Good Tidings in 2011

China must address its property bubble.

China's inflation problem stems from the country's rapid monetary growth in the past decade. That is due to the need to finance a vast property sector, which is, in turn, to generate fiscal revenues for local governments to finance their vast expenditure programs. Unless something is done to limit local government expenditure, China's inflation problem is likely to get out of control.

The government now recognizes inflation as the country's main challenge. It has raised interest rates once, deposit reserve ratios several times, and announced its intention to introduce price controls. The barrage of unconventional measures is due to the belief that China's economy is different from others and the conventional measure of raising interest rates may not be effective or necessary. The reluctance to change the price of money and the willingness to change the price of goods and services has not worked well so far.

Many in China argue that it is better to control the quantity of money rather than price. The price and quantity are two sides of the same coin. For the quantity measure to be effective, it needs to bring down inflation dramatically. A powerful government could make the quantity policy work by limiting credit expansion and forcing down the prices of goods and services. The Chinese government is trying to do exactly that.

The policy's effectiveness is quite limited so far. The government has been targeting credit expansion for the past year. But, the credit expansion outside of the system has made up for the slowdown within. For example, banks can sell corporate loans to their depositors directly, shrinking its balance sheet to meet the government's target. But, nothing has changed in reality. Fitch documented this phenomenon in its recent report.

The ineffectiveness of the recent measures casts doubts on the government's sincerity in fighting inflation. The constant and marginal policy announcements could be interpreted that the inflation fighting is now largely a propaganda job. Such perceptions could spark popular panic, which would cause the household sector to hoard goods like rice and cooking oil. When the masses flee from holding money, a full blown crisis will unfold.

I have been arguing for increasing interest rates. That won't cure inflation either. It is meant to compensate depositors to sustain the value of their wealth. It can prevent social unrest. To cure inflation, China must deal with government expenditures. Unless it is restrained, inflation will continue and keep rising.

There are two ways to limit local government expenditure. One is to cut their funding source. Their main revenue sources are land sales, property taxes, and bank loans. The last source is drying up a bit, as banks are saddled with high exposure to the sector already and are trying to decrease it. This change isn't biting yet because local governments haven't spent all the money they borrowed before.

Deflating the property bubble will have a bigger effect on local government funding. Last year, new property sales reached 14 percent of GDP. The money went one way or another into the government's coffers. Considering the pace of the property market growth local governments expect much more from it in the future. They have planned their expenditures accordingly.

The property under contraction may be worth half of China's 2010 GDP. The land banks that the property developers hold and local governments have prepared could build properties worth considerably more. If all these properties are sold at the current prices, the money supply needs to expand rapidly, at least continuing the 20 percent per annum pace of the past eight years, i.e., money supply doubling every four years. Runaway inflation is inevitable in such a scenario.

One could play games with the money supply statistics by limiting the quantity under the formal definition while leaving loopholes for credit expansion through other channels. It won't change the reality. Inflation will continue to rise even when the government reports slower monetary growth.

Only when property prices drop sharply can we believe that the government is serious about fighting inflation. The level of property prices defines how much local governments can spend. Fighting the property bubble is a must for fighting inflation. As long as property price remains elevated, fighting inflation must be a show only.

Is the solution to the problem is to cut off funding for local governments? I'm not sure. China's local governments are so powerful that they can decisively influence the national policies and find new ways to raise revenues. Without reforming the local governments China's inflation problem may not be solvable.

While conspiracy theories are very popular in China, the reality is that only a bad mistake by itself can cause a big crisis. China is so large and so popular among multinational corporations that it has numerous advantages in the today's world. The international environment is a big plus for the country. Only a big mistake by itself can trigger a crisis.

China has a strong government. The household sector or the business sector lives in the shadow of the government. Only the government system malfunctioning can cause a crisis to bring down the economy. Runaway government expenditure is a clear and present danger to the country. The coming year provides a great opportunity for China to deal with the problem. But, if China lets the property bubble grow, as has happened under previous circumstances, China could suffer a hard landing in 2012. It could unsettle China's development path like so many times in the past century.

Andy Xie is a board member of Rosetta Stone Advisors Limited