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China’s economic year of living dangerously

David Dollar's picture

Last week China reported its first quarter GDP data.  Consumer inflation for the quarter was 8%, which is too high, but we already knew that.  The main news was that GDP growth came in at 10.6% year-on-year.  This is down from last year’s 11.7% rate, but higher than most forecasts for 2008 (including the Bank’s revised 9.4% forecast).  There was a healthy decline in the trade surplus for the quarter of about $5 billion or 10%.  The trade adjustment took a good form in that exports grew at a respectable 21% rate while imports surged 29%.  Most of this increase in exports was to the European Union, while growth of exports to the U.S. moderated to a 5% rate.  All of this looks to be in the direction of the rebalancing that China is trying to achieve.

About the same time that the data came out I gave a talk at the Institute for International Economics (link corrected on Jan. 12, 2009) in Washington, DC, with some excellent economists and China experts present.  The tone of my remarks was cautious optimism that China is gradually shifting toward more domestically driven growth and has the potential to weather the downturn in the U.S. and the global economy rather well.  Some participants agreed with this relatively upbeat assessment, but a number of economists thought that the risks of a much more negative outcome were pretty high.  It is useful to run through the thinking behind the pessimistic view in order to be prepared with measures to counter a sharp downturn if it starts to develop.

The pessimistic view starts by noting that there has been relatively little policy adjustment so far.  While the dollar-RMB exchange rate gets the headlines, and the appreciation here has been at a faster rate in the first quarter, China’s trade-weighted exchange rate has not appreciated.  Put another way: the RMB continues to depreciate against the Euro, stimulating exports to what is now China’s largest trade partner.  This stimulus is key to sustaining inflation at too high a rate, and trade-weighted appreciation will be needed to bring China’s inflation under control.  Almost everyone at the seminar was baffled that China has been reluctant to raise interest rates (especially the deposit rate, which is now sharply negative in real terms: 4% deposit rate on one-year and close to zero on demand deposits, against inflation of 8%).  The consensus view was that slow movement on exchange rate and interest rates was a sop to export-oriented industrial interests in coastal provinces. 

In the first quarter China grew well despite no kick (even slight subtraction) from net exports, and that’s encouraging.  But further reductions in the trade surplus will mean that net exports become a significant subtraction from GDP growth.  I pointed out that, in theory, if domestic consumption continues to grow at the rates seen recently (in the 10% real range) then China potentially can continue to grow well even with declines in net exports. 

The key question I raised is how people will behave as the export sectors slow down, some factories close, and some people are thrown out of work.  The pessimistic view is that up until now investment has continued at a high rate, much of it still going to export-oriented industry.  Later in 2008 there is potential for a rude awakening as firms and their financers discover that there is serious excess capacity and declining profitability.  We see some small signs of this in the first quarter data: the growth rate of corporate profits dropped sharply from a real rate of increase of about 22% in first quarter 2007 to 8% in first quarter 2008 (I am deflating here with the CPI). 

The pessimistic scenario is that there is a sharp drop in investment as 2008 develops as firms and banks become aware that future profits in exports and industry more generally are not so promising.  Banks discover that some of the loans they have made in the boom years are not being serviced.  If these sectoral problems feed into generalized pessimism and consumer caution, then the overall slowdown could be quite sharp.

While the Bank has highlighted these negative possibilities in recent reports and I have blogged about them, we have also argued that in these circumstances the government has a lot of fiscal space to stimulate the economy.  But the pessimistic view continues along these lines: the government has few instruments to stimulate private consumption if households become wary.  The personal income tax is minor, so any tinkering with that would have little effect.  I have raised the possibility of a temporary VAT reduction to stimulate consumption.  The VAT is of course collected at the firm level, so there is some risk that a cut would lead firms to try to bolster profits rather than pass most of it on to households in the form of price cuts.  In China’s highly competitive domestic goods markets it is possible that price cuts would in fact come about quickly, but it is also possible that a VAT cut would mostly shore up profits of firms, but that they remain reluctant to invest because of overall uncertainties.  This discussion left me thinking that the Chinese authorities need to plan ahead for stimulative policies that have real potential to work.

I opened my talk by suggesting that this is a “year of living dangerously” for the Chinese economy.  The year starts with real concern about over-heating and too-high inflation, but by the end of 2008 focus may very well shift to an unexpectedly sharp downturn in investment and growth that will require clever stimulus policies.  The discussion at IIE left me thinking that, if anything, the risks on the downside were more serious than I had thought and that this clever planning was even more urgent.

