Key Trends in the World Economy

Inflation and the international surge in commodity prices - with particularly attention to the impact on China

Summary

Rising or sustained high rates of inflation in major developing economies have been widely noted in the financial media – annual consumer inflation increasing to 5.1% in China in November and being 5.6% in Brazil, 7.3% in Turkey, 11.1% in Argentina and 11.4% in India. In some countries, particularly China, discussion of the causes of this inflationary rise has focused on money supply within the individual country.

That this is not a comprehensive or adequate explanation is shown by examination of international price trends. International commodity prices have sharply risen since June 2010. Of particular relevance to inflationary developments in China, international food prices, which remained significantly subdued for the year up to June 2010, have begun to rise sharply. These food price increases, in contrast to the pattern for a year previously, are broadly in line with industrial commodity price shifts.

Such international food price acceleration is outside the control of individual countries and must be factored into analysis of inflation within them. As rising commodity prices are evidently not rooted in the monetary situation in individual countries, it follows that explanation of inflation in China, or other countries, purely in terms of money supply within their own economies is inadequate. A response purely in terms of monetary policy would threfore also be inadequate as a response to such inflationary pressures. An overall international analysis is required.

*   *   *

The pattern of inflation in China

A key feature of inflation in China is the extreme disparity between food and non-food price increases. Non-food inflation in China in November was 1.9%. Food inflation, in contrast, was 11.7%. The 5.1% average consumer price index (CPI) therefore conceals sharply divergent trends.

Such a pattern by itself makes it unlikely that the most powerful factor operating in inflation is the increase in China's money supply. If the fundamental cause of the inflationary pressure were excessive rise of monetary stock, compared to the economy's supply side, then one would expect inflationary price pressures to be more evenly spread. This reality is confirmed by analysing trends in international commodity and food prices.

The long term trend in commodity prices

To assess recent inflationary developments it is useful to place commodity price behaviour  against a longer-term background. Figure 1, therefore, shows the Dow-Jones UBS commodity price index over a 10 year period.

The trend is evident. Commodity prices rose progressively from a trough in 2002 to a peak immediately prior to the onset of the international financial crisis in 2008. A sharp fall then occurred until the end of 2008. Since then a new rise of commodity prices occurred.

Figure 1

 

The sharp rise in commodity prices in the second half of 2010

Turing to greater detail within this overall trend, the major international rise in commodity prices since June 2010 may be seen in Figure 2. This also highlights the significantly different behaviour of industrial and food commodity prices in the aftermath of the international financial crisis.

Figure 2

 

Commodity price behaviour during the international financial crisis

The price fall between the peak in the previous business cycle and the trough during the financial crisis was greater for industrial than food commodities. However, the timing of the declines did not differ significantly. The Economist index of industrial commodity prices peaked in March 2008 and then fell by 55.0% to a December 2008 trough. The index of food prices peaked in June 2008 before falling 35.6% to its trough - also in December 2008.

An increase in non-food and food commodity prices following their December 2008 joint lows initially took place in parallel. Between December 2008 and May 2009, food commodity prices rose by 19.7% and industrial commodities by 23.5% - i.e. an essentially similar upward movement.

Industrial and food commodity prices then diverged sharply from June 2009. Prices for industrial commodities continued to rise while food prices remained stagnant and even declined marginally. This strong divergence of industrial and food commodity prices lasted for a year until June 2010. Between May 2009 and June 2010 industrial commodity prices rose to reach 75.6% above the December 2008 level, while food commodity prices fell to 10.4% above their December 2008 trough.

Therefore from mid-2009 to mid-2010, while industrial commodity prices were rising strongly, food prices declined marginally.

The new upsurge in international food prices

The new inflationary trend is that from June 2010 onwards international food commodity prices also began to rise strongly. By 14 December 2010, food commodity prices had risen to 51.8% above their December 2008 level – a 38% increase since June 2010. In the same period industrial commodity prices rose to 146.1% above their December 2008 level – a 40% rise.

Therefore, from June 2010 onwards international food prices broke with their year long stagnation and began to rise in parallel with industrial commodity prices.

Conclusion - rising food prices and inflation in China

In summary, a new feature of the international inflationary situation since June 2010 is that food prices broke out of a previous year of stability, indeed of mild decline, and began a rapid increase. It was  increasing food prices which drove the acceleration of China’s official annual CPI to 5.1% in November. The official acceleration in China's food prices, accounting for one third of its CPI, from 7.5% in August, to 8.0% in September, 10.1% in October, and 11.7% in November tells the clear story.

That the sharp rise in food prices in China in the second half of 2010 was part of a clear and strong international upward trend makes clear that inflationary acceleration cannot be explained simply by monetary conditions within China.¹ A far more comprehensive, and international, framework is required.

Notes

New data shows Shanghai’s rapid rise as a world-class education centre

This blog has previously commented on the dramatic rise of Asia and China’s education system. Some people thought this was exaggerated for reasons well rebutted in a recent article in the Financial Times:

“There are two stereotypes about schooling in east Asia: the students work extremely hard, and the learning is by rote. In fact, things are more complicated, as the OECD’s latest global schools survey has shown.

