Chinese Economy: Post GFC

Introduction

   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.

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[i] Arvind Virmani,”Potential Growth Stars of the 21^st Century: India, China and The Asian Century,” Occasional Paper, Chintan, October 1999, www.icrier.org/avpapers.html and Arvind Virmani, “Star Performers of the 20^th (21^st) 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

http://www.imf.org/external/pubs/cat/wp1_sp.aspx?s_year=2012&e_year=2012&brtype=default.

[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 .

Inflation & Monetary Policy 2015-16

Introduction

   This note takes stock of inflation and monetary policy during the last few years and draws implications for future. The most important conclusion is the need for a 1 to 2% reduction in the repo rate during the current  year.

Inflation

          Inflation as measured by the Private Consumption deflator (PFCE) is projected by the CSO in  2014-15 to be 5.4 per cent , down 3.1 per cent from 2013-14 and 4 per cent points from 2012-13.  It is likely to fall by another per cent point to 4.5% in 2015-16. Average annual CPI inflation mirrors this decline, with a 3 per cent fall between 2013-4 and 2014-15. The CPI rise to 5.4% in February (from 3.3% in November 2014) is largely due to effect of unseasonal rains on seasonal vegetables. The marginal decline in CPI inflation in March to 5.2 per cent supports this conclusion. The effect of

Monetary Tightening

          With a nominal Repo rate of 7.5%, Real repo rate (using PFCE inflation) was 2.5% in 2014-15. The reduction of the nominal Repo rate from an average 7.9% in 2013-14 has been too small to keep the real rate from rising from a negative -0.9% in 2013-14 to 2.5% during 2014-15. This represents a sharp 3.4% point tightening of monetary policy at a time when inflation has fallen sharply. The tightening is equally sharp if we use average CPI inflation to derive the real repo rate, which has increased from -1.9% in 2013-14 to 1.7% in 2014-15

        Even though the economy is growing at a little over 7.4 per cent as per the new GDP data with base 2011-12, this is not true of the organized sector of the economy, which is growing at a much lower rate. High real interest rates are choking off recovery of interest sensitive consumer durable sectors like automobiles and housing and also of real estate in general.  Lower interest rates are critical to faster recovery of these sectors. One indication of this is the fact that the index of motor vehicle production in 2014-15 averaged 12% lower than it did in 2011-12. GDP from (Value added in) the Construction sector in 2014-15 is projected to be only 2.5 per cent higher than it was three years earlier in 2011-12.
    

    As the labor intensive real estate, housing and construction sectors uses a lot of rural migrant labor, the poor performance of these sectors is partly responsible for the documented slowdown in rural wage growth. This, along with a slowdown in agricultural growth can also be linked to the reported softening of rural demand after several years of firm demand. It should therefore be no surprise that demand for industries such as cement and steel supplying inputs to these two sectors are also in the doldrums.

Rupee Appreciation

     The Indian rupee has appreciated by almost 10% in real effective exchange rate terms (REER36 country index). This represents an additional tightening of the monetary policy.  The timing of current and capital account liberalization should be modulated to minimize the appreciation of the exchange rate.  A faster reduction on controls on capital outflows and reduction in import protection can help moderate the appreciation of the rupee and certainly needs to be part of the policy mix.  

     However the real interest rate interest differential with global rates has been rising and is now too high. It is drawing in excessive short term capital flow and leading to real appreciation of the rupee. If there is no change in nominal rates, the ratio of short term (ST)  to medium-long term (MLT) capital inflows is likely to worsen .

      The rupee appreciation is adversely affecting demand for the globally connected, globally competitive parts of the corporate sector (worsening the demand-supply balance), which seems to be operating at 60% to 70% capacity utilization and delaying recovery of fixed investment and the upturn in the corporate investment cycle. This consists of two parts: One the Metals & Mining: With Coal and mining policy being sorted out through transparent auctions, corporate metals and mining sector is likely to recover, followed by fixed investment in the sector. Two, the rest of the globally connected corporate sector.  In this case a correction of the appreciation will lead to faster recovery of demand, profits, ROE , sustaining the shift from debt to equity initiated by the fall in real interest rates. Fixed investment revival will follow with a lag.

      The delayed recovery in the globally connected & competitive (GC&C) sector also adversely effects the recovery in excise and corporate tax collections, which are collected mostly from the large, organsed corporate sector. Consequently both the corporate cycle and the tax revenue cycle(post global financial crisis)  are lagging GDP growth recovery compared to the normal recovery cycle (pre GFC).

       A rise in US interest rates will reverse some of the rising real interest differential, but that is still more than 6 months away. The profit expectation, ROE and risk profile of the globalized part of India’s corporate sector will worsen in 6-9 months if nothing is done to reverse the appreciation.