Comments

Submitted by Louis Kuijs (WB) on
David, You relay the view of economists who are more pessimistic about China’s growth prospects this year than we at the World Bank are. If I understand it correctly, the pessimists note that, while the world is slowing down considerably, there has not yet been a lot of significant policy reform in China to support the structural change in pattern of growth towards more domestic demand in general and consumption in particular. I agree there has so far only been a modest amount of structural reform. However, I would separate the question about the amount of structural reform from the discussion about growth prospects this year and next. Structural reform to rebalance China’s pattern of growth is very important. However, there is no obvious reason why the lack of significant structural change would grind growth to a halt this year or next. Indeed, China entered 2008 with a strong momentum in the domestic economy and so far, data on the ground has remained strong. Economic activity and exports stand up well in the face of international headwind. And prospects for the drivers of investment and consumption remain fairly good. Growth of headline profits fell in the first 2 months of this year. However, adjusted for the volatile mining and petroleum related sectors, profit growth in "core manufacturing" remained at a solid 30 % in the first 2 months (year on year, in current prices), despite domestic cost pressures. The expected slowdown of exports later this year will have an impact on domestic demand. I would think this impact will mainly be via an adjustment of investment plans of businesses in the tradable sector. Employment in the export sector will be hit. However, the importance of the export sector for job creation should not be exaggerated. In recent years, the “non tradable” sector (services and the part of industry catering to domestic demand) has created many more jobs than the export sector. In the Bank's (and other professional forecasters') central scenarios, there is so far no need for a significant relaxation of policy. As we have argued in our reports, the government would do well to prepare for the case where the slowdown is much more severe than we all currently expect. But there is no need yet to implement such an easing. As we have argued, if an easing of policy is deemed appropriate, it would make sense to ease fiscal policy. Given current inflationary concerns, it would not be obvious to relax monetary policy. Fortunately, given the strong fiscal position, the government has ample scope to use fiscal policy if needed. The pessimists you refer to find that income tax does not provide much room. However, I would mainly look at the spending side anyway. There is a large number of areas of expenditure where increasing spending would be in line with the government’s medium and long term plans, including education, health, and social spending, particularly in rural areas. In all, while I agree it is good to remain cautious and to be ready in case things turn out more nasty than currently expected, the prospects for continued strong growth momentum in China’s domestic economy and its strong macroeconomic position continue to keep me cautiously optimistic.

Submitted by Cliff Tan on
David: Thanks for the post. Could the real story be that authorities are, in fact, hoping for that "pessimistic" slowdown and so are holding off on raising interest rates in the meanwhile? Call this the bureaucratic compromise. It might resolve mysteries at the IIE but still seems a dangerous game to play. Second, I'm always amused that whenever China looks like it might actually slide towards the 5-year goal targets that everyone suddenly seems alarmed. And this despite the fact that the financial community as a whole has, year after year, tended to parrot the official "it'll be slower this year" forecasts - this year they might actually be right but sometimes you wouldn't know it by the alarm. Regards

I have been living in China, tracking China moacroeconomic, industrial control achieving high growth and price stability softlanding. China Peoples Banking raises interest rate 6 times, deposit rate 13 times to 16 %, aimed at cut excessive liquidity due to RMB, stock, housing market speculating and excessive fixed investment ( as high as 30 %)resulted 8.7 %, in Feb, fortunately stock market undergo 50 % correction, hosuing market start to cool, money supply growth drop from last years 24 % to March 16.3 %, drag GDP from 11.9 % to 10.6 first quarter 2008. If you are in China, you will see crowded shopper, stong domestic consumer, business demand already pushing economic overheating. The 12 % RMB appreciation already causing China export decline. China can not afford any shock from widening RMB appreciation than 5 % per year. ( that is Peoples Congress policy) Any big RMB appreciation will result big inflow of hot money, speculation in stock, housing market excessive liquidity. and will kill the exporter, as it did in Taiwan, Asian crisis. China will achieve softlanding to achieve 9. % GDP, 5 % CPI in the coming, under central bank cut money supply growth from 16 % to 12 %. as they did in 1994-1996 ( forecsed by my simulation model 3 years ahead, lectured to 15 cities 30 million executives, investors 1994- 1997.and presented to US, ECB, Asian 14 global central banks governors conferences 1999. details on www.osawh.com/riskm.html.

Three interesting comments from Warren, Cliff, and my colleague Louis. I agree with Cliff that growth slowing down to the 8-9% range should not be cause for alarm. This is in fact the government’s stated target and in line with what most analysts think is sustainable. The problem would come if growth slowed significantly more than that. Warren points out that consumption is humming along pretty nicely, at about a 9% rate of growth. But in recent years that has been augmented by investment growth at a higher rate and net export growth. The question that no one can answer for sure is what happens to consumer confidence when net exports decline and subtract from GDP growth and when investment falls off. In the past China has had sharp cycles in which investment growth dropped precipitously. It would be a mistake to assume that those past sharp declines cannot be repeated. This scenario may be low probability, but it is still worth worrying about and planning for. Finally, Louis is right that it is premature to loosen the policy stance; if anything some more monetary tightening is needed now to make sure inflation does not take on a life of its own. I agree with Cliff that holding off on monetary tightening in the hope that the global slowdown takes the wind out of inflation sails is a “dangerous game.”

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