China’s macroeconomic policy dilemmas
Like many with strong opinions, I sometimes criticize (politely, I hope) press coverage of topics that I follow closely.
For example, I have long thought that coverage of China’s consumption boom should be qualified by noting that exports and investment continue to grow faster than consumption. As a result, consumption is still trending down as a share of China’s GDP. That helps to explain how savings growth has been able to outpaces investment growth. China’s current account surplus is rising, not falling.
But more often than naught, I am impressed by how well the financial press covers difficult topics. For example, Andrew Batson’s reporting of China’s very strong first quarter GDP in Friday’s Wall Street Journal hit all the right notes. Batson's reporting combined reactions to China's GDP data from some of the best Anglophone China watchers around – Jon Anderson, Nick Lardy, Louis Kuijs – with the reaction of key Chinese policy makers.
Li Xiaochao – the spokesperson for China’s National Bureau of Statistics – seemed to indicate that China intends to continue to take a series of small steps to try to slow its growth without changing too much.
“One very important lesson we have learned is not to make excessively large policy adjustments but rather to take small micro-steps and fine-tune them. The aim is to avoid a hard landing of the economy.”
China has avoided a hard landing. But it also hasn’t really started on any approach path that will lead to a landing of any kind – hard or soft. Its economy is gaining altitude.
Consequently, a key question that arises from Batson's reporting — and Li Xiaochao's statement — is whether a new set of small steps will work better than the small steps that have been tried so far. A tiny appreciation against the dollar, for example, won’t work if the dollar continues to slide against other currencies.
If China’s goal is to avoid too big of a boom now in order to limit the risk of a big bust later, its existing policy approach hasn’t worked. Stephen Roach made this point quite clearly last Friday.
It’s been about three years since the current tightening campaign began. Yet China’s GDP growth has accelerated steadily over that period, from 9.5% in 2004 to 9.9% in 2005, 10.7% in 2006, and now to 11.1% in 1Q07.
Roach expects – based on his conversations with key Chinese policy makers – that China will take more decisive actions to cool its economy. The credibility of China’s leadership is one the line. He expects China to use administrative controls to clamp down on investment.
Clamping down on investment has worked in the past. Think back to early 2004. But it has consequences. It is a step away from relying more on markets and less on central planning to govern China’s economy. Restraining domestic demand growth (by curbing investment) rather than restraining export growth (by allowing the RMB to appreciate) also has tended to increase, not decrease, China’s current account surplus.
I suspect that a new round of administrative tightening – perhaps accompanied by a removal of tax preferences for exports but not accompanied by sufficient RMB appreciation against the dollar to offset the dollar’s slide v other currencies – will deliver more of the same.
Another China watcher — Eswar Prasad — implicitly recommends a different policy course. Call it less NDRC, more PboC. Or less central planning and more central banking.
Prasad argues that China needs to rely more on the traditional tools of macroeconomic management, like interest rates. In order to do so, China needs to let its exchange rate move. Otherwise, higher Chinese rates will just suck more money into China, thwarting the desired tightening (India is discovering this now). China needs higher rates than in the US to curb investment growth — and to make it attractive for firms to put their profits on deposit in the banks rather than plough them back into anything that offers a nominal return of 2-3%. But higher rates will pull in more money (or would, but for controls) and work against China’s ongoing efforts to encourage private capital outflows unless there is a meaningful chance the RMB will fall.
Prasad thinks China’s authorities want financial modernization more than exchange rate flexibility, and consequently recommends framing external demands for more flexibility as a necessary part of financial modernization. Without the ability to raise interest rates in a meaningful way, China will be forced to rely more and more on administrative controls. After all, the banks are very liquid and have plenty of funds to lend out. And interest rates are too low to curb demand for borrowing.
Prasad’s position has long appealed to me. But I am losing conviction. I suspect China probably missed the window when it could have gained a degree of monetary autonomy with a modest revaluation and a bit more RMB “flexibility.”
By waiting, China let pressures build. China’s current account surplus is on track to reach $350b, if not more, this year. To bring about balance in the absence of government intervention, China needs to let the RMB appreciate enough so that import growth rises and export growth slows enough to bring the surplus down. OR it needs to let the RMB rise to the point where there are strong expectations that it will fall. That would induce $350b of private capital to flow out of China in a world where Chinese rates are higher – not lower – than they are today.
To gain monetary flexibility, China now needs – I suspect – a rather large revaluation. One large enough to end strong expectations of further appreciation. One large enough to induce private capital outflows even with higher Chinese interest rates. I don’t think China’s authorities are willing to let that happen.
That implies that administrative controls will remain the main policy tools available to China’s authorities. But changes in prices controlled by the government can also play a role. The RMB/ dollar is certainly one such price.
I consequently hope that China relies a bit more on RMB appreciation to slow export growth and a bit less on administrative controls to curb domestic investment this time around.
“To gain monetary flexibility, China now needs – I suspect – a rather large revaluation. One large enough to end strong expectations of further appreciation. One large enough to induce private capital outflows even with higher Chinese interest rates. I don’t think China’s authorities are willing to let that happen.”
