Thursday, July 27, 2006
Global: China's Control Problem
Stephen S. Roach (New York)
July 21, 2006
It’s one thing for small, early-stage developing countries to experience periodic spurts of hyper-growth. It’s another matter altogether when that happens for large, mid-stage developing economies. That’s precisely the case in China today where extremely rapid economic growth seems in danger of veering out of control. Unfortunately, without an effective policy arsenal and more of a market-based system, it is very difficult for incrementally-inclined Chinese authorities to temper
the excesses of the boom. Nor is the just-announced second tweak in bank reserve ratios likely to make much of a difference. The risk is the longer the boom runs, the tougher it will be to avoid a more treacherous endgame.
The latest Chinese growth numbers were off the charts. Never mind the decade-high 11.3% y-o-y comparison just released for real GDP in 2Q06. What caught my eye was the 19.5% surge of industrial output in June. With a relatively small services sector and a highly inefficient agricultural sector, the Chinese growth story has long been dominated by the more reliably measured ups and downs of manufacturing activity. Other than a few monthly comparisons that were distorted by calendar-year effects during lunar New Year celebrations, our China team believes this is the
strongest industrial output comparison that China has ever reported. Nor is there any secret as to the forces that are behind this boom. It continues to be concentrated in two sectors -- fixed investment and exports -- that now account for more than 80% of total Chinese GDP. Collectively, these sectors surged ahead by nearly a 30% y-o-y rate in 2Q06.
This is not a sustainable outcome for any economy. Sure, China is special, with its economic development dominated by urbanization, infrastructure, and industrialization. These are all capital-intensive activities that would naturally bias the investment share of Chinese GDP to the upside. At the same time, lacking in support from internal private consumption and bolstered by massive fixed investments by foreign multinational corporations, China’s low-cost export-led impetus also makes good sense. But this unbalanced growth model has now gone to excess. Even in their heydays, investment shares in Japan and Korea never went above 40% of GDP; China’s investment ratio is likely to hit 50% this year -- underscoring the growing risk of a major overhang of excess supply. Similarly, Chinese export momentum has encountered increasingly tough political resistance that has been manifested in the form of mounting trade frictions and protectionist risks. Moreover, China is struggling mightily with the consequences of its industrial boom -- namely, soaring prices of energy and other industrial materials, severe environmental degradation, and mounting risks of bottlenecks that have the potential to crimp economic activity.
Senior Chinese authorities have expressed considerable concern over this overheated state of affairs. On a recent visit to the Henan province, Premier Wen Jiabao stressed, “We need to prevent unhealthy and unstable situations and the imbalances that can occur during fast economic development to prevent major ups and downs in the economy.” In keeping with that spirit, the People’s Bank of China has raised both lending rates and bank reserve requirements in an effort to slow investment spending. And the National Development and Reform Commission (NDRC) -- the modern-day counterpart of China’s old central planning agency -- has issued some administrative
directives aimed at constraining project approvals in several overheated Chinese industries -- namely, aluminium, cement, ferrous alloys, coal, coking coal, carbide-based PVC, and residential construction activity. Make no mistake, official China is very unhappy with the current excessive rate of economic growth. This came!
through loud and clear in my discussions with senior Chinese officials during three visits in the past three months.
The problem is that China is lacking in standard options to slow its white-hot economy. The main reason is limited monetary policy traction -- the most potent counter-cyclical stabilization tool in the macro policy arsenal. The efficacy of Chinese monetary policy is frustrated by two structural shortcomings -- undeveloped capital markets, which limit the impact of interest rate fluctuations on corporate borrowing, and a highly fragmented banking system, which diffuses the transmission of centralized policy directives. Several operational constraints also mute the
impacts of Chinese monetary policy -- especially, a tightly managed currency regime that compromises the independence of the People’s Bank of China and ongoing concerns over social stability, which biases wary authorities toward incremental actions.
China’s latest batch of economic statistics attests to the relative impotence of its
counter-cyclical policy approach. The first round of monetary tightening actions taken this spring -- a 27 bp hike in bank lending rates together with a 50 bp increase in bank reserve ratios -- were identical to those implemented during the overheating of 2004. If they didn’t work back then, it is highly unlikely they will work today. Inasmuch as the economy has grown by another 35% in nominal terms since 2004, the current overheating problems are actually far more serious than they
were just two years ago (see my 19 June 2006 essay, “Scale and the Chinese Policy Challenge”). In this context, Chinese authorities have no choice other than to up the ante on policy restraint. A failure to act could see an overheated economy quickly come to a boil.
Most believe the People’s Bank of China will lead the charge in acting to slow the Chinese economy. I don’t. The 21 July announcement of a second 50 bp increase in bank reserve ratios is certainly an important nod in that direction. But the risk is that these actions are simply not enough to temper the excesses of the Chinese boom. A fragmented banking system -- with China’s “big four” banks collectively having over 75,000 branches -- underscores the autonomy of “directed lending” at the local level that is likely to remain unconstrained by another round of incremental monetary
tightening measures. Moreover, with China’s banking system -- especially its biggest banks --running a chronic excess reserve position for interbank settlement and liquidity-management needs, this latest increase in bank reserve ratios is unlikely to have much of an impact on the still vigorous expansion of credit (see M. Goodfriend and E. Prasad, “A Framework for Independent Monetary Policy in China,” IMF Working Paper, April 2006). In other words, in contrast with the incremental tightening preferences of ever-cautious senior Chinese officials, the big risk of the boom is that it will now take a far more aggressive monetary tightening to slow this fast-moving train.
I think the odds of such a draconian shift in Chinese monetary policy are low. It would only heighten the risks of sharp curtailment in credit and a related increase in unemployment -- an unacceptable outcome for a Chinese leadership that has long put its highest priority on social stability. In the absence of more aggressive monetary tightening, the onus of policy restraint would have to fall more on administrative actions. That seems likely to thrust the NDRC into the limelight as the major actor in the Chinese policy arena. Accordingly, I would not be surprised if Chairman Ma Kai of the NDRC announces a major broadening of industries and regions to be targeted
for restraints on project finance. Such a policy approach favoring quantity restraints over interest rate signals could well represent a setback on the road to reform. But given China’s blended system of ownership and a still embryonic market system, there is really no other option. A key lesson from all of this is the urgency for China to move ahead rapidly on banking reform. Only then can a fragmented
system be centralized, enabling monetary policy to achieve the traction that China needs for macro control.
I have never bought into the China-collapse scenarios that have long been so fashionable in the West. Time and again, China has shown a remarkable ability to withstand severe external blows -- most recently, from the Asian financial crisis of 1997-98 and the bubble-induced global recession of 2000-01. I remain hopeful of a similar outcome this time, as well. At the same time, I would be the first to concede that China now faces major internal challenges that could actually be far
more vexing. Unlike the external shocks which China was able to counter by drawing on its massive reservoir of domestic saving as a source of stimulus, the current internal pressures will require the authorities to impose significant policy restraint. By waiting until the economy has overheated and is at risk of veering out of control, the need to act -- and act decisively -- has become more urgent. Nor can China rely on orthodox stabilization efforts to get the job done. Its central planners are likely to be more important than its central bankers in regaining control over a runaway economy.
All this raises the odds of a more abrupt China slowdown -- along with related downside risks to pan-Asian exports, commodity prices, and oil demand. I am not in the China hard-landing camp. But the administrative policy tightening I now envision suggests that the coming downshift in Chinese economic growth could well be a good deal bumpier than widely thought. The longer China waits, the bigger the bumps.