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Shrewd, far-sighted and pro-growth …

January 18, 2006

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India's economy policy has not been as "shrewd, far-sighted and pro-growth" as China's.  That's why Nick Kristof is betting on the former communists in Beijing, not the Oxbridge/ Reserve Bank of India/ IMF economist now running the show in New Dehli ...

I am not part of the Nick Kristof-Thomas Friedman we all need-to-go-to-Beijing to learn how far-sighted economic policy makers do things school of thought. 

It is hard to argue with success, or China's recent growth rate.  But to me, China's recent policy has been pro-growth now, even if that growth comes at the expense of bigger risks in the future.  So it is the "shrewd" and "far-sighted" part of Kristof's argument that troubles me. 

China's recent growth has been propelled by two things:

  • A huge surge in exports - they have roughly tripled since 2001.  The surge in exports has been supported by a huge surge in reserves.  China's reserves also have roughly tripled. 
  • A huge surge in investment, both absolutely and relative to China's GDP.  And far more of that investment has been financed by the Chinese banks that Kristof criticizes as a disaster than by foreign direct investment.  Bank lending really surged in 2003 and early 2004 -- and it still is increasing at a decent clip.

Both the surge in exports and the surge in bank lending have stemmed in no small part from policy choices made by the Chinese government, not the least China's steadfast commitment to a dollar peg after 2002.  These policies have generated rapid growth now, but, I suspect, problems later.  

China's rapid export growth since 2002 - growth that has contributed directly to a pace of industrial production growth that is high even by Chinese standards (See Jean-Luc Buchalet) - does not just stem from joining the WTO or China's inherent dynamism. China's economic policy mix also changed in 2002: it stopped linking to a rising currency, and started linking to a falling currency.      Even today, after the 2005 dollar rally, the dollar is far weaker than it was in 2001 and early 2002.

The dollar peg contributed to fast export growth in two ways.  First, the renminbi fell significantly against the euro.  That led directly to a surge in Chinese exports in Europe.  Don't forget, China's exports to Europe have been growing even faster than its exports to the US.   Maintaining the dollar peg also contributed to the growth in China's exports to the US, even though China only gained in competitiveness from inflation and productivity differentials.  Why?   Because reserve accumulation soared to around 10% of China's revised GDP, and by investing its reserves in dollars, China has helped to keep US rates down, US housing prices up and US consumption strong.

China bought fast export growth by financing its biggest customer big time.  Vendor financing - particularly on rather generous terms -- buys growth today, but sometimes, trouble tomorrow.

Pro-growth?  Sure.   Far-sighted?   Too early to tell.   The benefits of China's policy are front-loaded; the costs, I would argue, are back loaded.  More on that later.

The surge in bank lending that has contributed to China's investment boom raises similar question.  Credit booms generate growth today.   Loans rarely go bad immediately.    But if the credit boom gives rise to a set of new bad loans, it can generate problems tomorrow.

Not all of the recent surge in investment has been financed by a surge in bank lending.  But lots of it has.  China is in the process of reforming its banking system, to be sure.  But that is different from saying the China has a modern banking system.   Banks owned by the central government - the state commercial banks - have made a ton of loans.  And banks owned in part by China's local governments have made a ton of loans as well.  The joint stock commercial banks are still smaller than the big four state commercial banks, but they are growing far faster.

A credit boom almost always improves bank balance sheets in the short-run.  The stock of performing loans surges.  The share of NPLs falls just from lending growth.  And with a floor on lending rates and a cap on deposit rates, China's government assures that these loans are profitable.  Bank income rises - making it easier to write off bad loans.

And all that lending means new roads, new factories, new apartments and all sorts of signs of progress.  

The benefits of a lending boom are front-loaded while the costs are back loaded.   Too much capacity relative to demand.   Too many new apartments even for a city growing as fast as Shanghai.  Falling prices.  A new round of bad loans.   Less investment and slower growth.  A banking system that ends up needing an even bigger government bailout.

Letting the banks try to lend their way out of trouble certainly has been pro-growth.  But it is not obvious to me that it will prove over time to be shrewd and far-sighted.

One of the funny things about China is that we don't know quite how much growth China has actually bought with its existing policy mix.   The official data probably understates China's real growth over the past few years.   In 1998, electricity consumption data suggested a far stronger slowdown than appeared in the official GDP data; right now, electricity consumption data suggests far stronger growth.  See Buchalet again.  He has a nice chart comparing the official growth data and the electricity data.

Of course, you can tell a different story if you focus on China's low 2005 oil imports.   The only obvious way to reconcile the electricity story with the oil story is a big fall in the amount of oil China burns to produce electricity.    Demand got ahead of coal generated electricity supply in 03/04, but supply caught up in 05 ... slowing the pace of growth of demand.   

