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The Silver Linings In China’s Slowdown August 9, 2012

BY: Patrick Chovanec

Earlier this week, I was interviewed by the Council on Foreign Relations(CFR) for its website, about the current state of the Chinese economy.

Silver Linings in China’s Slowdown

China’s gross domestic product for the second quarter declined to 7.6%in July, its lowest level since the height of the global financial crisis in 2009. At the same time, the International Monetary Fund reduced its 2012 growth forecast for China by 0.2 percentage points to 8%. While China has been adversely affected by external factors like the eurozone crisis, its current slowdown is mainly the result of internal structural issues, including a suppression of domestic consumption, says Tsinghua University’s Patrick Chovanec.

“The main growth driver of the past several years has been an investment boom that was engineered in response to the global financial crisis,” explains Chovanec, “and this investment boom is buckling under its own weight.”

What are the main causes-internal and external-of China’s worsening economic slowdown?

A lot of people compare this slowdown to what happened in late 2008, early 2009. The main difference is that what happened in 2008 was primarily due to external causes- a fall-off in exports caused by the economic crisis in the United States. What’s happening now in China is mainly due to internal reasons. The main growth driver of the past several years has been an investment boom that was engineered in response to the global financial crisis, the last slowdown, and this investment boom is buckling under its own weight. It’s not sustainable, and it has given rise to inflation and now to bad debt, and that bad debt is dragging down Chinese growth. And, of course, people pay attention to whether Chinese exports are rising or falling. It’s relevant because if Chinese exports are very vibrant, that creates something of a cushion for the Chinese economy.

If the causes of the slowdown are more internal, and not just a response to outside factors like the eurozone crisis, should we expect a more long-term slowdown?

It really depends on what the Chinese leadership chooses to do. China is due for a correction. That correction will be good for China in the sense that a lot of the growth we’ve been seeing over the past several years is not sustainable and in many ways does more harm than good. So in some ways, slower growth, if it’s part of an adjustment toward a more sustainable growth path, is actually good. That doesn’t mean it’s painless, so there is a lot of resistance, even though in principle China’s leaders know that China needs to make this economic adjustment away from dependence on exports and investment-driven growth toward more domestic consumption-driven growth. If they resist a meaningful adjustment and if they try to pump up the economy even more- try to push this growth model to its limits and beyond- then the repercussions could be more damaging and painful than embracing any economic adjustment, painful as that might be.

I would add that there are lots of areas of potential growth in the Chinese economy- in agriculture, in services, in healthcare, in retail, in logistics. The problem is that that growth is not as easily achieved as pumping money and boosting investment. Unfortunately, that more sustainable growth is not where the focus has been these past few years. But there is nothing to say that the Chinese economy has to be doomed to slow growth.

What are some policy responses China should take to boost domestic consumption and diversify sources of growth?

They have to realize that it is a structural issue. Part of China’s export-led growth model was to suppress consumption in order to maximize investment and then make up the difference through selling abroad. The Chinese economy is geared toward channeling resources away from the household sector- Chinese savers and consumers- toward investors and producers to boost production and basically turbo-charge GDP growth. To re-balance the Chinese economy, you have to channel those resources back to the household sector through changing exchange rate policy, interest rate policy, the tax policy.

The problem is that if you channel resources back to the household sector, you knock the legs out from under the growth that you’ve got, and nobody wants to do that. That’s the biggest challenge- that these are deep reforms that change the way the Chinese economy works, and it takes some foresight and some vision to pursue that.

What of the short-term measures the Chinese central bank has taken by cutting interest rates twice since the beginning of June? Should we expect further measures along this line?

Unfortunately, the short-term response we have seen is to fixate on GDP growth. Even though they talk about the need for quality GDP growth over quantity, whenever GDP starts to look like it’s falling- even slightly- the immediate response is, “We have to shore it up.” The easiest way to shore it up is through more lending, more investment. You get a situation where any movement toward meaningful reform or meaningful re-balancing is put on a shelf. A lot of people have been critical of the efforts to re-stimulate the Chinese economy for precisely that reason. There is a broader recognition that what the Chinese economy needs is not more stimulus, but reform. I don’t think there is a full appreciation for just how constrained the Chinese government really is, even if it chooses to go down that path of re-stimulating the economy. They are actually quite limited in their ability, in the tools they have available to continue pushing down this path.

