Tuesday, August 25, 2015

Chinese Economy: Post GFC


   A series of recent developments in China have exposed the extent of growth slowdown in China, previously hidden by the careful control that the CCP exercises over information.  This means that in the short term the external environment will become more uncertain as markets understand and absorb this new information. The effect on the real economy however depends on how much of the growth slowdown has already occurred and has been transmitted to commodity markets and China’s supply chain. As with the growth slowdown that has already occurred (from 10% to 6-7%), further deceleration will have both a positive effect through lower oil & other commodity prices, and a negative one from Chinese excess capacity in tradable goods.  However, in the medium term a decline in the growth rate of the Chinese economy will be co-related with a decline in investment in manufacturing and other tradable goods, reducing the over-capacity created by past Chinese investment.  This will benefit the Indian economy.

Trends & Bubble

     The Chinese economy has long stood out as an economy that has been able to maintain very fast growth for several decades.[i] Right up to and including the Global Financial crises it had averaged a GDP growth rate of 9.9 per cent per annum for three decades. However a study of such fast growing economies also showed that such high growth rates cannot be maintained indefinitely.[ii]  Some of us had predicted at the end of the 1990s, that the growth slowdown would occur around the middle of the current decade.[iii] The advent of the Global financial Crisis in 2008, increased greatly the probability of this growth slowdown occurring during the 2010s. I had also suggested that the degree of slowdown could be minimized if and only if the basic model of Chinese growth was changed from a “net export-investment” led one to a to neutral one with respect to wages & profits, consumption & investment, manufacturing & services and exports & imports.[iv]  This did not happen.
   The massive credit policy response of the Chinese government, which cannot be distinguished from fiscal-monetary policy, given that the Chinese banking system was practically a department of its Finance Ministry, masked the, degree to which the global slowdown in GDP and Trade growth had affected the Chinese economy. At that time I had warned in the IMF that this credit fueled growth could be maintained for a maximum of three to five years, before growth would slow down. The credit boom raised the formal debt:GDP ratio of the economy increased from 121% of GDP in 2008 to 163% of GDP by 2013. The debt routed through the unregulated shadow banking sector has been estimated by private analysts to have increased by a 100% of GDP. The effects of the debt fueled bubble were felt not just in manufacturing excess capacity but also in the real estate sector. We know from the history of such debt fueled bubbles, as analysts began to warn in 2014, that  substantial proportion of bring down the rowth rate sharply (hard landing) when they burst.  
    A number of reports have appeared over the past few years about empty apartment complexes and even empty cities in China. This and other indicators such as growth in electricity consumption, led several analysts (including us) to conclude that China’s actual growth was likely a per cent point below the officials numbers released by the Government i.e. around 6%. Recent developments suggest that the growth is trending down further by about 1 to 2%, below the 6% that is likely already happened, i.e. it may be trending towards a 4-5% level.  Thus growth rates of 4% or lower, representing a hard landing for the Chinese economy,  are no longer unimaginable for the Chinese economy, if fundamental structural reforms to shift from an export-investment led economy to a domestic consumption led economy do not take place. 

Market Developments & Devaluation

       The panic reaction revealed by the use of draconian control methods to prop up the stock market in June and the shock devaluation in August suggest that the Communist Party (CCP) may have lost its ability to manage the economy and maintain a growth rate of around 6% (a much wanted soft landing). Consequently the probability of a decline in Chinese growth rate to 4% (feared hard landing) has now increased to 30%, from less than 10% a year ago and about 1% about three years ago.  

Monetary Policy

    China's monetary policy actions on August 24, 2015, fall into two categories: A conventional reduction in Banks reserve ratio combined with a cut in the benchmark lending rate. These will have little or no effect on China's growth rate, which is on a clear declining trend and is currently around 6% even though official data suggest it is close to 7%. Over the past year or so China's capital account has moved from a net inflow to a net outflow situation. Before the devaluation these outflows were likely met from foreign exchange reserve draw down. This would reduce the monetary base and lead to a tightening of monetary policy. Thus the monetary policy action may also be seen as a move to counter this tightening.  
     Looking forward, expectation of further devaluation could accelerate the capital outflow. Thus the authorities are confronted by a dillema. If the exchange rate is genuinely freed it could set off a spiral of capital outflows and further devaluations. The other option is to hold the exchange rate, meet all outflows from the ample foreign exchange reserves and offset the consequent monetary tightening by further reductions in the bank reserve ratios and (controlled) interest rates. The authorities are likely to lean towards the latter option, perhaps interspersed with small devaluations of the Yuan, linked to visible changes in the external environment for China.
   The second part of the monetary actions consisted of increasing financing for banks and financial institutions that operate in rural areas and provide consumer credit for consumer durable (automobile) purchase. Though such lending has long term potential it is probably too little and too late to have an impact in 2015.

