Has Anyone Noticed The Mammoth Shifts in Chinese Economic Policy?
I don’t think people realize that the Chinese have just made a rather sizable shift in economic policy. The Chinese are moving on multiple fronts now toward a new economic paradigm that includes slower growth but more domestic consumption. And this will have major implications for the rest of the world.
The Currency Wars Backdrop
Back in the fall, when the talk was of currency wars and Chinese currency manipulation, it was clear that China would have to move or face protectionism. The political problem for the Chinese is their massive current account surplus. And so the question was how could the Chinese reduce this current account surplus without destabilising the economy’s export-driven model.
Which levers could the Chinese pull in order to meet their own national goals of continued high growth while dampening anti-Chinese protectionist sentiment abroad? Here are the variables in the mix:
- Currency: many pundits are talking about China as the bad guy, currency manipulators bent on free-riding on the world’s open economies in a quest to steal growth at others’ expense. The principal way the Chinese are reputed to have done so is through holding the currency at an artificially low exchange rate peg to the US dollar, creating a large current account surplus and building massive US dollar foreign reserves.
- Export-led growth: the current account balance is an outgrowth of an export-oriented economic plan. The Chinese have banked their future on becoming the world’s factory. They produce goods not just for the domestic economy, but rather with the explicit purpose of exporting abroad. This has meant that the productive capacity of the Chinese was especially vulnerable from the loss of consumption demand the deep global recession created.
- Massive capital investment: the Chinese have embarked on a capital spending binge in order to at once maintain the manufacturing sector’s viability, expand that capability away from the coastal regions and to prevent the loss of external demand from collapsing growth.
- Easy money: the Chinese have allowed a huge expansion in credit and maintained interest rates low in order to keep credit flowing to fund capital investment both for infrastructure.
- Speculation, hoarding and bubbles: this credit growth has created extra demand for industrial commodities and spilled over into property and land, bidding up prices. Stories of hoarding in commodities and speculation in property by both municipal governments and private citizens abound.
The Chinese Response
Back in the Fall, speculation was that the Chinese could fall prey to the Japanese Plaza Accord strategy. That would have them yield on the currency front but compensate by keeping interest rates low in order to maintain growth. In Japan, this strategy led to an unsustainable bubble and economic collapse. Regarding China’s following the same destructive path, in October Michael Pettis wrote:
So after years of dragging its feet, postponing a rebalancing, and forcing rising trade surpluses onto the rest of the world, China may have to adjust its currency policies so quickly that it risks a sharp contraction at home. So what will China do?
This, for me, is the most interesting and perhaps important question. Most probably Beijing will do the same thing Tokyo did after the Plaza Accords and Beijing did after the renminbi began appreciating in 2005. It will lower real interest rates and force credit expansion.
This of course will have the effect of unwinding the impact of the renminbi appreciation. As some Chinese manufacturers (in the tradable goods sector) lose competitiveness because of the rising renminbi, others (in the capital intensive sector) will regain it because of even lower financing costs. Jobs lost in one sector will be balanced with jobs gained in the other.
But there will be a hidden cost to this strategy – perhaps a huge one. The revaluing renminbi will shift income from exporters to households, as it should, but cheaper financing costs will shift income from households (who provide most of the country’s net savings) to the large companies that have access to bank credit. So China won’t really rebalance, because this requires a real and permanent increase in the household share of GDP. Instead what will happen is that it will reduce Chinese overdependence on exports and increase China’s even greater overdependence on investment.
This will not benefit China. It will fuel even more real estate, manufacturing and infrastructure overcapacity without having rebalanced consumption. Expect, for example, even more ships, steel, and chemicals in a world that really does not want any more.
I don’t think the Chinese are following the Japanese route. The currency wars have died down due to global growth. So the Chinese have signalled in many ways that they are following the path that Stephen Roach has been advocating, namely of increased domestic demand by increasing employment, wages while providing a better social safety net.
Roach wrote this about China last month:
In early March, China’s National People’s Congress will approve its 12th Five-Year Plan. This Plan is likely to go down in history as one of China’s boldest strategic initiatives.
