Tied and Tested

Larry Kudlow
Posted: May 09, 2004 12:00 AM

 Columnist Tom Friedman of The New York Times recently wrote that "When Chinese authorities told banks to cut back their wild lending, commodity prices and stock markets tumbled all over the world." The always clever Friedman then conjured up a prayer, concluding: "May China's leaders live to 120, and may they enjoy 9 percent GDP growth every year of their lives. Thank you, Father. Amen."

 It's good to see Friedman appealing to a higher power, but his prayer has been answered over the past 10 years. Since China's 1994 currency-stabilization reform, which firmly linked the yuan to the dollar, real economic growth in the country has averaged 8.9 percent per year -- with no recessions. Call this the post-Tiananmen Square modern era of Chinese growth.

 Most important to the continuing health of China's rapidly emerging economy have been pro-growth measures to reduce tariffs, market-liberalization steps, agricultural reforms (which began in the late 1970s) and, in particular, currency reform to stabilize the yuan -- which has been crucial to attracting deep-pocketed international investors.

 China has become one of the world's primary growth engines. Almost single-handedly, China has pulled Japan into an export-led recovery, ending a 15-year Japanese downturn. In fact, China has anchored an economic revival throughout the Asian-Pacific rim. Its huge industrial demand has contributed mightily to a revival of the U.S. commodity and manufacturing sectors and has had a boom-triggering impact on world shipping.

 In short, the global economy needs China.

 In recent weeks, China has taken a few modest steps to slow its allegedly overheated economy. It raised bank-reserve requirements, clamped down on cement, steel and aluminum projects to curb excess development, and implemented some land-use rules to slow industrial growth.

 Amidst the current growth wave, government-reported Chinese inflation has picked up. In mid-2002, China was deflating at a 1.3 percent pace, but recent consumer-price readings have hovered around 3 percent. The corporate-goods index, a proxy for wholesale prices, was deflating at a 4 percent clip in 2002. Now it's rising at a 6.5 percent rate.

 Look familiar?

 In effect, China's price trends mirror and magnify U.S. price trends. This is because the yuan is tied to the dollar. So it's really the U.S. Federal Reserve calling the tune for Chinese money. Friedman missed this point.

 As the Fed reflated its way out of deflation in recent years by lowering interest rates and expanding the money supply, China's economy benefited enormously (as did other emerging economies). And as China's economy is not nearly as diverse, flexible or developed as America's, price swings tend to be more exaggerated than those in the United States.

 Still, there is no inflation crisis occurring in either country.

 The Greenspan Fed undoubtedly overshot liquidity additions to the U.S. economy in fighting deflation in 2000-02. This spilled over to China. Core inflation (excluding food and energy) is now creeping up in the United States. Also, it is noteworthy that the overall Consumer Price Index did rise 5.1 percent annually in this year's first quarter. All this is why Greenspan should have raised rates when he had the chance this week.

 In another telling parallel, bond rates in China and the United States have moved higher -- once again, in sync. Importantly, the U.S. dollar has reversed a two-year decline and appreciated by roughly 6.5 percent. This means the dollar-linked yuan has also appreciated in lockstep with the greenback.

 It would be a bad mistake if China broke its currency link to the dollar, as suggested by the Treasury Department and others. Fearing a yuan collapse, global investors might pull their capital out of China and deflate the boom. Emerging-country currencies almost never float, seldom appreciate and nearly always sink.

 Instead, should the yuan remain dollar-linked, it will rise in the months ahead with the appreciating greenback. The Fed can do for China what the Asian power cannot yet do for itself.

 Currency appreciation amounts to a de facto tightening of monetary policy in both countries. As currency values rise, increased consumer and business purchasing power will slow price increases. In response to the recent dollar rise, U.S. dollar-denominated commodity prices have corrected sharply lower, with stock markets also losing some steam.

 In not acting to raise rates at its recent meeting, the Fed missed a great opportunity to quell inflation expectations. Hopefully they'll move in June. Global stock, bond, currency and commodity markets have already built in a near 75-basis-point Fed move. Why wait? The sooner the Fed acts, the less action it will have to take later on.

 With a bit of stimulus removal -- nothing more than a lightening up on the monetary accelerator -- rising price fears can be halted in China and the United States. This would prolong bull-market prosperity cycles in both countries. Once again, Tom Friedman's prayer would be answered.