The conventional view is that China has a debt-to-GDP ratio of about 30% and that it has all kinds of resources to throw at boosting growth. I would draw a comparison to Japan in 1990. Japan had many of the same qualities that would lead you to think it could stimulate its way out of any dilemma. Japan had a high savings rate, almost no foreign debt, and it had a strong fiscal position because of all the taxes raised during the boom of the 1980s. But when the Japanese turned on the fiscal tap, the money went primarily to socialized losses and to counteract a contraction in private investment. The Japanese were able to prevent GDP from collapsing, but they were not able to sustain high levels of GDP growth in the 1990s; the fiscal resources that Japan had went to fill a hole, to pay for the growth of the 1980s.

With the lending boom that took place in China in the last three or four years, it was fiscal spending in disguise, and now the bill is coming due. Once the fiscal taps are open, the money released will go to pay for the growth of the past four years, not the next quarter, not the next year, not the next decade. You start to see that already, with the bailouts starting to take place in China; local governments, even the national government, devoting resources to bailing out property developers, bailing out state-owned enterprises, bailing out companies that have run into trouble, bailing out local governments.

What are the implications of the economic slowdown for the Chinese political situation, particularly given a once-a-decade leadership transition this year?

There’s been little political capital for anyone to spend on meaningful reform or any kind of resolute action on the economy, because if people did have political capital to spend, it was going to be devoted to ensuring their seat at the [leadership] table. What happens after the leadership transition [is] hard to say. The slowdown we are seeing, and particularly the pressures that it has created in the financial system and the credit system in China- the danger of default and the danger of a domino effect rippling through the Chinese economy- has pressed some difficult choices on [the] leadership at a point where they are least prepared to make decisions. The economic situation is not waiting for the leadership transition to work itself out before demanding some kind of response.

What are the potential repercussions of China’s economic situation on the U.S. and global economies?

It depends where you sit relative to the Chinese economy. There are countries and companies that have been riding this investment boom that has been driving Chinese growth, but I would argue that is not sustainable and is now collapsing under its own weight. And for those countries- like Australia selling iron ore, Chile selling copper, Brazil selling iron ore, Germany selling machinery- they’re very exposed to this economic adjustment that’s taking place, this correction.

But if your goal over the long-term is to sell to the Chinese consumer, and if you have an economy positioned to do that- if you’re a producer of finished goods or a producer of food- then this economic adjustment could be a good thing if it unlocks the buying power of the Chinese consumer. For any economy around the world that wants to sell more to China, that wants to have a more balanced trade relationship with China, a meaningful economic adjustment that resulted in a more balanced domestic economy in China would be a very positive thing.

If you have lower GDP in China, that doesn’t necessarily mean that China’s consumption has to fall. In fact, China has $3 trillion in reserve; that’s buying power. China has produced more than it has consumed for many years; China could afford to consume more than it produced. That would be a major growth driver for the rest of the world. It would provide a cushion for China to undertake this kind of economic adjustment that otherwise could be extremely painful.

 

China cuts rates as global economic crisis deepens June 10, 2012

BEIJING (Reuters) – China delivered a surprise interest rate cut on Thursday to combat faltering growth, underlining concern among policymakers worldwide that the euro area’s deepening crisis is threatening the health of the global economy.

The country’s first rate cut since the depths of the global financial crisis in 2008/09 came after the Federal Reserve’s second highest official made a case for more policy easing in the United States, and followed an emergency conference call on Tuesday by the financial leaders of the Group of Seven industrialized nations to discuss Europe’s debt crisis.

It was followed shortly after by comments from Fed Chairman Ben Bernanke that the U.S. central bank was prepared to take action to protect the financial system and U.S. economy.

“The Federal Reserve remains prepared to take action as needed to protect the U.S. economy in the event that financial stresses escalate,” Bernanke said in prepared testimony to the U.S. Congress.

Marc Ostwald, a rate strategist at Monument Securities in London, said the China rate cut combined with Federal Reserve hints and hopes in markets that Europe will deal urgently with Spain’s banking crisis would support risk assets.

