Summary
China’s economy is slowing down from a high base. Further slowdown, probably substantial, is likely in the second half. It is a good thing for China’s economy overall. The past rapid growth depends on bubble economy. It is not sustainable. The longer it lasts, the more pain its downfall would cause. China’s choice is to take the medicine now or face surgery later.
The slowdown doesn’t imply that the monetary tightening is sufficient. China’s interest rate is far too low for the average inflation rate over the next five years. If not corrected, inflation would continue to rise despite the economic slowdown. China should increase deposit rates by three percentage points as quickly as possible to stop inflation expectation from worsening.
The slowdown isn’t likely to become hard landing. Exports, consumption, and infrastructure are likely to continue to grow. China has the luxury to pop the property bubble without a recession because the dollar is weak.
If China loosens up again in the name of protecting growth, it would surely revive the property bubble. It increases the magnitude of the adjustment in future. Its bursting is likely to be prompted by the Fed’s monetary tightening rather than China’s choosing. A hard landing becomes inevitable.
Slowdown may have begun
The national consumption of electricity slowed significantly in April. There are no firm evidences on if it was due to supply availability or weakening demand. The April exports grew by 29.9% and imports up by 21.8% from last year. Taking into account of price increase, the imports didn’t rise significantly.
In terms of business feedbacks the export sector appears to have the best response. The data support that. The export businesses seem to be able to raise prices substantially. 20% increase from last year seems to be common. Hong Kong recently reported 8% increase in the price of its re-exports. It is always difficult to pin down price data. The official data are often inaccurate. Considering that retail sales are weak in all OECD economies, I suspect that price increase accounts for most of China’s export growth now.
Most businesses are complaining of liquidity problem. It is likely to affect their expenditure. Local governments are deeply in debt, cannot sell much land, and are not getting bank loans like before. The government and business spending are much more than the household spending. Economic slowdown should be a logical conclusion from such observations.
Inflation is cutting household consumption. Even though retail sales are still growing at double digit rate, after subtracting for inflation, it is growing less than GDP. Considering how small and weak the household sector is, it is unlikely to sustain the economic growth rate while the government and business sectors are slowing down.
The slowdown is healthy
The current slowdown is from a very high base. Electricity consumption averaged under 8% in the 1990s. If the economic efficiency is improving, even 8% can generate 10% GDP growth rate. In the past eight years, electricity consumption has grown at 13%. Further slowdown from the current level shouldn’t be viewed as alarming.
In the third quarter, the slowdown may accelerate as local governments and developers give up hope for central government loosening policy again, accept lower level of liquidity, and cut expenditure accordingly. When it occurs, the electricity consumption may drop below 10% growth rate, possibly even below 8%.
Alarmist talks on economic crash would proliferate in the second half. However, they have no merits. First and foremost, the current growth rate depends on bubble and isn’t sustainable. The longer it lasts, the more pain it would incur when it bursts. Second, China’s choice is to accept bitter medicine now or face terrible surgery later. To loosen up again to revive growth is to drink poison to quench the thirst.
Even though local governments will cut back, their expenditures will still grow, though at much slower pace. It would be good for efficiency. It is obvious that image projects are significant in local government spending. If liquidity constraint forces them to cancel such projects, it would be very good for efficiency.
While exports may not be growing like before in volume, the price increase is welcome news. It boosts wages, which helps consumption. China is lucky in that regard. No other country is rising to challenge China’s manufacturing yet. Hence, it could pass the cost increase to global consumer through price increase. This gives China the time to deal with the inflation problem. If the exports were falling due to rising price, China would be forced into pushing inflation down quickly, which would make a hard landing more likely.
Inflation is hurting consumption. But it is still growing at a good pace. A new generation of consumers seems to have higher consumption preference. As long as wages keep growing, hopefully above inflation, the consumer sector will continue to grow.
The consumer, infrastructure, and export sectors will continue to grow even as the property sector deflates and the local government expenditures slow. Now is a great time for the central government to deflate the property market. The risk of a hard landing is relatively low. Even though the growth rate may become worryingly low over the next year, it would still be good by the future standard, which I would discuss later.
Good timing for adjustment is now
China is suffering a vast property bubble. The adjustment is a matter of time. Now is better than later, because China can handle its consequences without worrying about the external pressure. The Fed will raise interest rate above 5% either due to inflation or economic recovery. The timing is uncertain. It could start in the second half of 2012. When it happens, the dollar is likely to rebound. The vast amount of hot money inside China could leave. A property crash would follow. Such an abrupt adjustment would be very bad for China. Choosing to adjust now is in the country’s best interest.
Fifteen years ago, Southeast Asia didn’t adjust, because the weak dollar kept sending it liquidity to feed its property bubble. When the dollar turned, the whole region fell apart. The economic crisis soon became political crisis. The region is still struggling with its legacy. China should learn from its neighbors.
A popular theory against tightening is that China must grow out of its problems. If the growth slows down, many problems are exposed. This argument is terribly wrong. The problems originate from speculation. The leverage behind it is exposed when monetary policy is tightened. But, without adjustment, the problems only become bigger. The speculators will never retrench during good times. If China listens to this view, it is heading to the cliff.
