The Chinese Economy: Slowdown for the Sake of Future Growth

In addition to the artificially lowered exchange rate and interest rate, the Chinese economy faces other structural problems and we’ll explore them in this post. Here we’ll also explain why the Chinese authorities are treating the current slowdown as an opportunity to restructure the economy for future growth.

Problems in the Financial Market 

China’s currency Renminbi isn’t freely convertible and foreigners are often denied access to the currency. The process of internationalization has just started. Besides, the major Chinese banks are still controlled by the state and have to fulfill policy goals instead of putting profitability and shareholder value as the top priority.

For example, in response to the financial crisis, the state banks loosened credit more than private banks run on market principles would optimally do, because they had to help the central authorities to stimulate the economy. This prevents the efficient allocation of capital, and also increases non-performing loans ratio at state banks. These aren’t the features of a mature, sophisticated market economy.

(Comment: Another problem is the lack of competition in China’s financial market, as Premier Wen told the press earlier this month. Besides, the rich and the powerful with connections to bankers and public officials have much easier access to credit. This again makes capital allocation inefficient and undermines the fairness of the financial system. Reforms are needed but they’ll have to face fierce opposition of the vested interests.) 

Fear of a Hard Landing 

Given the above problems, together with the downturn in China’s real estate market and the European debt crisis (which hurt Chinese exports), some observers already worry about a hard landing in China, though its economy isn’t as highly leveraged as the U.S economy.

(Comment: The Guardian published a debate between Andrew Batson and Patrick Chovanec on whether China will face a hard landing this year. A professor at Tsinghua University, Chovanec is an active blogger and an expert on the Chinese economy. His blog features a brilliant analysis of the downturn in China’s real estate market.) 

Restructuring to Pave Way for Future Growth 

You may wonder why the United States can enjoy a high credit rating even when the country owes so much debt, while China can’t. Some Chinese may think this is a conspiracy: the credit rating agencies, which are mainly run by Americans and Europeans, are biased towards America. However, the truth is the American economy can support a bigger size due to its sound economic structure, while the structure of the Chinese economy isn’t as efficient or robust.

The Chinese authorities are well aware of this. That’s why they’d rather slow down the economy than to push for higher growth in the short term. It can be foreseen that, to improve the health and stability of its economic structure, China will try hard to shift the growth engine from investment to consumption in the next few years, with the help of a higher interest rate as well as other policies.

(Comment: Despite the unfavorable conditions, I believe the Chinese economy probably won’t suffer from a hard landing. As a report titled “Growth Worries” from the Economist Intelligence Unit suggests, even if the economic slowdown is more severe than expected, the Chinese authorities can carry out fiscal expansion since they aren’t debt-laden like its Western counterparts.

Indeed, the capacity for fiscal stimulus should be high, given that the heavy local government debt, a chronic problem in China, appears to be under control. Besides, since inflation has fallen to below 4% this year, there is room to inject money into the economy and lower the interest rate, though this is contradictory with the long-term goal to rebalance the economy.)

(Entry 3 of 6 in The Global Economic Landscape in 2012 series)

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The Chinese Economy: Structural Imbalances

After a discussion on the American economy, this time we’ll 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 China’s 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 

China’s 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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The Global Economic Landscape in 2012

On March 23, I attended a talk on the world’s economic and financial landscape. The speaker, Stephen Wong, is a former managing director of an investment bank and now a part-time instructor at the Chinese University of Hong Kong. The talk was succinct and informative, and I enjoyed it a lot.

Sharing many of Stephen’s opinions, I’d like to recap them here. I’ll also add my own points of view, which are in the Comment sections scattered in the posts.

This 6-part series covers the American and Chinese economies as well as the European debt crisis. To better understand the global macroeconomic environment, act now and click on the links below:
 
Part 1  The U.S. Economy: Private Deleveraging and the Slow Return to Growth 
Part 2  The Chinese Economy: Structural Imbalances 
Part 3  The Chinese Economy: Slowdown for the Sake of Future Growth 
Part 4  The Eurozone Crisis: Problems of a Currency Union 
Part 5  The Eurozone Crisis: Not a Matter of Fiscal Irresponsibility 
Part 6  The Eurozone Crisis: Differences between the U.S. and the Euro Area 

In today’s globalized world, what happens in countries thousands of miles away can have a direct impact on your life. The global economy, besides having a growing impact on our life, is an integral part in our understanding of the world. Thus, whatever country you live in and whatever industry you work in, it’s useful to learn more about the world economy.

I hope you’ll enjoy this exciting journey to explore the world economy. You’re most welcome to leave a comment.