“It will be construed positively particularly in close alignment with what we’ve seen,” he said.

The Chinese cut and Bernanke’s statement stood in contrast, however, to the decision by the European Central Bank on Wednesday to leave rates unchanged and hold off on more stimulus, placing the onus on fighting Europe’s crisis on governments.

The People’s Bank of China, the central bank, cut the official one-year borrowing rate by 25 basis points to 6.31 percent and the one-year deposit rate by a similar amount to 3.25 percent.

The cuts confounded the call of many economists who thought the central bank would refrain from cutting policy rates this year even though policymakers had voiced the need to support growth.

“It’s obviously a very strong signal that the government wants to boost the economy, given the current weakness, especially in demand,” Qinwei Wang, economist at Capital Economics in London, told Reuters.

The European Union is China’s single biggest foreign customer, and faltering demand there has led to worries about the knock-on effect to domestic consumption if industrial activity slows dramatically.

A sudden collapse in global trade in late 2008 saw an estimated 20 million Chinese jobs axed in a matter of months, prompting Beijing to roll-out a 4 trillion yuan ($635 billion) fiscal stimulus plan to bolster domestic economic activity.

While the cut to borrowing costs should help in the near term to shore up an economy on course for its weakest full-year expansion since 1999, the central bank also gave banks more room to set competitive lending and deposit rates to further liberalize China’s financial market.

The rate cut, announced after financial markets closed in Asia, helped shares elsewhere rally. World shares, measured by the MSCI world equity index rose to its highest level in more than a week. The euro rose.

China last changed the borrowing rate in July 2011 when the 1-year benchmark lending rate was raised by 25 bps to 6.56 percent.

GOOD AND BAD

Many world leaders, including in Europe, have been alarmed about the latest turbulence in the euro area debt saga as Spain is fast losing the confidence of financial markets, although it did successfully sell debt on Thursday.

A Greek election this month could also push Athens closer to leaving the bloc.

The problems of Spain’s banks were underlined on Thursday when financial sector sources told Reuters an International Monetary Fund report on Spanish banks next week will show the country’s troubled lenders need a cash injection of at least 40 billion euros ($50 billion).

“We must find ways to deal with this fairly quickly because (Spain) is today the major threat to the world economy,” Swedish Finance Minister Anders Borg told Reuters.

After the G7 call this week, Japan’s Finance Minister Jun Azumi said the grouping shared the view that it should work to ease financial market worries ahead of a G20 meeting in Mexico later this month, where Europe is likely to top the agenda.

Janet Yellen, the Fed’s vice chair, warned on Wednesday of “significant” risks facing the economy.

“Hence, it may well be appropriate to insure against adverse shocks,” she said in remarks before the Boston Economic Club.

Several countries, including China and India, have seen economic growth take a hit this year as the euro zone crisis has hurt global confidence. Several euro area countries are struggling with recession.

Britain is among them, but better than expected economic data allowed the Bank of England to hold off on any new stimulus on Thursday

China’s policy announcement on Thursday meanwhile raised concerns for some that the rate move is pre-empting grim news in a deluge of China data due over the weekend that will include all of the country’s key barometers, such as investment and industrial production.

“The concern is that with industrial production and CPI data coming out of China at the weekend, that it’s indicative of them

knowing something about weak data going forward,” said Adrian Schmidt, currency strategist at Lloyd’s Bank in London.

The PBoC has cut bank reserves for the biggest banks by 150 basis points from a record-high of 21.5 percent in three moves since November, after a two-year tightening campaign to rein in inflation and cool steaming economic growth.

That has freed an estimated 1.2 trillion yuan ($190 billion) for new lending, as Beijing sought to stimulate economic activity without resorting to a major fiscal spending package like 2008’s initiative.

Beijing is still tackling the after-effects of that program, which triggered a frenzy of real estate speculation, saw local governments amass 10.7 trillion yuan of debt, and drove inflation to a three-year peak by July 2011.

(Additional reporting by Koh Gui Qing and Aileen Wang; Editing by Neil Fullick/Jeremy Gaunt)