In essence, it will change the character of China’s economic model – moving from the export- and investment-led structure of the past 30 years toward a pattern of growth that is driven increasingly by Chinese consumers. This shift will have profound implications for China, the rest of Asia, and the broader global economy…
First, China will begin to wean itself from the manufacturing model that has underpinned export- and investment-led growth. While the manufacturing approach served China well for 30 years, its dependence on capital-intensive, labor-saving productivity enhancement makes it incapable of absorbing the country’s massive labor surplus.
Instead, under the new Plan, China will adopt a more labor-intensive services model. It will, one hopes, provide a detailed blueprint for the development of large-scale transactions-intensive industries such as wholesale and retail trade, domestic transport and supply-chain logistics, health care, and leisure and hospitality.
Such a transition would provide China with much greater job-creating potential…
The new Plan’s second pro-consumption initiative will seek to boost wages. The main focus will be the lagging wages of rural workers, whose per capita incomes are currently only 30% of those in urban areas – precisely the opposite of China’s aspirations for a more “harmonious society.” Among the reforms will be tax policies aimed at boosting rural purchasing power, measures to broaden rural land ownership, and technology-led programs to raise agricultural productivity…
Major efforts to shift from saving toward spending are also required.
That issue frames the third major component of the new Plan’s pro-consumption agenda – the need to build a social safety net in order to reduce fear-driven precautionary saving. Specifically, that means Social Security, private pensions, and medical and unemployment insurance – plans that exist on paper but are woefully underfunded.
For example, in 2009, China’s retirement-system assets – national Social Security, local government retirement benefit plans, and private sector pensions – totaled just RMB2.4 trillion ($364 billion). That boils down to only about $470 of lifetime retirement benefits for the average Chinese worker. Little wonder that families save out of fear of the future. China’s new Plan must rectify this shortfall immediately.
This five year plan is also remarkable because it explicitly lowers future Chinese growth forecasts, starting to get the country off the fast growth treadmill which has created serious structural issues. Chairman Wen said “we want to put the emphasis of our work on the quality and the benefits of economic growth,” which I take to mean that the government want to focus on jobs and wage growth and move away from export-led and infrastructure-led growth.
On the currency front, the Chinese have already widened the band for the renminbi. It seems, clear, however, that they are not prepared to move too quickly in revaluing the currency for fear of destabilising the economy. Because global growth is more robust now than at any time in the last three years, this gives the Chinese a window of opportunity on this front. But the protectionists will rise again when the economy turns down.
What makes it most clear that they are not repeating the Japanese experiment with easier money into the teeth of a super-bubble comes from the banking and financial sector. With consumer price inflation rising, the threat of civil unrest is top of mind. The State Council has made some tax relief plans. But that will almost certainly not be enough. As a result, China has now started to increase interest rates and has already increased reserve requirements multiple times in the past year. The government did not announce a formal lending quota this year. In lieu of that announcement, it has made several other moves. These announcements that China is turning the screws on a well-advanced credit boom are all over the place. Last week the government announced that banks were to set up crisis-handling procedures, ostensibly in preparation for economic dislocation. But dislocation from what? I would say this is part of a plan to deal with non-performing loans that are going to surface as the monetary authorities continue to tighten.
Will all of this be too little too late?
After all, the Chinese housing bubble is reputed to be as great as the U.S. and Japanese bubbles. The value of housing stock will be 350% of GDP this year. There is no way to deal with the non-performing loans that such a bubble creates without a huge slowdown in growth. And the credit bubble has fanned out far beyond infrastructure, housing and manufacturing. Chinese investors are buying up properties in New York and Vancouver as well as dabbling in the booming art market.
Michael Pettis has anticipated this slowing. But he sees slower Chinese growth as a positive. If there is a soft landing, that is undoubtedly true. But if growth decelerates too abruptly, would the Chinese double up on the infrastructure projects? And what other measures would they take in order to cushion the slowing? What impact would this have on industrial commodity prices, building materials prices or the stocks of companies in those businesses? My view is that it will be difficult to make these moves and prevent a hard landing without a lot more on the infrastructure front. If growth falls too quickly, I don’t expect we will see any more mini-revaluations. In any event, mammoth changes are afoot in Chinese economic policy. Expect to hear more about it as time passes and this shift becomes more readily apparent.