Journalists, always handy with analogies, have had a field day with China’s booming economy, calling it a runaway train, a juggernaut, a supertanker, and an overloaded truck on a bumpy road. Following the announcement that China’s US$2.8 trillion economy posted 11.1% year on year GDP growth in the first quarter of 2007, they were at it again – the economy was about to run aground, or become a train wreck, or suffer a hard landing. At the very least, said many articles, the economy was overheating.
China-based economists, however, take issue with those terms. According to them, a more appropriate description of China’s rapid GDP growth might be ‘red herring.’ None of the five economists interviewed for this article expressed concern about the rate of GDP growth, even though the 11.1% first quarter growth marked an acceleration from 10.4% growth in the fourth quarter of 2006, and even though the 10.7% annual GDP growth in 2006 was already the fastest in 11 years. Just one of the five economists China Knowledge at Wharton was worried – and only mildly – about the risk of overheating, and all of them predicted a smooth, fast-growing economy for at least the next few years.
“In my opinion, this 11.1% growth rate doesn’t matter,” said Li Weisen, economics professor at Fudan University in Shanghai. “The recent growth rate of 10%, or more than 10%, is natural, and if the rate is a little bit high, it doesn’t really matter.”
Professor Li’s comments were echoed by Beijing-based Shen Minggao, China economist for Citigroup. “I am not scared by 11.1% growth,” declared Shen.
The Point Missed
The Chinese government does have its economic worries, but slowing the rate of GDP growth is not one of them. Discussions about GDP growth miss the point, say economists. In China, the key concern is money supply, and the current policy of raising bank reserve requirements, and interest rates, is aimed at absorbing excess liquidity, not slowing GDP growth, and the ultimate goal is to contain inflation.
The talk about overheating arises partly from a misunderstanding about Chinese policy announcements, said Arthur Kroeber, director of Dragonomics Research and Advisory in Beijing. “People don’t know how to understand the pronouncements of Chinese officials,” said Kroeber. “In China, you have the legacy of central planning, where every year the government has to set a target for x, y and z, and because we are not a centrally planned economy any more, these targets are less significant than they used to be. In other words, when (Premier) Wen Jiabao says the (GDP growth) target for the year is 8%, what he is saying is, ‘I am sure the economy this year will grow by at least 8%,’ which it is. There is no chance of him being wrong. They don’t want to come out with a number that is going to be wrong, so with GDP in particular, they come out with these very lowball figures.”
In early March, as Kroeber said, Premier Wen announced that the government had set a target growth rate of 8%, according to Xinhua News Agency. Another example of a low target would be the 11th Five Year plan, which began in 2006. That plan set a very modest – and very reachable – annual GDP growth target of 7.5%.
Press reports, often in the wake of quarterly GDP growth figures, add to the misperception that the government is trying to cool GDP growth to forestall overheating. “Reports that the Chinese government wants to slow down the economy are not true,” said Kroeber. “Cooling the economy implies that the government thinks its current growth rate of 10, 10½ percent is too high, and they would want it to be lower, say 9%, and they do not want that.”
Forget GDP, Focus Liquidity
In any case, GDP growth figures are not a reliable measure of overheating, said Stephen Green, senior economist for Standard Chartered in Shanghai. “The economy can grow 100% per year as long as there’s no inflation, and the growth is sustainable, at least in terms of classic economic theory,” said Green. “Economies overheat when demand outstrips supply, and there’s inflation, and that starts impacting upon firms’ decisions, and then the central bank starts raising interest rates. The Chinese economy is growing at 11% officially, but there’s low inflation still, so the question is, what do people mean when they call it overheating? Because it’s not any kind of classical overheating. At the moment I don’t think the whole overheating argument has any feet, really.”
China’s consumer price index rose 2.8% for the first four months of 2007, although it did spike to 3.3% in March, piercing the 3% mark for the first time in more than two years. If inflation were to hit 5%, said Green, it would be a problem, and overheating would become an issue.
The Central Bank of China has raised reserve requirements seven times and raised interest rates three times since mid 2006, but these moves are not aimed at slowing GDP growth, say economists: they are aimed at money supply. Too much money in the system can push up asset prices, particularly real estate and stock market prices, and that is what policy makers are primarily worried about.
“They are trying to manage a rising tide of cash in the economy,” said Kroeber. “Economic growth is going very rapidly, and you have a big trade surplus and capital flows, which risk adding additional cash to the system, and as that money moves into the system, they need to take it out of circulation, and they do this mainly by raising reserve ratios.” There is no limit to how high the central bank can raise reserve ratios, he added.
So far, the policy adjustments seem to be working. “I would say they are on policy auto pilot right now,” said Kroeber. “They have set in train a pattern of raising reserve ratios by half a point every month or two, and I think these will continue. It is quite reasonable; it is a tried and true mechanism for controlling excess liquidity in countries that are facing big inflows of capital.”
The Underlying Problems
Although the adjustments have been successful, they are only temporary fixes, say economists. It is relatively easy to absorb excess liquidity, but much harder to deal with the underlying structural problems that fuel the liquidity – primarily re-investment by companies and over-spending by local governments, exacerbated by high inflows of foreign capital, and compounded by a lack of investment outlets for households.
“That (increasing interest rates and reserve ratios) only deals with the results of the excess liquidity,” said Shen Minggao, of Citigroup. “Whenever there is too much liquidity they soak it up, but the underlying problems are still there, and solving that would require some drastic changes, for example, if they hike interest rates by 200 basis points, or hike the reserve requirement by 200 basis points, that could make a big difference. That’s the monetary policy side. But in the real economy side, they need to do two things: one is promote consumption, in real terms, and that means they need to focus more on the consumption of services side rather than the production side, and two, they need to develop the capital market.”
