Sunday, July 11, 2004
Is the overheating Chinese economy a problem?
Once again, the pundits have been all over this one. Questions on whether the Chinese economy is overheating, whether a hard-landing is inevitable etc have occupied the minds of international economists for a while now. With good reason too. China has been a big contributor to world economic growth the past few years. So, I read with some interest Martin Wolf's take that the Chinese economy could in fact do with some overheating.
Last year, fixed investment grew by 26 per cent in real terms (see chart). In the year to the first quarter of 2004, it grew at more than 40 per cent. In the long run, investment cannot grow 2 1/2 times as fast as the economy, let alone four times. Since the share of investment in gross domestic product reached an almost incredible 47 per cent in 2003, that long run must come soon, if not now. The growth of investment will have to slow sharply, as it did in the second half of the 1990s.
Even the view that there is a deep imbalance between the medium-term rates of growth of investment and consumption is open to question (see chart). About one-third of the fixed investment last year was in property (see chart). But a good part of this was investment in residential property. This, then, is investment in consumer durables. Once one makes an adjustment for this, argues Jonathan Anderson of UBS, the pattern of expansion looks far better balanced.
Yet there is a still more fundamental point: overheating and higher inflation may be not the problem but the solution. China has a pegged exchange rate against the US dollar. Since the middle of 2001, China has enjoyed a real depreciation of about 11 per cent, according to J P Morgan, as the dollar has tumbled. But last year China had a current account surplus of Dollars 46bn (Pounds 25bn), an inflow of Dollars 47bn in net direct investment, and reserve accumulations (before the bank recapitalisation) of Dollars 162bn. The overall balance of payments surplus (the sum of the current account and net capital inflow) was about 11 per cent of GDP. Under a fixed exchange rate, monetary expansion, excess demand, higher prices and an appreciation of the real exchange rate are the mechanism for eliminating such a disequilibrium. The obvious objection to this mechanism is that it is wasteful. But to this concern, legitimate though it is, there is a simple answer: try as the authorities might, these destabilising consequences of being a member of the dollar area cannot be avoided. If they cannot stand the heat, they should move to a different kitchen. The conclusion then is that, while some slowdown is inevitable, there is no reason whatsoever to wish for a brutal one. China can do with some overheating.
This leads us to the second question: have the authorities chosen the right mechanisms? They have used a series of administrative measures that target excesses in particular sectors. The most important are controls on the release of land for construction and on credit-creation by the banks. Many economists would argue that the authorities should have used higher interest rates instead.
The arguments in favour of higher interest rates are evident, particularly since central bank interest rates are only about 3 per cent (and so negative in real terms). Yet there are also arguments against them. One is that higher interest rates would curb borrowing by the relatively efficient private sector but not the profligate local governments and state enterprises. A still more important argument is that significantly higher interest rates are likely to encourage greater capital inflow, further reserve accumulations and so greater monetary expansion. Monetary policy is an ineffective tool for macroeconomic policy in a country with a fixed exchange rate, unless it possesses effective controls on capital inflows.
This leads us to our third question: have the measures been applied too sharply? Xia Bin, of the Development Research Center of the State Council, has argued that the envisaged growth of credit, at 17 per cent, is too slow. In the year to the first quarter growth of investment was 43 per cent. By the fourth quarter, according to HSBC, this should be down to 15 per cent. But HSBC argues that next year it will be less than 10 per cent. Such a sharp decline would reduce GDP growth to 7 per cent. For most economies 7 per cent growth would be no hard landing. For China and its trading partners, it would feel like one.
This brings us to the final question: is a sharp slowdown now inevitable? The answer is: "almost certainly yes". Last year, investment must have generated about 10 percentage points of GDP growth, on its own. If investment growth were to fall to 10 per cent next year, this contribution would more than halve. Given the weight of investment in GDP, big changes in its growth must have a powerful impact on the growth of the economy.