If they dont revalue now they’ll have the same problem, worse, later. Administrative controls are no substitute for revaluation, except in the short term. You agree?
“To bring about balance in the absence of government intervention, China needs to let the RMB appreciate enough so that import growth rises and export growth slows enough to bring the surplus down.”
Yes, and further, in an early stage appreciation will make the surplus larger (Jcurve)!!
I wonder whether the reason the Chinese are not worrying about dollar devaluation leading to a decline in liquidity is because the concurrent rise in the RMB would replace the purchasing power of the devalued dollar. That is, if you hold $1T in dollars and, say $5T in RMB, and the value of the dollar-denominated assets drops by 10%, a rise of RMB-valued assets by just 2% perfectly offsets.
Alas, the PBoC (and by implication the Chinese government) has RMB denominated liabilities and $ (and euro) denominated assets …
and on the broader point, a move in the rmb doesn’t have to lead to any change in “liquidity” — the PBoC decides how much RMB liquidity to inject into the system by the scale of its sterilization operations. Slower reserve growth and less sterilization = same amount of RMB liquidity.
Japan eyes active state investment fund
Japan is considering establishing a special state investment fund to manage part of its $909bn in foreign exchange reserves and improve returns.
Fundamental question:
China’s GDP growth is skewed toward domestic investment and exports. Given that the authorities recognize risk inherent in the sustainability of the overall growth rate, what is it that causes them to favor the adjustment channel of domestic investment (monetary policy) over exports (FX policy)? Why do they want to be as cautious as they are on the FX side, to the point where it seems to be the last resort adjustment channel, particularly since they must understand it boxes them in to some degree on the domestic tightening front? What is the risk they fear in not moving more quickly on FX adjustment?
i would argue that China has been unable to use classic monetary policy and unwilling to use the fx channel — and so has instead relied on a policy tool not normally used in advanced economies (administrative controls on credit) as a tool of macro control.
why? I suspect the Chinese enormously over-estimated the impact of small exchange rate moves; they really worried a 2% appreciation might change things (or at least seem to). they also worry about the impact of RMB appreciation on labor intensive sectors –i.e. jobs. this fear is real, but a country cannot both move upmarket (see China, cars over the past week — as well as the shift in electronics components production to China) and keep all low-end export jobs …
Finally, i have come to the conclusion that certain export interests have effectively captured policy — interest group pressure plays a role here. using the pboc to provide an off-budget export subsidy has generated a lot of winners … and the winners from a policy shift (china’s future taxpayers) aren’t organized.
Very interesting to hear about Japan’s plans for an investment fund. I am increasingly uneasy about this trend. It is all too easy for financially naive central bankers to get seduced into investing in risky assets after a long period when risk has been a worry rather than a reality. Unlike in Singapore, in Japan and China the reserves are matched by government debt, so they cannot afford to lose money. If they have more reserves than they know what to do with, and do not want to unwind the currency switch out of their currency, they should consider using currency swaps to take the currency position instead and pay off some of their government debt. Central banks already seem to be reluctant to allow financial instability to take its course without being directly involved themselves.
Brad,
Profit margins tend to be very slim in China. A 2% profit margin in textile manufacturing is typical even with the average Chinese worker pay of $126 per month. A $20 shirt sold at Walmart is likely purchased for only $3 from the textile manufacturer. The bulk of the price markup is in the retailing, marketing, and distribution of the shirt. Thus the sale of a shirt made in China contributes more to the GDP of the US Economy than to the Chinese economy. Sourcing directly from China, Walmart’s global procurement headquarters is located in Shenzhen China.
A revaluation of 20 to 30 percent would be devastating for a lot of export manufacturers and the labor-intensive employment situation in China. It is prudent for the Chinese government to take gradual steps toward revaluating the yuan currency. The US government scapegoats the low paid Chinese workers rather than address the obscene profits by Walmart and other multinational corporations that promote the “race to the bottom” for global labor standards.
Industrial profit margins, on the other hand, are 15%. If China really wants to climb up the development curve, maybe it’s time to let Bangladesh make the shirts for Wal Mart.
Macroman,
Unlike the homogenized US economy, there are really two China’s in the single Chinese nation. The urban developed cities of Shenzhen, Hong Kong, Shanghai and Beijing have infrastructure and industrial technology base comparable to many Western developed nations. The hinterlands of China due to transportation issues and rural cultures are a completely different story. While a middle class and urbanized segment of Chinese society has grown to perhaps 300 million, it would be totally irresponsible and reckless, leading to political instability, for the government to disregard the economic interests for the majority of the population. Labor intensive employment is an essential bedrock for the economic and political stability of the Chinese nation state.
Instead of simply scapegoating the Chinese for every US domestic economic issue, both nations need to find realistic and mutual solutions. For instance, the US “Cold War” restrictions on the export of civilian high-tech products to China are outdated and detrimental to mutual prosperity; why is the Washington Consensus so concerned with the supposed “military expansion strategic threat” from the Chinese to US global hegemony? In reality, Chinese diplomatic and political relations are the best in world history with most of its close neighbors including Vietnam, South Korea, Russia and India.
