The Unbound Economy
Is China Really Immune to the Crisis?
Kenneth Rogoff
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CAMBRIDGE – Addressing the annual World Economic Forum in Davos, Switzerland, Chinese Premier Wen Jiabao explained his government’s plans to counter the global economic meltdown with public spending and loans. He all but guaranteed that China’s annual growth would remain above 8% in 2009. Wen’s words were like warm milk to the recession-numbed audience of global political and business leaders.
But does the Chinese government really have the tools needed to keep its economy so resilient? Perhaps, but it is far from obvious.
America’s deepening recession is slamming China’s export sector, just as it has everywhere else in Asia. The immediate problem is a credit crunch not so much in China as in the United States and Europe, where many small and medium-size importers cannot get the trade credits they need to buy inventory from abroad.
As a result, some once-booming Chinese coastal areas now look like ghost towns, as tens of thousands of laid-off workers have packed their bags and returned to the countryside. Similarly, in Beijing’s Korean section, perhaps half of the 200,000-300,000 inhabitants – mainly workers (and their families) who are paid by Korean companies that produce goods in China for export – reportedly have gone home.
With roughly $2 trillion in foreign-exchange reserves, the Chinese do have deep pockets to fund massive increases in government spending, and to help backstop bank loans. Many leading Chinese researchers are convinced that that the government will do whatever it takes to keep growth above 8%. But there is a catch. Even if successful in the short run, the huge shift toward government spending will almost certainly lead to significantly slower growth rates a few years down the road.
Simply put, it is far from clear that marginal infrastructure projects are worth building, given that China is already investing more than 45% of its income, much of it in infrastructure. True, some of China’s fiscal stimulus effectively consists of loans to the private sector via the highly controlled banking sector. But is there any reason to believe that new loans will go to worthy projects rather than to politically connected borrowers?
In fact, China’s success so far has come from maintaining a balance between government and private sector expansion. Sharply raising the government’s already outsized profile in the economy will upset this delicate balance leading to slower growth in the future.
It would be preferable for China to find a way to substitute Chinese for US private consumption demand, but the system seems unable to move quickly in this direction. If government investment has to be the main vehicle, then it would be far better to build desperately needed schools and hospitals than “bridges to nowhere,” as Japan famously did when it went down a similar path in the 1990’s. Unfortunately, China’s local officials need to excel in the country’s “growth tournament” to get promoted. Schools and hospitals simply do not generate the kind of fast tax revenue and GDP growth needed to outperform political rivals.
Even prior to the onset of the global recession, there were strong reasons to doubt the sustainability of China’s growth paradigm. The environmental degradation is obvious even to casual observers. And economists have started to calculate that if China were to continue its prodigious growth rate, it would soon occupy far too large a share of the global economy to maintain its recent export trajectory. So a shift to greater domestic consumption was inevitable anyway. The global recession has simply brought that problem forward a few years.
Interestingly, the US faces a number of similar challenges. For years, the US achieved fast growth by deferring attention to a variety of issues, ranging from the environment to infrastructure to health care. Even absent the financial crisis, addressing the shortcomings in these areas would likely have slowed down US growth.
This is not to say that the US and China are the same. One of the great challenges ahead is to find a way to bring these two countries’ savings into line, given the vast trade imbalances that many believe planted the seeds of financial crisis.
I was reminded of the challenge recently when a Chinese researcher explained that men in China today feel compelled to save in order to find a bride. The same week, a former student of mine who lost his lucrative financial-sector job explained that he had no savings because it was so expensive to date in New York! These social differences have little to do with the yuan-dollar exchange rate, although that matters, too.
One way or the other, the financial crisis is likely to slow medium-term Chinese growth significantly. But will its leaders succeed in stabilizing the situation in the near term? I hope so, but I would be more convinced by a plan tilted more toward domestic private consumption, health, and education than to one based on the same growth strategy of the past 30 years.
Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF.
Copyright: Project Syndicate, 2009.
www.project-syndicate.org
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tvselvakumaran 01:54 20 Feb 09
Professor Rogoff is right when he points out several shortcomings of the Chinese model of economic growth. However, it is only in the long-term (over 12 years) that the Chinese model is quite suspect. The main problem with the Chinese economy, in the long-term, is that its demographics is not favorable to its growth. Having pursued a one-child policy officially for several decades now, China finds that its demographic profile is skewing more and more towards an aging population. The second problem is that with a communist political framework firmly in place, China's economy is going to encounter serious difficulties when it graduates, in the coming years, from an economy based on manufacturing to one that is based on services and information, and further on towards an innovation-based economy. The third problem, which Professor Rogoff also mentions, is that there needs to be a serious alternative for exports, as an engine of economic growth. Relying only on exports for achieving rapid economic growth is an unsustainable policy in the long-term. The majority of China's population is poor, and lives in rural areas with inadequate infrastructure. The consumer demand among this section of China's population should rise fast enough to offset the slowing of China's export growth. This is a very challenging goal indeed.
