China’s economic year of living dangerously

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David DollarLast 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.


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