DC — it is hard for me to square the low reported profit margins in China’s export sector with the large amount of investment in that sector … the basic story of china over the past few years is booming exports, surging earnings fueling a surge in biz savings and investment and particularly strong investment in the export sector (with lots of movement upmarket).
that doesn’t mean all parts of the export sector are doing well — but i do think macroman has a point, china cannot hold on too low-end textiles and challenge korea and japan and taiwan for high-end electronics component production/ increasingly auto assembly for export (tho china is doing both high and low end assembly) … and to some extent, low textile margins are a product of competition among chinese firms, not competition between Chinese firms and other firms. a RMB revaluation that just shifts up the costs of all firms (in $) won’t have much of an impact if low profits are from competition among chinese firms.
in any case, China’s strong export growth numbers suggest that china can manage a bit of RMB appreciation. 30% y/y growth is unsustainable for much longer — economically and politically. China’s export base is now too big. Going from $250b to $1,000b in about six years is one thing. Going from $1,000b to $4,000b in quite another …
What I do not understand Dave, is why the Chinese do not fix against a basket with a heavier weight given to other currencies, especially the euro? It makes no difference to employment whether the labour intensive goods are sold to the US or Europe, Japan, Britain etc. As you know, I think the Americans are stupid not to accept the inflows from China and invest them in their own reserves, so it would surely be sensible for China to do this themselves. Besides antagonising the Americans, it has to be bad investment strategy to stick to one currency.
Brad
china cannot hold on too low-end textiles and challenge korea and japan and taiwan for high-end electronics component production/ increasingly auto assembly for export (tho china is doing both high and low end assembly)
Dave – Reply
Since there are really two China’s in the single Chinese nation, an underdeveloped rural sector and urban developed sector, it is perfectly rational to promote both high and low end economic development. Chinese government has little choice but to promote a high growth economy in every economic sphere; the existing socio-economic situation is inherently unstable with the vast gap in wealth bewtween coastal and interior provinces. Unless employment and living standards are raised, Chinese history has a long record of popular revolts and revolutions dating back centuries. Frankly, there are just too many people and mouths to feed in China. Chinese President Jiang Zemin told former President Bill Clinton in a private conversation at a Seattle forum, “If you think the Chinese government is doing such a shitty job, we would be more than happy to let 10% of China’s population emigrate to the United States. Let’s see how the US government can feed and clothe another 100 million people”. Perhaps wisely, Clinton didn’t retort to Jiang’s statement by taking the Chinese up on their offer.
DC — if low-end China wasn’t tied up in a currency union with high-end China, i might agree with you. but it is by now quite clear that setting china’s overall exchange at a level that protects low-end export processing jobs distorts the global trading system and leaves high-end China hyper competitive.
China is on track for a $300-400b current account surplus (my guess is that it will be closer to $400b) b/c of the boom in machinery exports/ growing chinese value added in the electronics sector.
but also note that China’s export boom actually hasn’t been all that great in a lot of ways at creating “jobs” in part b/c China has relied too heavily on capital intensive investment in part b/c of low interest rates and the easy availability of capital. labor income is falling as a share of gdp. job creation hasn’t been all that impressive. that doesn’t suggest the current model is working all that well on its own terms — tho clearly lots of firms in the export sector/ lots on mncs that source from china are doing very well.
Our host is correct in pointing out that industrialization concentrated in EPZs has done little to benefit those in rural parts of China. It is this industrial policy that has increased–and not reduced–inequality in China. Kuijs and Wang wrote a good paper on this matter recently. If “high-end” industries were concentrated in coastal areas and “low-end” ones in interior areas then I would be amenable to arguments to the contrary. As it is, most industrial activity regardless of sophistication is concentrated in coastal areas, rendering the “two Chinas” trope (calling John Edwards) moot.
Current export bias does misprice a number of things in China. The worse underpricing is suffered by the one productive factor called “human capital” (and also “human-related” consumption based on services, such as health). This makes it difficult for China to move from a “savings-investment based” growth to a “productivity based” growth. The ultimate consequence of these distortions will be: (a) unsustainably large I and S (that will be necessary just to replace the existing capital stock), and (b) a trend toward zero of income and consumption growth rates.
The current development strategy has served China well, but now is going too far and is damaging the country. Remember the “Tale of two cities”…
Brad points out that “Alas, the PBoC (and by implication the Chinese government) has RMB denominated liabilities and $ (and euro) denominated assets … ”
True, Brad, and it’s a good point. But in China “the government” is almost identical to “people with serious money.” In one pocket, the government pocket, the people with money have RMB-denominated liabilities and dollar-denominated assets. But in the other pocket, the enterprises they control, they have RMB-denominated assets. So, if the dollar crashes, the government has an accounting problem. But the government ministers have more money to console themselves with as they work out how to deal with it.