“Shanghai came top in the Pisa [Programme for International Student Assessment] survey, with three other east Asian territories in the first five. But not all east Asian countries did well, says the OECD’s Andreas Schleicher, adding that it’s innovative thought that is assessed. Shanghai schools aren’t turning children into walking textbooks: they are channelling their ability and enthusiasm into exceptional results. How?...

“The Pisa survey tests 15-year olds, with a rotating focus on maths, reading and science. The emphasis is on broad learning: literacy tests involve reasoning, for example. In the three previous editions - 2000, 2003 and 2006 - Finland came top. But this year, with the focus on reading, Finland was displaced by Shanghai, with South Korea second, Hong Kong fourth and Singapore fifth…

“So why did Shanghai do so well? The OECD points to Chinese school reforms: it was impressed by the initiative shown by teachers, who are now better paid, better trained and keen to mould their own curricula. Poor teachers are speedily replaced. China has also expanded school access, and moved away from learning by rote.

“The last point is key: Russia performs well in rote-based assessments, but not in Pisa, says Schleicher, head of the indicators and analysis division at the OECD’s directorate for education. China does well in both rote-based and broader assessments.

“If schools did well just because of hard work, then countries with similar cultures should see similar results. But… Shanghai beats Taiwan, and Hong Kong beats Macau...

“Is Shanghai the exception or the rule in Chinese school standards? In some countries, major cities underperform the national average, but that seems less likely in China, given the coast-interior disparities. However, the OECD did look at some rural areas, and found they matched Shanghai’s quality... What the Pisa results suggest is that, just like Chinese companies, Chinese schoolchildren won’t be pushed to the back of the class.”

The OECD noted that even in rural China results approached average levels for the OECD countries:"Citing further, as-yet unpublished OECD research, Mr Schleicher said: “We have actually done Pisa in 12 of the provinces in China. Even in some of the very poor areas you get performance close to the OECD average."

The finding that Shanghai’s secondary school education is now ranked number one in the world by the OECD’s survey, which is regarded as the most comprehensive international comparison, is of course striking. But a second indicative development, at the highest level of the academic world, is that it has been announced that Shanghai’s Jiao Tong University has attracted as full time professor the winner of the Nobel prize for medicine, and discoverer of HIV, Luc Montagnier.

Taking first some more detail on the OECD study, the PISA report is published every three years. It is based on a study of half a million school students, at age 15, in more than seventy economies. The report found that Shanghai came ahead of the lead countries, South Korea and Finland, and was placed first in each of the categories of reading, maths and science - with skill in complex mathematics found to be more than eight times the OECD average: ‘The province of Shanghai, China, took part for the first time and scored higher in reading than any country. It also topped the table in maths and science. More than one-quarter of Shanghai’s 15-year-olds demonstrated advanced mathematical thinking skills to solve complex problems, compared to an OECD average of just 3%.’

The OECD found that strength of Asian countries, including Shanghai’s, was not based on a policy concentrating resources exclusively on “elite education” but its foundation was targeting raising broad educational achievements - which then also helped raised the level of top ranked institutions. OECD education expert Eric Charbonnier notes Asia’s success was a result of educational values that favour equality as well as quality and that: "In Shanghai, a city of 20 million, they followed policies to fight against social inequality, to target the schools that were in most difficulty and send them the best performing heads and most experienced teachers."

Education statistics for Shanghai are indeed now extremely striking. For a developing country, China’s 99.4% enrolment in primary education is already, as the OECD puts it, “the envy of many countries” while junior secondary school participation rates in China are now 99%. But in Shanghai not only has senior secondary school enrolment attained 98% but admissions into higher education have achieved 80% of the relevant age group. That this growth reflects quality, not just quantity, is confirmed clearly by the OECD’s ranking of Shanghai’s secondary education as world number one.

The implications of this educational effort for future economic growth are evident. OECD Secretary-General Angel Gurria notes: “Better educational outcomes are a strong predictor for future economic growth… While national income and educational achievement are still related, PISA shows that two countries with similar levels of prosperity can produce very different results. This shows that an image of a world divided neatly into rich and well-educated countries and poor and badly-educated countries is now out of date.”

Turning from secondary education to the top of the academic ladder, Shanghai’s Jiao Tong university has announced that Luc Montagnier, Nobel Prize winner in medicine for the discovery of HIV, has accepted a full time professorship. Montagnier stated that a key attraction for him was that the University had agreed to create a research centre with 20-30 staff. Shanghai Jiao Tong University is rated as one of China’s top universities with its original foundations in science and engineering.

Evidently Shanghai’s educational achievements are in the lead of, and well ahead of, China as a whole – the majority of China’s population still lives in the countryside. No one in China would expect Shanghai’s achievement as being ranked number one in the world in secondary education to be translated rapidly into an equivalent success at overall university level – building up average university level research and education will take even greater resources than primary and secondary education. Jiao Tong and Fudan, Shanghai’s top universities, are well ahead of the average college level yet achieved in China. But the extraordinary achievement of Shanghai in being ranked number one in the world in secondary education shows the dynamic which is underway.

