Former Premier Zhu Rongji finished inflation off in the mid-1990s, earning him the moniker ‘China’s Paul Volker’ for his draconian measures. His inflation-busting was followed by a reform of the state sector in the late 1990s that drove tens of thousands of state-owned enterprises into bankruptcy and rendered more than 30 million people unemployed.  Since 2010, headline and core CPI inflation have averaged only 2.6% year-on-year and 1.6% YoY, respectively (see Exhibit 1).
A collapse in the money multiplier and money velocity may explain why inflation has not returned despite repeated talk and concern about the inflation genie getting out of the bottle.
Such talk is of course not confined to China. Data shows that, despite massive quantitative easing (QE) programmes by the G7 central banks, the average global money multiplier and global money velocity have dropped persistently  since the Global Financial Crisis.
Today’s COVID-19 driven multi-billion dollar QE may not add sustained inflationary pressures given the loss of systemic confidence that could also explain the lack of post-GFC inflationary pressures.
Structural and cyclical factors
China’s lack of inflation has been the result of structural economic and policy changes. Its money multiplier has fallen since financial innovation sped up in 2006 before recovering in 2019. Recently, it has rolled over again. Money velocity has dropped steadily since the early 2000s. 
What is the cause? One factor is Beijing’s restraint from massive reflation. Another is a loss of systemic confidence in the economic outlook in the face of geopolitical tensions and the COVID-19 shock. This has resulted in a lack of bank loan growth and a down-cycle since 2018 (see Exhibit 2).
When the liquidity constraint is not binding
Since the People’s Bank of China determines the amount of base money, it should in principle be able to turn around the money multiplier and money velocity by pumping liquidity into the system. However, when the banks are not liquidity constrained, this impairs the transmission from base money to loan growth. Whether banks lend and whether economic agents borrow depends on the systemic confidence in the outlook, not on the stock of deposits that banks hold.
Weak confidence dampens loan growth on both the demand and supply side despite an injection of liquidity. Confidence has flagged in the face of uncertainties stemming from structural reforms, anti-corruption campaigns, a change in the macroeconomic policy objective to deleveraging from ‘growth at all cost’ and other factors.
Arguably, much of the upside pressure on prices seen recently has come from temporary factors: supply bottlenecks due to COVID-19 disruptions and a short-term burst of post-pandemic demand. This should fade when things return to normal. If, however, the pandemic plunges the Chinese (and world) economy into a downturn again, the price pressures would also fade.
In the post-COVID-19 recovery, we may see inflation spikes, but not necessarily sustained inflation as there is no evidence of any wage-price spiral. Inflation volatility underlies our forecast for a 3.0%-3.5% yield range for China government bonds this year and offers tactical trading opportunities for the market.
 See “China’s Impossible Trinity: The Structural Challenges to the ‘Chinese Dream’”, Chi Lo, Palgrave Macmillan, 2015, chapter 4.
 See “The Inflation Compendium (Part 1)”, Q-Series, UBS, 15 March 2021, pp. 12.
 For details, see “Chi on China: The Crypto-Renminbi’s Disruption to the Market, Economic Growth and Policy”, 5 August 2020.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
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