Will China Export Inflation? We Have Our Doubts

Ever since China’s government renewed its GDP growth target of “around 5%” for 2024, investors have been wondering how officials planned to get there. How would they address signs of weak consumer demand, the property crash’s hangover and the downstream consequences of the Tech regulatory crackdown as well as the US’s Tech export restrictions? The government’s attempt to answer that started emerging over the weekend, courtesy of a big policy speech from Premier Li Qiang: big public investment in manufacturing and infrastructure to foster “new, quality productive forces.” Predictably, economists are racing to estimate the impact not just on China, but on global growth and inflation. One, from the New York Fed, caught our eye Tuesday as an example of the skepticism lingering in this bull market.

The full analysis, which you can find at the New York Fed’s Liberty Street Economics blog, is long, but worth a read if you are into that sort of thing. After slicing and dicing a range of Chinese data and plugging certain assumptions into their models, the economists concluded that industrial stimulus risks causing a “sugar high” in China’s economy, creating fast but unsustainable growth that pushes inflation higher on our shores.^[i] They acknowledge their findings are an outlier from conventional wisdom, which argues stimulus and subsidized Chinese exports will flood the West with cheap goods, causing the US to import disinflation or maybe even deflation. They do see this cheap export flood as likely, but they argue faster growth within China will outweigh it, boosting demand (and competition) for global imports, while the manufacturing push will hoover up global commodity supply—pushing natural resource prices higher and renewing supply chain kinks.

Perhaps the most interesting thing about this is its reflection of sentiment. Considering how long the world has feared a Chinese hard landing, it would seem fair to presume the prospect of faster growth there would cheer investors some. But that doesn’t seem to be the case, and this piece isn’t the only one we have seen casting it in a rather negative light. Even those that don’t take their thesis all the way to reaccelerating global inflation see a Chinese resurgence as the potential impetus for a trade war, not a jump start for the global economic engine. This is the sort of reaction we would expect to see at the beginning of a bull market, when the pessimism of disbelief reigns and all good news gets cast as secretly bad or soon to become bad. We aren’t at that deep pessimism today, nearly a year and a half from global stocks’ October 12, 2022 low. But the general mood over China shows plenty of skepticism remains in the marketplace, which is a counterpoint to all the talk of AI hype-fueled bubbles.

Especially if the skepticism has a high likelihood of being misplaced, which we think it does, in a roundabout way. This might sound weird, because we aren’t as optimistic when it comes to the actual Chinese economic forecast. Attempting to turbocharge growth through heavy industry and infrastructure is a move from China’s old playbook, before officials shifted emphasis to services and consumption over a decade ago.

Then, they changed tack because the old ways were increasingly inefficient, requiring ever more investment to produce equivalent GDP. The payoff just wasn’t there, inspiring the government to instead continue China’s progression along the typical development arc from agriculture to manufacturing to services. This bore a lot of fruit over the years as services grew faster than heavy industry and became the largest segment of China’s economy. But it also meant growth naturally slowed as China continued growing off a larger base. Slower growth probably continues, and while we think headlines elsewhere overstate the fallout from repeated COVID lockdowns and the property bubble’s aftermath, we doubt investment in heavy industry boosts domestic demand enough to drive rip-roaring services and consumption growth. Much of the spending, as has been the case in solar panels in China, may be misallocated. The New York Fed agrees with this in its long-run analysis—it just sees a temporary boomlet in the interim.

But for argument’s sake, let us throw China a bone and presume the public initiatives do at least drive a factory construction boom and increase global commodity demand—first from construction, then from the new factories buying up resources and intermediate components. Is this the Western inflationary scenario the New York Fed makes it out to be? We don’t think so, for a simple reason: When demand increases, supply responds.

That is just how commodity cycles work. Demand outstrips supply, lifting prices. Those higher prices incentivize commodity producers to invest in new mines or boost output at existing ones. New supply soon follows, stabilizing prices. Eventually they overshoot, production outstrips demand and prices fall—leading to the same shortages that start the cycle over again. Whenever China heats up, copper, steel and other industrial metal producers ramp up pretty quickly in search of the added profits. This is why past China booms haven’t fueled hot Western inflation, and we doubt it would unfold differently this time.

Nor do we think higher Chinese exports are likely to cause major new global shipping headaches, reaccelerating inflation from that angle. We just have too much fresh evidence of the supply chain adapting to similar disruptions after the pandemic, and now global shipping capacity is on the precipice of a big increase as fleets add new cargo ships—estimates of added capacity run close to 10%.^[ii] Here, too, we also have evidence from past stretches of hot Chinese (and Asian in general) exports that shipbuilders are happy to respond to higher demand, keeping rates in check.

So overall, we don’t think China’s new growth strategy means a ton for developed markets, good or bad. A backlash to cheap subsidized imports is worth watching for the distant possibility it could lead to a trade war, but that is a ways off from here and hardly a given. Misallocated investment creating winners and losers in China is a risk as well, but given how isolated China is from global markets, any fallout is unlikely to spill over. Most likely, China continues growing at gradually slower rates, as it did pre-pandemic. That is the status quo markets have been just fine with for a while now.