A slowdown is now inevitable, but a sharp one is undesirable. China does need more fixed capital and fast growth. Its real exchange rate also needs to appreciate. The big issue is not so much overheating as the inefficiency of Chinese investment. The right question is whether investment is being allocated sensibly. Until the market mechanism is further extended, the answer must, in large part, be "no".
Last year, fixed investment grew by 26 per cent in real terms (see chart). In the year to the first quarter of 2004, it grew at more than 40 per cent. In the long run, investment cannot grow 2 1/2 times as fast as the economy, let alone four times. Since the share of investment in gross domestic product reached an almost incredible 47 per cent in 2003, that long run must come soon, if not now. The growth of investment will have to slow sharply, as it did in the second half of the 1990s.
Even the view that there is a deep imbalance between the medium-term rates of growth of investment and consumption is open to question (see chart). About one-third of the fixed investment last year was in property (see chart). But a good part of this was investment in residential property. This, then, is investment in consumer durables. Once one makes an adjustment for this, argues Jonathan Anderson of UBS, the pattern of expansion looks far better balanced.
Yet there is a still more fundamental point: overheating and higher inflation may be not the problem but the solution. China has a pegged exchange rate against the US dollar. Since the middle of 2001, China has enjoyed a real depreciation of about 11 per cent, according to J P Morgan, as the dollar has tumbled. But last year China had a current account surplus of Dollars 46bn (Pounds 25bn), an inflow of Dollars 47bn in net direct investment, and reserve accumulations (before the bank recapitalisation) of Dollars 162bn. The overall balance of payments surplus (the sum of the current account and net capital inflow) was about 11 per cent of GDP. Under a fixed exchange rate, monetary expansion, excess demand, higher prices and an appreciation of the real exchange rate are the mechanism for eliminating such a disequilibrium. The obvious objection to this mechanism is that it is wasteful. But to this concern, legitimate though it is, there is a simple answer: try as the authorities might, these destabilising consequences of being a member of the dollar area cannot be avoided. If they cannot stand the heat, they should move to a different kitchen. The conclusion then is that, while some slowdown is inevitable, there is no reason whatsoever to wish for a brutal one. China can do with some overheating.
This leads us to the second question: have the authorities chosen the right mechanisms? They have used a series of administrative measures that target excesses in particular sectors. The most important are controls on the release of land for construction and on credit-creation by the banks. Many economists would argue that the authorities should have used higher interest rates instead.
The arguments in favour of higher interest rates are evident, particularly since central bank interest rates are only about 3 per cent (and so negative in real terms). Yet there are also arguments against them. One is that higher interest rates would curb borrowing by the relatively efficient private sector but not the profligate local governments and state enterprises. A still more important argument is that significantly higher interest rates are likely to encourage greater capital inflow, further reserve accumulations and so greater monetary expansion. Monetary policy is an ineffective tool for macroeconomic policy in a country with a fixed exchange rate, unless it possesses effective controls on capital inflows.
This leads us to our third question: have the measures been applied too sharply? Xia Bin, of the Development Research Center of the State Council, has argued that the envisaged growth of credit, at 17 per cent, is too slow. In the year to the first quarter growth of investment was 43 per cent. By the fourth quarter, according to HSBC, this should be down to 15 per cent. But HSBC argues that next year it will be less than 10 per cent. Such a sharp decline would reduce GDP growth to 7 per cent. For most economies 7 per cent growth would be no hard landing. For China and its trading partners, it would feel like one.
This brings us to the final question: is a sharp slowdown now inevitable? The answer is: "almost certainly yes". Last year, investment must have generated about 10 percentage points of GDP growth, on its own. If investment growth were to fall to 10 per cent next year, this contribution would more than halve. Given the weight of investment in GDP, big changes in its growth must have a powerful impact on the growth of the economy.
A slowdown is now inevitable, but a sharp one is undesirable. China does need more fixed capital and fast growth. Its real exchange rate also needs to appreciate. The big issue is not so much overheating as the inefficiency of Chinese investment. The right question is whether investment is being allocated sensibly. Until the market mechanism is further extended, the answer must, in large part, be "no".
