Jerome Powell’s China Problem Is Just Beginning

Investors betting that the US Federal Reserve is throttling back on interest rate hikes aren’t paying attention to events in China.

The jump in oil and other key commodity prices already points to a China reopening trade that’s likely only just beginning. In the last month, Xi Jinping’s economy swung suddenly from “zero-Covid” to 100% tolerance, altering the global economic trajectory in epochal ways, Asia Times wrote on Jan 27.

Not least of which is inflation dynamics. The Economist Intelligence Unit’s outlook argues that “stagnation in the US and the eurozone in 2023 will be offset by firmer growth elsewhere, particularly China.”

Even more important, EIU says, “a potential second spike in headline inflation in both the US and the eurozone — which could be driven by another jump in global commodity prices related to the war in Ukraine or China’s economic reopening after the lifting of its zero-Covid policy — could also trigger a more aggressive tightening cycle than we currently expect.”

Even tighter monetary policy by the fed and the European Central Bank “would prompt a more severe decline in asset prices and a collapse in consumer spending, resulting in a deep global recession,” EIU analysts say. “Other central banks in both the developed and the emerging world would be forced to follow suit, weighing on growth across the board and increasing debt pressures.”

All this means that investors expecting an end to fed rate hikes are sure to be disappointed. The same may be true of those arguing the ECB may soon call an end to its own tightening cycle.

*** Much More Tenuous Position

“In our view, a stronger China increases the chances of a stubbornly hawkish Fed,” says strategist Tavis McCourt at Raymond James. “With China, we do need more of everything. If that drives enough demand to get commodity prices back up closer to where they were in the spring of last year, then that puts the progress we’ve seen on inflation in a much more tenuous position.”

Of course, China’s move beyond the Covid era is a positive for global growth and markets. Few would agree more than Ray Dalio, the billionaire founder of Bridgewater Associates, whose 2022 China bet paid off spectacularly.

Reuters reports that Bridgewater doubled its fund assets in China to more than US$2.93 billion over the past year, making it the biggest foreign hedge fund in the world’s No 2 economy.

The feat “goes to show that building a scaled business in China is very much possible,” observes Peter Alexander, managing director of consultancy Z-Ben Advisors.

Yet the inflationary implications of China’s return to normalcy remain an open question for officials everywhere. Raghuram Rajan, former governor of the Reserve Bank of India, says that while “China’s opening is good news overall, but potentially, the inflationary impact — there could be some.”

Rajan, also a former top International Monetary Fund (IMF) economist, is among the few observers who predicted the 2008 subprime mortgage crisis. He notes that “if Chinese natural gas demand increases, because the factories, their households demand more electricity, then it’s going to put pressure on Europe because natural gas, they’re competing [in] the same markets for liquid natural gas.”

In 2022, says economist Fredric Neumann at HSBC, China’s slowdown made US Fed boss Jerome Powell’s job somewhat easier. Yet Xi’s economy will “make it harder this year” for fed officials.

Bank of Korea Governor Rhee Chang-yong notes that China may stoke inflation along with boosting his nation’s exports. “If China’s economy is recovering fast, that might be good for the current account balance of Korea,” Rhee told reporters. “But it may cause crude oil prices to rise.”

ECB President Christine Lagarde harbors similar concerns. China’s reopening, “will have inflationary pressure on many of us,” she told the World Economic Forum in Davos last week. “There will be constraints, there will be more inflationary pressure coming out of that added demand in commodities and energy in particular.”

*** China Consumption Is Ramping Up

The most immediate transmission point is energy markets, says strategist Michael Tran at RBC Capital Markets. “While early, there are already indications suggesting that the Chinese consumption machine” is ramping up, he notes.

“Given the focus on energy security, we anticipate that Chinese imports will continue to pick up, particularly as refinery runs ramp [up] and stockpiling crude remains a strategic priority,” Tran adds.

