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Sunday, September 27, 2009

Why China must do more to rebalance its economy

Martin Wolf writes on FT that rebalancing its investment-skewed economy is in China's own interest.


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China has had a good crisis. That became obvious at the "summer Davos" of the World Economic Forum, in Dalian, less than two weeks ago. Chinese confidence was palpable. But so was anxiety. The giant has survived the shock. But its recovery is driven by a surge in credit and fixed investment. In the longer term, China needs to rebalance its economy, by increasing consumption. It is time for the Chinese to enjoy themselves more. How unpleasant can that be?

The man who best captured both the confidence and the uncertainty was premier Wen Jiabao. He told the meeting that "the unprecedented global financial crisis has taken a heavy toll on the Chinese economy. Yet we have risen up to challenges and dealt with the difficulties with full confidence". But he also admitted that the "stabilisation and recovery of the Chinese economy are not yet steady, solid and balanced".

The data coming out of China suggest a powerful recovery is indeed under way. In the first half of the year, noted the premier, gross domestic product expanded 7.1 per cent. The September consensus forecasts suggest that the Chinese economy will expand 8.3 per cent in 2009 and 9.4 per cent in 2010. The Asian giant is expected to become the world's second largest economy in 2010, even at market prices.

According to the Economist Intelligence Unit, domestic demand may expand by as much as 11.5 per cent in real terms this year. Such a surge in Chinese internal demand is exactly what was needed. Chinese household consumption is also forecast to grow 9.3 per cent (see chart). Yet, as usual, real fixed investment is the locomotive. It is forecast to grow 14.8 per cent this year. If so, it would have grown faster than GDP in all but one of the past 10 years. This rising ratio of investment to GDP, from an already high level, is not a strength but a weakness. It suggests declining returns on capital. It risks creating ever-rising excess capacity. Moreover, when growth rates finally fall, the collapse in investment is going to knock a huge hole in demand.

The heavy reliance on investment is not the only risk ahead. So, too, is the surge in credit and money (see chart). Many believe this is bound to lead to another upswing in bad debt and destabilising asset bubbles. The jump in the ratio of broad money to GDP is also worrying, coming after a long period of stability.

China, it appears, has saved itself. Has it also been saving the world?

The most encouraging development is the shrinkage of China's current account and trade surpluses (see chart). Both exports and imports have fallen sharply, but exports have fallen further. Yet China's trade has been so volatile (along with everybody else's) that it is hard to be sure this will prove a turning point. Much will depend on the nature and pace of the global recovery. Moreover, the country will continue to run a substantial current account surplus and accumulate still more foreign currency reserves, even though they are already far larger than China needs for insurance purposes. After all, they reached $2,132bn (over 40 per cent of GDP) in June of this year.

That would be equivalent to official holdings by the US government of $6,000bn (€4,000bn, £3,670bn) all denominated in the currencies of other countries. It is little wonder such a huge exposure makes the Chinese government nervous. But nobody asked the Chinese to do this. On the contrary, US policymakers have consistently (and wisely) advised them to do the opposite. Having made what I believe was a huge mistake, the Chinese government cannot expect anybody to save them from its consequences.

A substantial appreciation of the Chinese currency is inevitable and desirable in the years ahead. The longer the Chinese authorities fight it, the bigger their losses (and the pain of adjustment) are going to be. What they have to do is cut those losses, by ceasing to accumulate yet more reserves. As Morris Goldstein and Nicholas Lardy of the Peterson Institute for International Economics argue, in an excellent recent study, the policies required to do this are also needed to help rebalance the economy in the long term.

It is important to understand how distorted China's economy now is: in 2007, personal consumption was just 35 per cent of GDP. Meanwhile, China was investing 11 per cent of GDP in low-yielding foreign assets, via its current account surplus. Remember how poor hundreds of millions of Chinese still are. Then consider that the net transfer of resources abroad was equal to a third of personal consumption.

This is surely indefensible. The premier may even agree. In Dalian, Mr Wen remarked that "we should focus on restructuring the economy, and make greater effort to enhance the role of domestic demand, especially final consumption, in spurring growth". An appreciation of the real exchange rate, ideally via a rise in the nominal exchange rate, would help. Not the least of the distortions of the current regime is the need to keep interest rates low, to curb capital inflows. This shifts massive amounts of income from households into corporate profits.

Whether China's partners will raise the issue of exchange rate policy in Pittsburgh, at the summit of the G20, is, alas, unclear. The Chinese are probably powerful enough to prevent it. But President Hu Jintao will surely complain about US protectionism. I sympathise with him. I would sympathise far more, however, if China's foreign currency interventions, combined with the sterilisation of their natural monetary effects, was not such a massive subsidy to its exports.

The big point for China is that, like it or not – and it is perfectly clear to even the casual visitor that many Chinese dislike it intensely – the explosive rise in trade and current account surpluses of the mid-2000s is an unrepeatable event.

The short-term rebalancing of this year, via a huge credit expansion and surge in fixed investment, is a temporary expedient. It must lead to a rebalancing of the Chinese economy towards consumption. This is in China's interests. It is also in the interests of a better balanced world economy. If the successful response of this year leads in this direction, the crisis will have brought great long-term benefit.

"A crisis," as they like to say in Washington these days, "is a terrible thing to waste." They may be ungrammatical. But they are right – and not only for the US.