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Thursday, April 12, 2012

The Chinese Economy: Structural Imbalances

After a discussion on the American economy, this time well turn to China, the second largest economy of the world, which is showing signs of a slowdown.

Slowdown to Correct Structural Imbalances 

After years of over 8% annual economic growth, China lowered its GDP growth target to 7.5% in March this year. Some wonder if this is a sign of pessimism about Chinas economic prospects. But in fact, the growth slowdown shouldn’t be taken as bad news.

Given the serious structural imbalances in the Chinese economy, the central government aims to use this as an opportunity to restructure the economy for the sake of sustainable growth in the long run. 

A Low Exchange Rate and the Reliance on Exports 

Over the years, China has artificially lowered its exchange rate and interest rate in order to achieve higher growth. An undervalued currency boosts exports and results in China’s huge current account surplus (see Figure 1). But the country’s export-led growth isn’t sustainable. The heavily-indebted, slow-growth Western economies won’t be able to afford to import so much from China forever.

(Comment: In fact, China, which has long been dubbed as the world’s factory, recorded a trade deficit of US$4 billion in the first two months this year. What must be noted is that the figure was distorted by the Chinese New Year, a time of the year when exports drop as factories close down for the holidays. Hence, though some analysts suggest the Renminbi exchange rate may be closer to its equilibrium level than we thought, it remains to be seen if the trade balance will return to huge surpluses.) 

A Low Interest Rate and the Reliance on Fixed Investment 

Chinas interest rate is artificially lowered too. Despite a high nominal rate relative to other countries, China’s real interest rates – i.e. the nominal interest rate minus the inflation rate – were low from 2003 to 2008 due to high inflation (see Figure 2). While domestic consumption remains weak (see Figure 3), China experiences over-investment, which is much higher than the world’s average (see Figure 4). Note that the fixed capital formation in Figure 4 covers investment from both the private and the public sectors.

(Comment: To see why firms make decisions based on the real but not the nominal interest rate, consider the case where the nominal interest rate is 5% and the price level rises 10% a year. In this scenario, the real interest rate is -5%. From a firm’s perspective, while it pays 5% interest if it invests this year, it needs to pay 10% more in production costs if it invests next year. Thus, it’s better to borrow money and invest in capital this year rather than next year. The lower the real interest rate, the lower is the cost of capital investment.)

In 2009, for example, capital investment contributed to over 90% of the GDP growth, which is a clear evidence of China’s economic imbalance. This is worrying since investment-driven growth isn’t sustainable. If consumption doesn’t increase along with investment, the economy will only end up with excess production capacity, and afterwards fixed investment will fall drastically. 

(Comment: While its current account balance has fallen sharply, China has failed to rebalance internally. Investment has boomed for the past three years, partly because of the government’s 4-trillion-yuan stimulus package in 2008. The money was spent on various infrastructure, including roads, railways and electricity supply, and was meant to offset the adverse effects of the global financial crisis.)

(Entry 2 of 6 in The Global Economic Landscape in 2012 series)

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