Or something.   Transparency has not been a big part of China's shrewd far-sighted pro-growth policy mix.   Trying to make sense of the data coming out of China remains a challenge.   In 2005, did growth slow (slowing oil imports, slowing imports in the first half of the year)?  Stay at the same high level (strong growth in electricity demand)? Or accelerate (export and investment growth stayed strong, imports slowed , consumption picked up)?  Beats me.

Many admire China's policy of intervening in the foreign exchange market, keeping its exchange rate weak and relying on exports for growth.   Some say that only the export sector can employ all the rural migrants that are set to join China's urban labor force.   Others argue that subsidizing multinationals is the key to the transfer of technology and know-how needed to jump-start Chinese manufacturing.

Maybe.  But I suspect the benefits of China's policy of supporting its exports with an undervalued exchange rate will, like the bank credit boom, prove to be front-loaded, while the costs are back loaded.

Right now, a non-trivial fraction of China's national wealth is tied up in long-term fixed-rate dollar-denominated loans to one very large debtor - the United States.    Chinese households (who now have $1.7 trillion in savings) deposit funds in banks that buy the central banks' sterilization bills, indirectly financing the central bank's accumulation of US treasuries and the like.   With $820 billion in total reserves ($880b counting reserves shifted to the state banks) and roughly $600 b, if not more, in dollars, China has bet at least ¼ of its revised GDP on the dollar's ability to hold value relative to the RMB.  Yu Yongding doesn't think that's a great bet.   Nor do I.  Nor, I bet, does Yu's boss.

Moreover, China may well find that it has to keep on financing the US - and adding to its bet on the dollar - long after its exports to the US have reached a plateau.  

Since the post-.com bubble in 2001-02, US imports have increased 13.5% of US GDP in 2001-02 to maybe 16% of US GDP in 2005.  Some of that is oil, but a lot of it is China - US imports from China have risen rapidly has a share of US GDP.  The rise in imports as a share of US GDP certainly made it far easier for exports to rise relative to China's GDP.

But if imports keep rising faster than US GDP, the US is on track for a 10% of GDP current account deficit real fast.  See last week's Outside the Box from John Mauldin, among others.   The q4 2005 US current account deficit will be close to 7%, and the income balance is set to swing to a deficit of 1% of GDP over the next two years on the back of the Fed's tightening.  Just keeping the trade deficit constant implies - in all probability - that imports will probably start to grow in line with GDP.

That will be a more difficult environment for China.  Less export growth.  Probably slower growth in industrial production. 

But the slowdown in Chinese export growth may not be matched by a reduction in the amount of financing China provides the US.   That means that the annual subsidy from China's central bank (read taxpayers) to the US won't go down, even though that subsidy, over time, could well less and less export growth.   Rather than financing growth, the annual increase in China's reserves will be needed just to sustain the status quo.

John Maudlin doesn't quite make this argument, but he comes close:

What if China and Japan decided to stop buying our debt with their excess dollars? Would that not mean US interest rates rise? That would mean fewer homes sold and at the very least a dramatic slowing, if not a retreat on home prices. That would mean there would be much less mortgage refinancings. As we saw last week, that would drop GDP about 3% or more, pushing us to the edge of recession.

It would also mean foreign currencies would rise and the dollar fall. That would mean we would buy less foreign goods, and specifically Chinese, Japanese and Korean goods. Their economies would slow down, and perhaps move into recession, thus dropping the value of their currencies and reducing their already razor thin profit margins. China in recession would not be a very happy dragon. They need to create 20,000,000 new jobs a year. Hard to do that in a recession.

So, the game continues. They buy our debt. We buy their stuff. They know, as we saw last week from the quote from the Chinese banking official, they are going to get screwed (that is a technical economic term) on their dollar holdings. But what else can they do? They are on a treadmill and have to keep running just to stay in place.

I suspect China hopped on this particular treadmill back in 2002 without much of a plan for how to hop off - and they are in the process of discovering that hopping off won't be easy.

In the past, China was running toward a much higher level of exports.  But at some point, China could start running in circles.   Reserves will keep rising; its exports won't - at least not as a share of GDP. Running just to stay in place isn't as much fun as running toward somewhere. 

Again.  Front loaded benefits, back loaded costs.  So far, I suspect China has gotten a large share of the benefits that come from a weak exchange rate and soaring reserves, but only a small share of the ultimate cost.  China's recent economic policy choices have worked so far.   But are they shrewd and far-sighted, or risky and short-sighted?   The classic Zhou Enlai quote may apply here: it is too early to tell.

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