Infrastructure

    Legacy problems in infrastructure, created partly by overoptimistic demand projections and partly by government directed lending by Public Sector Banks (without resolving difficult policy & regulatory issues) have not been resolved as quickly as necessary for speedy recovery of this sector.  They therefore continue to delay PSB (NPA) and corporate infrastructure revival in sectors such as highways. However, Central Government’s expenditure plans have begun a revival in power and railways sub-sectors.  This, along with reforms in other sectors, will also have a positive effect on corporates and banks with non-performing assets in other infrastructure sectors. 

   An obvious implication of the corporate problems outlined above is that the Banking sectors appetite for lending to these sectors is adversely affected.

Expectation Effects

     As a decline in repo-rates gives rise to expectations of debt asset price appreciation that will be reversed after the asset price appreciation, it is not sustainable after interest rates fall. Such expectations argue for sharper, quicker reductions in repo rates rather than in small steps over a long time period.

Inflation & Monetary Policy in 2015-16

  In projecting  inflation for 2015-16,  two factors are significant. First core, non-food, non-fuel inflation in March was 4.4 per cent, which was also the average of the last four months. Core (non-food, non-fuel) WPI inflation in March was even lower at -2.5%. It is reasonable to expect the gap between the two to close, particularly given decelerating inflation in transport, real estate and wages which are relevant elements between wholesale and retail markets. Thus we are already in 2015, well on the way to the 2018 inflation target of 4 per cent, at least as far as core inflation is concerned. Food inflation is currently running at around 6.1% in the CPI, but is much lower at 4.4% in the WPI, indicating that CPI food inflation is headed lower. If government focuses on agricultural reform and as promised in the budget, NITI can develop a consensus among the States, food inflation below 6% in January 2016 and 4% in 2018 is feasible. There is large gap between the CPI (4.5%) and WPI (-10.5%) on fuel inflation, because the complex system of price controls, administered prices and subsidies. However, even if there is some rise in global oil prices during the year, CPI fuel inflation is unlikely to exceed 6%. Thus total CPI inflation is likely to be between 5 and 5.5 per cent.

     Inflation as measured by the private consumption deflator or by average CPI inflation is therefore projected to decline further by about 1 per cent point. If the nominal repo rate remains unchanged, the real repo rate will increase further to 3.1% in private consumption deflator terms and to 2.1% in CPI terms. Such a tight monetary policy has not been seen since high growth year of 2007-8 when CPIIW inflation averaged 6.2% and global inflation pressures were high. Even if the nominal repo rate is reduced to an average of 6.5% for the year 2015-16, the real repo rate will be 1.1 per cent in terms of average CPI inflation and 2.1 per cent in terms of PFCE inflation, more than enough to keep pushing inflation towards the 4% target for 2017. Thus a reduction in the nominal repo rate is urgently required.

Transmission

   The argument of weak transmission of repo rate movement applies to both rate rises and rate reductions. If transmission of monetary policy signals like the repo rate is weak, a merely signaling of a change in intentions by the central bank can have little or no effect on market interest rates. The central bank may therefore need to make larger changes in the repo rate to have the same effect as in countries where markets are well integrated and efficient.

     It is also sometimes argued that monetary transmission is asymmetric in the Indian system, where ¾ of the assets are controlled by government owned banks.  To the extent that these banks are in turn controlled by risk-averse appointees of the government, part of whose time is spent on trying to minimize government pressure on lending to sub-sectors with high policy or regulatory risk and/or inefficient and failing borrowers (cronies), this has some validity.  In this situation, jaw boning by the Central bank in co-operation with the Government can be a valid instrument for correcting the asymmetry. Beyond this, it suggests that larger changes in repo rates would be required when lowering rates than when raising rates, thus introducing a down ward bias in rates.  
        Historical data indicates that as far as monetary policy managers are concerned, positive inflation surprises have historically predominated over negative ones and consequently the real repo rate has averaged a negative -2.5% or so since 2004. A balancing of these two factors suggests that a 4 per cent nominal  repo rate would be appropriate when inflation is projected to be at the long term target of 4 per cent (+/- 2%), with upward(downward) revision of repo rates if inflation surprises are positive(negative).

Conclusion

    A zero average real repo rate seems to be an appropriate long term target for the RBI, while shooting for a minimum one percent point reduction in the real repo rate for 2015-16. If inflation declines below the conservative projection of 5 to 5.5 in this note, a larger reduction in the nominal repo rate would be warranted.

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A shorter version of this post appeared earlier in ET blogs at  http://blogs.economictimes.indiatimes.com/PolicyAnalysis/why-a-reduction-in-the-nominal-repo-rate-is-urgently-required/