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How fast will China’s economy slow? And will China also slow the pace of RMB appreciation?

by Brad Setser
July 22, 2008

Chinese policy makers are concerned that China’s economy is slowing.

The stock market is obviously well off its highs, taming some animal spirits.

Housing prices in Shengzen are no longer rising.

Complaints from the export sector are growing – even though China’s exports are still up substantially relative to last year. Some forward looking indicators suggest that the global slowdown is catching up to China’s export sector – and a slowdown in exports could spillover into a slowdown in investment.

At the same time, China is worried about ongoing hot money inflows, and the ongoing difficulty sterilizing extraordinary fast reserve growth. A host of controls have been tightened. Controls on exporters. And now controls of FDI inflows. Yu Yongding of the Chinese Academic of Social Sciences characterizes China’s new capital account policy as “easy out, difficult in”. He is right. Note as well Dr. Yu’s comments on the “unattractiveness” of QDII)

And to make matters worse, there are fears that the recent rise in inflation has changed domestic expectations about future inflation. Dr. Yu writes that “inflation expectations have been firmly established among the public.”

Key members of the state council recently went south to hear the complaints of exporters first-hand. And Chinese policy makers are now meeting, reportedly to set the course of China’s economy policy over the course of the remainder of the year. Michael Pettis relays a report in the South China Morning Post:

The nation’s [China’s] top decision-making body, the Politburo, will meet this week to consider major economic policy for the mainland for the rest of the year amid growing concerns over slowing growth, rising inflation and, in particular, a dramatic decline in exports as the global economy slows. All the most senior leaders completed fact-finding missions to economic strongholds and key export bases early this week, according to reliable sources.

The policy choice is fairly binary: Should policy be directed at controlling inflation, or supporting growth?

Chinese policy makers are clearly worried that the global slowdown will spillover into China. Dr. Yu reports that the Chinese Academy of Social Sciences has been asked to look into the question, and that some of his colleagues believe that a 1% slowdown in the US translates into a 1% slowdown in China.

My colleagues at Institute of World Economics and Politics are calculating the possible impact of a slow down of the US economy on China’s growth. So far we have not reached a firm conclusion yet. Taking direct and indirect impacts into consideration, according our calculations, for a one percent slowdown in the US economy, which will have negative impact on China’s other trade patters, may cause a slowdown in China’s growth rate by one percent.

That seems high to me.

Over the last four quarters, the US imported just under $325b of goods from China (and exported just under $70b). That is roughly 9% of China’s GDP over the last four quarters. Assume that the Chinese value added is 50% (see the CBO for more), so the Chinese value-added in China’s exports to the US is around 4.5%. The difference between 20% y/y growth and 0% y/y growth in US imports from China (Chinese exports to the US) is a bit under 1% of GDP. But the slowdown from 20% y/y growth to current levels also reflects a slowdown in US non-oil demand growth of more than 1%.

This rough calculation leaves out the impact of a US slowdown on the rest of the world, and on China’s exports to the rest or the world. More importantly, it also leaves out the ways a US slowdown stimulates China. China manages its currency against the dollar. If the US slowdown pulls the dollar down, it also pulls the RMB down. And that stimulates China’s exports. There is a reason why Chinese exports to Europe have been growing so strongly over the past year.

And so long as China manages its currency against the dollar, it faces pressure to “import” US monetary policy. It can cut policy rates as the US cuts policy rates. Or it can keep rates high and attract large capital inflows – some of which aren’t sterilized and could result in rapid money growth, higher inflation and lower real interest rates.

So far the “stimulus” from a weaker dollar and low real rates has offset most of the slowdown in Chinese exports to the US. China’s exports to the US are basically flat in real terms over the past year – so China has in some sense already felt the impact of slower US growth. But Chinese policy makers are clearly worried that is still more to come – and that the problems in the US economy will neither be temporary nor well-contained.

Morris Goldstein and Nick Lardy argue that this shouldn’t matter. China’s exchange rate is as undervalued as it has ever been. The RMB’s appreciation against the dollar has been largely offset by the dollar’s depreciation against other currencies. Real appreciation has mostly come from the rise in inflation. Throw in stronger productivity growth in China than elsewhere, and the gap between China’s current exchange rate and the likely market exchange rate is as large as it has ever been.

Goldstein and Lardy note that China has failed to “rebalance” the basis of its growth away from exports and investment:”China has remained heavily dependent on investment and growing trade surpluses to sustain its double-digit growth rate.” A global slowdown presents a ideal opportunity for a bit of rebalancing. Exports are (perhaps) slowing on their own accord. Investment could slow too. China could try to push exports back up by slowing (or stopping) RMB appreciation. Or it could look to other policies to support growth –

Fiscal policy is an obvious choice. China has significant domestic needs. Better schools, for one. Better access to health care for another. Its government has large deposits at the central bank. Those deposits are part of China’s efforts to sterilize rapid reserve growth. With a different exchange rate regime, those deposits could be run down, supporting economic growth. Government spending hasn’t increased as fast as revenues. That too could change. China has plenty of ways of stimulating the broad economy rather than stimulating the export sector by holding the RMB down if growth is a bigger concern than inflation.

China’s choice doesn’t just matter for China. If China tries to support its growth amid the global slowdown by supporting its export sector, it is working against global adjustment. If China tries to support its growth by supporting domestic demand, it can help to facilitate global adjustment.

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