   Though the monetary actions will have little effect on China's real growth rate, they have helped correct the over-reaction in several global markets, starting with European markets and to a lesser extent in the US and Indian market.

China Growth Projection

    Real economic growth is therefore likely to slip towards the 4-5% level unless more fundamental reforms of China's growth model takes place. This includes a complete halt in lending to State, provincial and Party inked companies for investment in sectors with excess capacity and the diversion of this lending to the service sector and small & medium consumers. Further there is need for complete decontrol of wages, so household income income and consumption can rise & drive the Chinese economy. The political economy of China's Communist Party suggests, however, that the CCP will not undertake any reform that appears to undermine its unchallenged control of the economy and risks building alternative center of politico-economic power eg a genuine large scale domestic private sector.

  Chinese economic growth has likely already slowed to 6%. A further slow down to 4% would imply that 2/3rd of the growth slowdown has already occurred while 1/3rd is still to take place. Correspondingly, 2/3rd of the real impact of the China slowdown on natural resource prices and producers, on prices & producers of metals and other commodities and supply chains into its manufacturing machine have already occured. Only another third remains to be actualized. 

Implication for India

      Indian policy can minimize the adverse short term direct effects of Chinese hard landing by ensuring that the “Real effective exchange rate (36 country)” of the rupee does not appreciate (repeat not).  This is critical to maintaining medium term competitiveness, given the negative growth of Indian goods exports for the last seven months and the worsening of the balance on goods and services (in GDP) during the last three quarters.  Temporary measures to control any potential dumping by Chinese firms during the next year or so would also be justified, but these must be withdrawn once the immediate threat has passed.  India can minimize the negative effect of a Chinese hard landing by accelerating the reforms that are already on the Government's menu, such as the GST, bankruptcy law and other measures proposed in the last two budgets, plus the "Ease of Doing Business" and "Skilling India."

    In the medium-long term the reduction in profitability of investment, beginning to be revealed in the worsening profitability of foreign (FDI) firms operating in China, will also become visible in State and party controlled enterprises. With lower investible surpluses these State & party controlled firms will be forced to cut down their investment, and stop creating capacity that adds to global excess capacity in traded goods, particularly manufacturing.  Over time this will help reduce excess capacity globally and benefit India and other countries suffering from an imbalance between effective global demand and subsidized capacity creation by China.  In particular the globalized Indian corporate sector, producing standardize products such as metals and basic chemicals will benefit in the medium term.

   As a Chinese hard landing will put pressure on the global economic recovery, to really benefit from a Chinese hard landing, India may have to expand the menu of policy to other areas such as private entry into government monopoly controlled infrastructure, more competitive Banking sector, a reform of the EXIM policy through elimination of "specific duties" on textiles and a thorough overhaul of the QR-tariff regime for agriculture and Education policy & regulatory reform (including Health education) to enhance “Educate in India”. Sustained movement on institutional reforms (Police, legal & judicial reforms) is also important for long term growth sustainability.

[i] Arvind Virmani,”Potential Growth Stars of the 21st Century: India, China and The Asian Century,” Occasional Paper, Chintan, October 1999, www.icrier.org/avpapers.html and Arvind Virmani, “Star Performers of the 20th (21st) Century: Asian Tigers, Dragons or Elephants, Occasional Paper, Chintan, September 1999, www.icrier.org/avpapers.html .
[ii] Arvind Virmani, ““Accelerating And Sustaining Growth:  Economic and Political Lessons,” IMF Working Paper No.  WP/12/185, July 2012
[iii] China-India GDP growth Projections:Summary extracts from 2004 to 2014 (with references to originals).  IndiaChinaGrProjs04to14.docx .
[iv]  Arvind Virmani, “Global Crisis: Impact on China and India,” Keynote Address at a CII-CPR seminar, “Debating Inclusive Futures: Prosperity And Inequality In India and China,” March 19, 2009, New Delhi. http://www.cprindia.org/semiid.php?s=82  and Arvind Virmani, “Global Crisis: Impact on Growth Strategies”, Co-lead Presentation at the, Development Debate on Export Competitiveness, Korea Development Institute-WBI, Seoul Korea, March 10, 2010. http://info.worldbank.org/etools/docs/WBIvideos/avirmani/avirmani.html .

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