% to 5% (the horse appears to have bolted on 2%)
But it is a view unlikely to stand against the Fed’s resolve in the face of a rising CPI.
The Longer View On Inflation
In the medium to longer term, however, most expect inflationary pressure to become more common as the China dynamic unwinds.
One also assumes that ESG-related inflation will remain a constant in the early years of the transition, albeit a fairly controllable lever – the European Union’s recent back-pedalling to include gas and nuclear energy in its taxonomy being just one early example.
Similarly, China recently back-pedalled on its announced shift to mainly recycled steeled by 2025 – pushing this date out to 2030 after iron-ore prices soared.
Meanwhile, ageing populations in China and developed markets are likely to provide a deflationary anchor to ameliorate inflation.
Apart from war, the big wildcard remains technology – particularly that which relieves inflationary pressure on, and consumption of, finite resources.
Will technological innovation be able to yield efficiency gains sufficient to offset the short-to-mid-term inflationary pressures of ESG investment and the structural shifts in China?
Corporations are being compelled to innovate as part of the ESG imprimatur, suggesting the cosy, relatively easy profits of the past are less of a given – increasing investor risk globally.
Impact is the sweet spot of an ESG world, one of the few safe-havens for investors. But it comes with its own risks.
Real competition is arriving and only the fittest will survive, that is assuming investors and corporations can dodge the inflation trap, which is shaping up as the first hurdle.
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