China - The Problem with Fiat Currency and a Government that wants Inflation!

I've always enjoyed John Hempton's blog.  I found his recent entry (here) on Chinese kleptocracy opinionated and entertaining as usual.

His basic premise:

• Chinese government is corrupt, driven by personal interest
• One child policy and limited investment options drive high savings rate
• Banks (and deposit and borrowing rates) are regulated.  Deposit rates below inflation creates negative real rates
• Negative real rates fund SOEs and politically connected entities
• Borrowing at low cost (from deposits) and investing in a highly inflationary environment is effectively looting the public

His conclusion:

• The 'undiscussed' serious threat is deflation (or low inflation).  Low inflation (or deflation) creates positive real rates, and stops SOEs from 'looting' the public and paying back the banks
• And unless the Chinese can get the inflation back up, expect major social problems

While I think his premise is correct - the conclusion is rushed.  His assumption that it is difficult to increase inflation, in my opinion, is misguided.

Herein lies the problem of a fiat currency, particularly under China's currency controls.  Inflation can almost 'always' be manufactured (also known as money printing, much easier in today's digital world).  It is easy to maintain negative real  rates when you control the banking system and the currency. Deflation is not a 'threat', as they can always create inflation (the opposite is not true). And since they control the currency, they can always push money directly/indirectly to SOEs - funding is never a 'real' problem. Which would lead one to question the value of the Renminbi, but that is a separate story.

The real issue, in my view, is whether the government can maintain negative interest rates (keeping deposit rates below inflation), while maintaining social stability/the facade of wealth creation (in an inflationary environment) among the public.  Definitely a very tough balancing act!

PS.  The only way to maintain/balance this in the long term is to drive productivity growth.  Which is very difficult in today's environment.