In the short term (0 - 4 years), thanks to the freebies handed out by the American intellectual establishment, it seems quite certain that the Chinese economy is poised for 8%+ growth of annual GDP in real terms (i.e., after correcting for inflation). These freebies are mainly in the form of lax monetary policy and excess domestic spending -- 4 trillion dollars and counting -- in America, and are meant to ward off the ill-effects of voodoo spirits on the American economy and to suffuse it with animal spirits instead. This reckless spending has empowered China to announce its own two-year spending program, for an amount of 586 billion dollars at current exchange rates. As Premier Wen Jiabao explained at the World Economic Forum on January 28, because the Chinese government has carefully chosen to spend this money mainly on the poorest areas in China, one could expect that this spending would result in a dollar-for-dollar impact on the GDP, which, by itself, would ensure an 8%+ GDP growth for the next two years. Moreover, since China's own housing industry and its finance industry have not been seriously affected by the recent financial crisis in America, the Chinese government is free to focus its spending program to get the maximum effect for its money. Moreover, with over 2 trillion dollars of reserves, China's economy has already produced the resources in the past, that are required to finance this new fiscal spending program of the next two-years, and even further to six or seven years into the future. In addition, the phenomenal savings rate of Chinese families ensures that China need not worry at all about financing its deficit spending, unlike the United States. Most importantly, China can carry out this $586-billion spending program in the next two-years, and still engineer a mild appreciation of its currency against the US dollar, in case there are any complaints that it is manipulating its currency to keep it artificially depreciated.
In the medium term (4 - 12 years), the picture is less clear, only because the freebies handed out to China could lead to a protectionist backlash in Western economies. Nevertheless, the continuation of the 8%+ growth path seems a very real possibility for China. As such, the GDP of the United States for 2007 was about 14 trillion dollars, and that of China was 3.5 trillion dollars (in nominal terms). So, provided that the Chinese government does not get involved recklessly in any unilateral military adventures, there seems to be room for a doubling or a tripling of China's nominal GDP in the next 12 years. In any case, the Chinese intellectual establishment appears to have taken to some such forecast with a mission-critical focus, and is surely going to employ all its resources towards achieving that target. Broadly, two scenarios are possible in the medium-term.
Scenario I: There could be a re-enactment of the run-up to the East Asia crisis of 1997. Please recall that during the recession of 1990-91 also, the banking system in America was mired in a serious crisis -- the Savings & Loan crisis. The losses in this crisis extended to hundreds of billions of dollars. To ease the pain caused by failed property loans, the US Federal Reserve pumped huge amounts of liquidity into the US economy in the early 90s. With money available so freely at so low interest rates, investors and fund managers were looking for new avenues of investment that would beat the creeping inflation. At this point in time, the Latin American countries had already been bankrupted in the previous decade due to high volatility in the interest rates that the Fed under Paul Volcker had set to combat the high inflation of the 70s. So, this time, the American financial industry had to look to far off East Asia which had been demonstrating rapid economic growth for 20 years or so by then. In the five year period, 1988 - 1993, the market capitalization in all of East Asia had leapt 10-fold to over $870 billion. This inflow of dollars would only accelerate after 1993. With risk premia down to an absolute minimum, there was a super-charged, manic environment where billion-dollar deals were frequently done in minutes. Unfortunately, the East Asian and Chinese economies were not mature enough to present shovel-ready infrastructure projects or hand out consumer loans in the massive scale that the inflow of dollars demanded. So, the situation became inherently unsustainable.
By the mid-90s, the technology boom back in the US took off in earnest. The low-priced Chinese manufactured goods kept inflation very low, so that the American economy could function at rates well below the Non-Accelerating Inflation Rate of Unemployment (NAIRU). These factors enabled a sustained technology boom, which in turn provided a viable alternative for the dollars that were flowing into East Asia. Hence there was a sudden flight of massive amounts of capital out of East Asia. Though the East Asian countries had built up large reserves of foreign exchange, they could not handle this sudden and drastic outflow of dollars. The Thai baht was the first to devalue, forcing Thailand to default on its debt in 1997. The financial contagion spread to the rest of the East Asian countries one-by-one, putting an end to the 25-year economic boom in this region.
Fast-forward to 2009. The Fed has cut interest rates to the minimum possible range. There is a flood of liquidity in the economy. After two more years of fiscal spending, it could happen that the US government has succeeded in preventing prolonged deflation, and has gotten the economy out of recession but only into a mild recovery. Serious long-term prospects for economic growth are nowhere to be seen, even in the alternative energy sector or the hi-tech sector. So, once again money, in search of better returns than treasury securities, heads out to the fast-growing economies of China and East Asia. However, this time around, the American financial system has been taking massive losses in the mortgage crisis. So, there is going to be a steady stream instead of a flood. For their part, the economies of China and East Asia are much more mature now and would probably be able to absorb the inflow of a trillion or two of capital from the United States.
There is also an in-built stabilizer in this scenario. If the Fed resorts to a monetary policy that is too lax, and the politicians resort to protectionist backlash, then this would result in an all-too-rapid slowdown of exports from China. In return, China could abandon the US dollar, and finance its domestic spending program by printing more of its own currency. This would result in a race to the bottom. On the other hand, if the Fed, the US government and the private sector work in close co-ordination with China, then the American finance industry could get good returns on its capital investments in China. These rates of return would probably be high enough to offset the negative impact of inflation which could creep up anytime after this year. These returns, in combination with the alternative energy sector and hi-tech sector, could provide the foundations for robust economic growth in America for the next decade or so. Moreover, America could export millions of its citizen to China and East Asia as consultants in business, politics and as teachers of the English language.
Scenario II: A group of proximate countries either from Africa, Latin America or Eastern Europe could give China a run for its money, as the manufacturing capital of the world. With the United States spending trillions of dollars to upgrade its infrastructure and to shore up its own manufacturing base, this new group could negotiate an effective partnership with America, and possibly also with the European Union, to successfully keep out Chinese goods from Western markets. If this situation is achieved purely through more efficient production processes and not through any protectionist backlash, then China would have no choice but to rely solely on its internal demand to sustain rapid GDP growth. However, one should note that the emergence of such a competitor group would take at least a decade. In the cases of the East Asian Tigers, China and Japan, each of these economies had been growing rapidly for 20 years or more, before they were considered as serious threats to the world order existing then. Hence this scenario seems less likely to occur in the medium term than Scenario I.