Chinese household consumption and tourism will have significant impacts on global demand and pricing dynamics. In the short run, this may be a particular risk to Japan, which is experiencing the worst inflation in 42 years.

“After three years of isolation, there’s plenty of pent-up demand for foreign travel,” says economist Sheana Yue at Capital Economics. “We expect outbound tourism to have recovered from virtually nothing to 75% of the pre-pandemic level by the end of 2023.”

Sydney-based economist Tom Kennedy at JPMorgan Chase & Co adds that China’s reopening is “clearly beneficial for the external accounts and gross domestic product,” with the service sector enjoying the biggest boost.

Kennedy adds that in the pre-Covid era, Chinese tourist and student arrivals alone added about 0.5% and 0.4% to Australia’s GDP, respectively.

“These numbers are meaningful, though we have already assumed some recovery, and a full return is likely to be spread over numerous quarters, potentially taking until 2024,” Kennedy notes.

Singapore’s 2023 also just got considerably more interesting. Keith Tan, CEO of the Singapore Tourism Board, tells CNBC that much depends on “the airlines in China, and the airports in China, and whether they are ready to resume large numbers of international flights as well.”

*** Different Role

If anything is clear about 2023 it’s that China’s role in the global economy will be very different.

Economist Iris Pang at ING Bank notes that Asia’s biggest economy has slowed since the second quarter of 2022, mainly due to strict Covid measures that disrupted port and land logistics, retail sales and catering, and caused temporary shutdowns of factories in some key manufacturing locations.

“Even when restrictions were eased, a mixture of a weak domestic economy and high external inflation hit manufacturing in the fourth quarter of 2022,” Pang adds.

Pang says that “in addition, real estate developers have struggled to get enough cash to complete residential projects. This triggered a slew of easing measures for real estate developers to get financing via banks, stock and debt markets in the fourth quarter. The fragile economy means there has been no inflation pressure at all, and luckily no deflation.”

Xi’s pivot to reopening changes everything, though. China is indeed “an X factor” for global inflation that Powell’s team “can’t do much about,” says Leland Miller, CEO of Washington research firm China Beige Book.

The same goes for Japan. In January, core consumer prices in Tokyo alone rose 4.3% from a year earlier, the fastest pace since 1981. Such trends put price pressures considerably above the Bank of Japan’s 2% target as companies pass on higher costs to households.

*** BOJ Policies Unsustainable

So far, the BOJ has resisted the urge to scale back on its ultraloose policies, particularly of the last decade. Earlier this week, the IMF recommended that Governor Haruhiko Kuroda’s team allow government bond yields to rise more freely and set the stage for an exit from quantitative easing.

Traders, though, are increasingly betting that the BOJ will pivot away from ultraloose policies. “The BOJ’s position seems unsustainable, so it seems churlish not to test it,” says strategist Nicholas Smith at CLSA Japan.

The next BOJ policy meeting is on March 10. Complicating things, Kuroda’s term ends April 8. “Kuroda,” Smith adds, “is now in ‘lame duck’ session, so markets are likely to focus primarily on who will be picked as successor: that’s an issue about which we have disturbingly little guidance, so expect volatility.”

In the interim, rising inflation is contributing to the collapse in Prime Minister Fumio Kishida’s approval ratings, which are now in the mid-20s.

“Frustration with rising inflation and crumbling support for Kishida, combined with talk of elections, suggests Kishida will have to pick a far more hawkish BOJ governor to replace Kuroda,” Smith says.

Strategist Koichi Sugisaki at Morgan Stanley MUFG notes that trading dynamics may be forcing the BOJ’s hand. “If bond market functioning is not restored despite the enhanced funds-supplying operations, we think the likelihood of early yield curve control adjustment or abolishment will increase,” Sugisaki says.

But the real global litmus test for how China alters inflation dynamics will be the extent Powell’s team at fed headquarters will be forced to take drastic monetary measures. Odds are, there will be many to come.