Contrary to conventional wisdom, most of the liquidity in the Chinese economy has domestic origins. China’s growth has generated fat corporate profits, which companies usually re-invest back into production, rather than giving it to shareholders. And as citizens get richer, they stash more money in banks, which then lend it back into the system.
Foreign money also flows in, often into assets like real estate, but also into factories, services, and other means of production. “Foreign direct investment per se really does not create overcapacity in China because this investment is being done on the basis of people trying to earn a return on capital,” said Kroeber. “They still make mistakes, but there is more financial discipline. Over investment comes from the fact that there’s a lot of domestic liquidity.
Too much liquidity can cause overcapacity in production, and it can cause asset inflation, especially in stock and property markets. Overcapacity is not necessarily a problem, said Kroeber; in a fast-growing economy, it can help keep inflation under control, by keeping the supply of goods ahead of the demand. Production overcapacity does raise the risk of ‘nasty shakeouts’ in certain sectors, he said, especially the steel industry, but such problems are not imminent.
Prescriptions to Curb Asset Prices Rising
The bigger problem related to excess liquidity is its effect on asset prices, notably China’s stock and property markets. “The problem that most worries people are asset market bubbles,” said Min Tang, chief economist at the Asian Development Bank office in Beijing. “Whenever a country has a bubble, it is because it is too successful, and currently China is facing that kind of bubble – one is in the stock market, and the other is in the real estate sector. And that is a risk, if the government doesn’t handle it well. The risk is not tomorrow, or next month, but sooner or later that kind of high growth in stocks and real estate is not sustainable.”
In China, the asset bubbles are aggravated by a general lack of individual investment options, said Shen, of Citigroup. “Households have nowhere to invest,” he said. “The choices are bank deposits, the stock market, or the property market. But the government has introduced policies to cool down the property market, which has increased the risk of investing in property, so what can people do? If they don’t want their money in the bank, and they cannot invest in the property market, what they can do is put their money into the stock market.”
A series of measures begun in mid 2005 have helped cool the residential property market; those measures include higher down payments, higher mortgage interest rates, taxes on property sold within five years, and restrictions on foreign buying. But now the focus has shifted to the Shanghai Stock Exchange: with the real estate market slowing, many Chinese have seized upon equities as their investment of choice.
In the first two weeks of May, the Shanghai Composite Index set new highs almost every day, and according to the Shanghai Daily, more than 300,000 new brokerage accounts are opened each day in China. In the first quarter, share trading volume in China rose 580% from a year earlier, and it has accelerated in April and May; in the last six months, the Shanghai Composite Index – China’s largest – has surged from 1800 to its current level of around 4,000. “The stock market is a little bit irrational already, a little bit crazy,” said Tang, of the Asian Development Bank. “If the current trend continues, the index could reach 8,000 or 10,000, which would be very, very risky.”
Like Shen Minggao of Citigroup, Min Tang advocates a much sharper rise in interest rates. “A 2% raise would give a very, very strong signal to those speculators, and probably cause a mini crash of stock market, but that is not necessarily a bad thing,” he said. “An early crash is bigger than a late crash, and a small crash is bigger than a big crash. And the crash will come any way, so it is better to do it early rather than late.”
Such strong medicine would only be advisable in a robust economy, he added. “Most likely, with a 2% rise, growth would slow down a bit, and some enterprises would complain, but a recession would be very unlikely, because the overall momentum of the economy is very strong,” said Tang.
Shen advises further development of the country’s capital markets, which would create another outlet for household investment. “Although the boom in the stock market has helped a lot with liquidity, the stock market itself is not enough,” he said. “We need a good bond market. I think the government already realizes that, so it is likely that we will see more development in the capital market, and this will help lock up liquidity in the longer term, not just on a short term basis,” he said.
The robust amounts of cash injected into the Chinese economy by domestic firms, often with the encouragement of local governments, is a more intractable problem. Local governments compete to attract real estate developments, infrastructure projects, factories, foreign investment, and other income, a process that makes central government control of the economy difficult. “Local government competition is one of the driving forces for economic growth,” said Professor Li. “Even if the central government decides to cool down, the local governments have their own interests. If the government wants to do something, then they need to control themselves. That’s what I worry about.”
A Strong Economy Forward
Naturally, an economy that grows 10% or more per year tends to mask the deeper structural problems; in particular, it help absorbs industrial overcapacity. And, as mentioned, all the economists who talked to China Knowledge at Wharton were sanguine about the near-term economic outlook. “We are very optimistic about the growth outlook for the next three to five years, because it will still be led by investment and exports,” said Shen. “The only possible risk is a possible downturn in export growth, which could be led by a weakened external economy, such as a U.S. soft landing or something like that. But so far the external risk is relatively small, and it is unlikely to drive the Chinese economy down at this stage.”
Others echoed that point of view. “We’re in the midst of a five year boom, and nobody really knows when it’s going to end,” said Green, of Standard Chartered. “There are precious few signs that it’s over yet. Some people expect a long boom, another five years, others expect that it will slow more sharply. At the moment it is difficult to find any signs that it is going to slow.” Standard Chartered predicts 10.6% GDP growth this year, and 10% in 2008.
Just don’t talk about overheating. “Talk about overheating started in 2003,” said Kroeber. “There were all these people saying ‘it’s overheating it’s overheating there’s going to be a crash, a hard landing’, and that has been wrong quarter after quarter, year after year, for the last four years.”