Declaration of Interest

As the author is a visiting professor in Shanghai he needs to make a declaration of interest regarding the above article. But not evidently, in the sense that it distorts the data – the conclusions of the OECD’s study clearly was not influenced by the present author! But it strongly confirms my personal observations formed through teaching in Jiao Tong University. The level of interaction of students in and out of class, the ability of the research students, and the work ethic brought in from the rest of the education system is extraordinary – and as I know Oxford University first hand as a student I am aware what a top class university is like. It is the power and progress of China’s education system, not its cheap labour, that is now sustaining it on the human side as the world's most dynamic economy.

 

How the Financial Times assessed the OECD report

The new decline in US house prices - consequences for the economy and share prices

Newly published data for the S&P Case-Schiller index for the 3rd quarter of 2010 shows that US house prices fell 1.5% year on year - Figure 1. This reverses the 2.3% increase in the 1st quarter of 2010 and the 3.8% rise in the 2nd quarter of 2010.

Figure 1

 

This is is a serious development which must be carefully watched. It was, of course, the decline in US house prices. through the devastation created in the balance sheets of US banks by mortgage related lending, that was the proximate cause of the international financial crisis.

At that time the downturn in US house prices was also a leading indicator of a decline in US share prices - US house prices peaked in the 1st quarter of 2006 whereas US shares continued to rise until the 4th quarter of 2007. This combination of house price decline and share price drop, a simultaneous fall in two of the largest US asset markets, produced the devastating force of the financial crisis in autumn 2008.

As was noted on this blog at the time, it was the fall in asset prices which fundamentally determined the liquidity crisis, that is the seizing up of interbank lending markets, and not a liquidity crisis which produced the fall in asset prices.

This fact was confirmed by subsequent events. Since autumn 2008 central banks have taken the strongest measures in economic history to pump liquidity into markets and reduce borrowing rates - the new round of quantitative easing by the Federal Reserve (QE2) being simply the latest step. However such unprecedented measures have been unable to raise asset prices in housing and shares back to previous levels - thereby confirming that the underlying problem is in asset prices and not liquidity. US house prices are currently 30.0% below their peak while US share prices, measured by the S&P 500, are 24.6% below their peak.

What, therefore are the implications of a new downturn in US house prices? And should it be regarded as a harbinger of a fall to come in US share prices - if both asset markets were to drop a new intense round of financial crisis, with a double dip recession, would of course be inevitable?

An immediate and relatively superficial answer is that the new fall in US house prices is as yet both small and short lived - Figure 2. The 1.5% year on year drop to the 3rd quarter of 2010 compares to an 18.9% maximum fall registered in the 1st quarter of 2009. A fall which has so far existed for only for one quarter cannot compare to the 13 consecutive quarters of falling US house prices between the 4th quarter of 2006 and the 4th quarter of 2009.

But more fundamentally there is now a contradictory dynamic driving US house and share prices. Shares represent ownership of companies which generate a profit stream, they are therefore investment in the proper sense, and are sustained by the now record level of US company profits. The large scale lay offs and downward pressure on wages in the US are raising share prices as they are boosting profits. That is the asset values underlying share prices are being increased.

However, while house construction may be categorised as investment in the US national accounts, this is in fact a confusion as regards its real dynamics. Houses, given the very high level of home ownership in the US, are in general a very long term consumer product - only a minority proportion of the US housing stock is commercially owned as a real investment in the proper sense. House prices are therefore negatively affected by the high unemployment and  downward pressure on wages. The same processes raising US share prices are therefore depressing US house prices.

Figure 2

As US incomes will continue to be under pressure it is therefore quite possible that US house prices will continue a decline. But, as liquidity constraints do not exist, US share prices will be driven by company profitability - that is the determinant of the underlying value of the asset. Only if US profitability turns down should a new severe share price decline be expected.

Therefore the house price fall is likely to further undermine the political popularity of President Obama. It will be negative for certain US economic sectors - a new deterioration of banks balance sheets is possible, but a new large scale financial crisis is unlikely due to a fall in US house prices. The US population has remained essentially passive confronted with their falls in living standards. There has not been the significant social discontent seen in parts of Europe. The serious international risks to profitability lie in the threat of debt restructurings in Europe and that inflation in developing economies will lead to monetary tightening producing significant economic slowdowns in these markets.

A decline in US house prices, one of the largest asset markets in the world, is therefore a notable event requiring close monitoring. While it does not portend a new deep financial crisis it is, of course, a clear negative as regards US economic growth - an important reason that not double dip recession but continuing significantly slower than normal recovery remains the most likely perspective for the US economy.

The rise in US unemployment and falls in wages are slowly dragging US companies out of the recession through the rebound in profitability they are creating. The danger is that profitability will crack in the 'periphery' of the system - in the weaker economies in Europe and in developing markets.

Figure 2