Another argument is that tightening is hurting SMEs. They can’t get financing to grow. SMEs tend to be hurt more in a down credit cycle, as banks gravitate towards large companies for safety. But, the liquidity problem in the SME sector has a lot to do with speculation. An SME is in trouble if it is engaging in capex and can’t get the funding to keep it going. As the investment isn’t cash generating and the debt burden is already there, it could go bankrupt. Without an ongoing capex project, an SME can handle liquidity constraint by limiting investment and just reinvesting it operating profit. This is not the situation that many SMEs are in. Instead, they are in some sort of speculation that needs new money to keep the game going.
In the past three years, inflation has made business difficult for SMEs. On the other hand they see opportunities in asset inflation. While data are hard to get, it seems that most SMEs have cut capex and shifted to speculation. Some have pawned their factories to speculate in commodities, land, or stocks. If the trend isn’t checked, the speculation would get worse, tying down more and more bank loans. The difficulties in the SME sector should not be used for opposing the tightening.
Slowdown doesn’t mean the end of tightening
When the slowdown becomes apparent, many will argue that the tightening should stop, if not reversing. This would be wrong. The economy is coming off an unbalanced shape. Some liquidity tightness is triggering a significant adjustment in the local government and real estate sectors. Much of China’s inflation problem could be blamed on the excessive spending from these two sectors. But, without these excesses, China’s inflation would be much higher than before, because the labor and energy market balances have shifted in favor of inflation. The equilibrium interest rates would be much higher in this decade than in the past.
The past isn’t past yet. China’s M2 doubled in the past four years. Its inflationary power is yet to work through the economy. The current M2 target of 16% is substantially above the potential growth rate of the economy. Hence, it is still adding to inflation, though less than before.
China is entering a decade of double digit wage growth. It is a good thing for economic rebalancing. But its inflationary impact shouldn’t be discounted. If not handled well, it could lead to instability. The energy market is in a similar shape. The price for China’s main fuel, coal, is likely to rise significantly, due to rising production cost and slower production growth. It is likely that 5% inflation is a long term phenomenon. To deal with it, deposit rates need to be raised above 5% as quickly as possible. Otherwise, inflation expectation won’t stabilize.
Stabilizing inflation expectation should be viewed as a long term fight, separate from the adjustment in the local government and property sectors. The tightening policy should be viewed as normalization to reflect the new reality.
‘Slow’ growth may be necessary
The era of underutilized factors of production-labor, land, resources, and environment is over. It has significant implications for sustainable growth rate. ‘Trying to maintain the past rapid growth’ is dangerous in this decade.
Three decades ago, when China opened up to foreign capital and trade, it was a hugely underutilized economy. The labor force employed in the state sector wasn’t doing much. The natural resource base, mainly the energy sector, was untapped. China essentially underpriced these factors to increase market share in the world. This process of filling up the cup was the reason for the rapid growth.
The cup is now filled and some. In many areas, China has borrowed from the future to subsidize today’s production. The environment, for example, costs a staggering amount of money, possibly more than China’s foreign exchange reserves, to clean up. Not cleaning up is to sacrifice the people’s health for GDP. But, a massive health crisis is a matter of time. When it happens, the political force will shift the priority from growth to safety overnight. It would be better to start the process now, instead of facing it suddenly one day.
China’s labor market is facing serious shortage in the blue collar segment and surplus in the college graduate segment. The later couldn’t be solved through pushing growth, which only boosts demand for blue collar workers due to the nature of growth. Only economic rebalancing towards service and away from construction could solve the employment problem for college graduates.
The growth in the future depends mainly on productivity (‘TFP’) and, to a lesser extent, capital deepening. China has probably experienced total factor productivity of 4-5% per annum. Sustaining this rate may be difficult, as easy learning is done. But, China’s economy has a lot of inefficiencies due to structural problems. Reforms could reduce such inefficiencies. Putting the two together, 4-5% is still possible.
China’s infrastructure development is still massive but getting close to the end. Highways, railroads, subways, etcs., are likely to be completed soon. Further growth will have low efficiency, like in Japan. Capital deepening in China has mainly happened in infrastructure and, lately, in heavy industries. The opportunities in this decade are less than in the last. This factor is still big now but may decline to zero by the end of this decade.
Hence, China’s growth is likely to trend down from 10% now to 5% by 2020. This reality shouldn’t be viewed with alarm. 5% is very good growth, if the quality is good. Even though China’s nominal GDP doubled in the past eight years, it is difficult to find many people who would feel that way.
China doesn’t need rapid growth like before. The employment problem is largely solved. The aim of economic growth should shift to quality of life. When the system is configured properly, 5% can deliver very good improvement in quality of life.
Lastly, the economic slowdown could still make China the largest economy between 2020-2022. With 5% inflation rate, the growth trajectory can still triple the nominal GDP to $18 trillion by 2020, similar to the US’s then. If China doesn’t suffer a hard landing and devaluation, this path is possible. Hence, China should be more conservative in growth and stability tradeoffs.
Sustainability is more important than speed.