by Nicholas R. Lardy, Peterson Institute for International Economics
Op-ed in the Wall Street Journal Asia
September 30, 2008
© Wall Street Journal Asia
For several years economic policymakers in Beijing and elsewhere have had an overriding worry: that China has been engaging in headlong investment- and export-driven growth that has fueled inflation, polluted the environment, and irritated its trading partners. But in the last several quarters, something new has happened. Partly as a result of the slump in the United States and Europe, China is experiencing its own economic slowdown.
This trend is welcome because it reduces inflationary pressure and distortions in investment associated with excessively rapid growth. It could also lead China to rebalance its own model of economic growth and thus could ease trade pressures. But it brings new challenges. Without appropriate policies growth could fall much further, meaning China would become less of an engine of global growth just when the world needs it most.
China's expansion in 2003–07 was supercharged by a rapidly rising global trade surplus, propelling growth to a peak of 12.6 percent in the second quarter of 2007. But the external contribution to China's growth is now waning as growth slows in its main export markets. In addition, domestic investment is slowing due to a softening property market. Property price appreciation is slowing markedly as sales have plummeted since January, a possible harbinger of absolute price declines. The combined effect of weaker external and domestic investment demand already has pushed China's growth rate down to 10.1 percent in the second quarter this year.
While some slowdown is welcome, China's leadership now believes that the risk of growth slowing too much exceeds the risk of inflation. Thus they have begun monetary easing by raising bank lending quotas, cutting required reserves, and reducing interest rates on loans. This may prove ineffective. If expectations of future declines in house prices are taking hold, it is unlikely that greater availability of credit for mortgages will allow China to avoid a potentially major property correction. And if export growth softens further, as now seems likely, the private firms that dominate export production are unlikely to take on more debt in order to add to their capacity.
Rather, China should increase investment in infrastructure selectively and redouble its efforts to stimulate private consumption. China has invested massively in infrastructure in recent years, but some components have been surprisingly neglected. The road network has exploded while the rail network has expanded only marginally, leading to critical shortages of capacity to move coal and other goods that are most efficiently carried by rail. China has built so many power plants that some regions now have excess capacity. But investments to create a national power grid, which would allow more efficient utilization of generating capacity, have lagged. Selective expansion of infrastructure investment could yield high returns and offset part of the decline in property and manufacturing investment.
Faster expansion of private consumption has the greatest potential to keep China's growth from falling below 8 percent. Household consumption spending has grown relatively slowly over the past decade and now accounts for just slightly over a third of total output, the lowest of any country in the world.
To reverse this trend and thus rebalance, the government needs to move more strongly in three policy domains. On the fiscal front the government needs to rebuild the social safety net more rapidly. This frayed badly in the 1990s as state-owned enterprises, which were major providers of social services and pensions to urban workers, were privatized or failed on a large scale. Progress has been made, but large portions of the population remain without adequate health, unemployment, and disability insurance coverage. The pension scheme also remains weak. Thus household precautionary demand for savings went up in the 1990s, cutting into consumption expenditures.
Significant financial reform is needed as well. Given the primitive financial system, most household savings are in bank deposits. But the authorities fix nominal interest on these deposits at rates that are well below inflation. This reduces household disposable income below the levels that would be attained if the authorities allowed market-determined interest rates.
Finally, to achieve rebalancing the authorities must allow the exchange rate to appreciate further. China is on track to rack up a second consecutive year with a trade surplus exceeding $300 billion, the world's second largest. Massive government intervention in the foreign exchange market, which has pushed China's reserves up to $1.8 trillion, has limited appreciation of the yuan to about 20 percent since mid-2005, when currency flexibility was first introduced. This is wholly inadequate given the doubling of China's trade surplus since 2005 as well as Premier Wen Jiabao's stated desire to "reduce China's excessively large trade surplus."
Without these stronger policies China runs the risk of its growth falling sharply below the pace authorities believe is necessary to generate jobs and maintain social stability. And the global economy runs the risk of losing much of China's strong contribution to growth. The right policies would bring benefits to China and the rest of the world as well.
Nicholas R. Lardy is a senior fellow at the Peterson Institute for International Economics and coauthor of China's Rise: Challenges and Opportunities.