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‘Growth’ problems won’t go away yet

THE Chinese economy, having chalked up an average growth rate of 9.7 per cent for over two decades, sustained another year of double-digit growth last year, at 11.5 per cent. This was first announced by Premier Wen Jiabao on Nov 20 last year whilst visiting Singapore. Soon after this, the Chinese Academy of Social Sciences put 2007 growth at 11.6 per cent. After the usual statistical adjustment, real growth is likely to be 11.6 per cent or slightly higher.

Since its accession to the World Trade Organisation (WTO) in December 2001, China has experienced doubledigit economic growth rates averaging 10.6 per cent. As a result, its total gross domestic product (GDP) last year was almost double its 2002 level. China, already a huge economy of almost US$3.2 trillion (S$4.6 trillion) at market exchange rates, is about to displace Germany as the world’s third-largest economy.

When a mammoth economy like that grows so fast, the effects can reverberate far and wide, affecting global levels of production, consumption, trade, and financial movements.

In fact, last year the Chinese economy contributed about as much to global GDP as the United States.

East Asian economies such as Japan, South Korea, Taiwan and Singapore have also enjoyed growth at near double-digit rates for two to three decades. But they have never registered double-digit rates of growth for five years in a row like China. The country’s ‘super-growth’, with annual inflation kept below 3 per cent, is quite unprecedented, particularly since China is already a large economic powerhouse with a huge base.

Such growth has even taken China’s economic policymakers by surprise. The 11th Five-Year Programme (2006-2010) had envisioned a potential annual growth rate of only 7 to 8 per cent. As a result, the Chinese leadership was initially quite worried about economic overheating. Indeed, foreign commentators have for some time anticipated an imminent hard landing.

Why has China’s super-growth been able to consistently defy gravity? High growth has been mainly propelled by high levels of domestic fixed investment, which has been growing at an average rate of 26 per cent since 2002. Domestic consumption, while a less important source of growth, has also been growing at double-digit rates (around 12 per cent for the same period).

Foreign trade and foreign direct investment have also contributed to economic expansion, with exports growing over 30 per cent a year since China joined the WTO. More significantly, the bulk of investment spending every year goes to infrastructure building and industrial expansion (which in turn builds up capacity for further growth), with a relatively smaller proportion for property and housing development.

Rare exception

INDEED, China is a rare example of an economy that has sustained high levels of capital investment over a long period. China has regularly devoted almost 45 per cent of its GDP to gross domestic investment. This has been matched by an equally high level of gross domestic savings (almost 50 per cent). Chinese households are fabulous savers.

The retained income of corporations is also an important part of domestic savings, as state-owned enterprises usually plough back their earnings into investment instead of redistributing them to shareholders. In short, there is no scarcity of capital for domestic investment.

The pro-growth policies of the central government are well known. The ruling Chinese Communist Party critically depends on good economic growth for social stability as well as political legitimacy.

The central government is always inclined to mobilise domestic savings as cheap (in fact, subsidised) capital for many large-scale infrastructure projects, from highways and railways to ports. This explains how China constructed the world’s second-largest highway network after the US in just over a decade.

Indeed, such ‘growth bias’ has extended all the way down to provincial and local governments. These governments are vying for more foreign direct investment for industrial expansion. They also want more domestic capital for infrastructure-building in order to generate more local employment and deliver economic growth.

Deeply entrenched

HIGH economic performance is of critical importance to the political careers of local officials, though environmental protection has recently been added as another indicator of performance. The pro-growth institutional structure in China is indeed extensive and deeply entrenched.

Economic theory suggests that decade-long growth and low inflation is the result of a rise in total factor productivity. Various academic studies and much anecdotal evidence indicate that the Chinese economy has indeed experienced substantial productivity gains. Wage increases in recent years offer a good example of labour productivity growth. It stands to reason that the heavy investment in physical and human capital, the successful financial sector reform, the extensive technology spillovers (and the learning effect) from multinationals, together with China’s integration with the global economy, must have borne fruit.

China has also exhibited a highly impressive external sector performance, as manifested in its swelling foreign reserves, rising trade surplus, and extremely low external debt. All these show that the prolonged economic boom was not built on a house of cards, but on real economic fundamentals.

But the fact that sustained growth is supported by strong economic fundamentals does not mean that the economy will not overheat or run into other constraints. Any economy experiencing a long period of high growth will inevitably develop structural tensions, giving rise to various distortions and imbalances. Cracks will show up sooner or later.

Inflation has already become a problem. The consumer price index (CPI) began to move up in February (2.7 per cent) last year, initially because of rising food prices. It soon snowballed to 6.5 per cent in October and further to 6.9 per cent in November, the highest in more than a decade. China’s annual inflation for last year as a whole is likely to exceed 4.7 per cent.

This is still not serious in terms of ‘core inflation’, that is, excluding food items. But it is sufficient to cause the government to take action. This is partly because the current inflation rate has well exceeded the long-held ‘comfort level’ of 3 per cent, and partly because it is set to rise further in the months ahead after ‘importing’ more international inflation, partly as a result of rising energy prices.

In late November, China’s top leadership, the Politburo, led by President Hu Jintao, declared that preventing economic overheating and curbing inflation would be the country’s most important policy priorities this year.

Overheating and inflation have been officially described as ‘twin economic woes’.

The subsequent annual Central Economic Work Conference reaffirmed the same policy line and came up with specific macroeconomic controls and price-stabilising measures. China’s top economic planning body, the National Development and Reform Commission, urged local authorities to stay vigilant against chain reaction price hikes.

It remains to be seen how far the government wants its retrenchment policies to cool growth. If the government is really determined to tackle the underlying causes of China’s long-term overheating, it will have to push much more vigorously for effective policy measures that go beyond battling inflation. It will need to include a broader range of policies to address the yuan exchange rate and macroeconomic imbalances.

All signs point to another year of strong growth of about 10 per cent this year, but with higher inflation, possibly from 5 to 6 per cent.

Just a few months ago, some analysts were unsure if inflation would pose a real threat to economic growth and social stability. The socalled ‘headline inflation’ (6.5 per cent for October and 6.9 per cent for November) was still reasonable for an economy growing at doubledigit rates. The rise in the CPI was primarily driven by increases in food prices (which constitute a third of the weighting in the CPI basket).

The price hike was actually not across the board, as many manufactured products still faced problems of overproduction.

Hence, the government refers to current inflation as ‘structural inflation’. ‘Core inflation’ remains quite subdued, rising to just around 1.5 per cent last year, again much better than in many countries in the region. Except for pork (in short supply due to an epidemic that led to culling of pigs), China is facing no serious food shortages. In fact, a bumper harvest was recorded last year.

Overall, China today is facing a kind of cost-push inflation. The government still has the means to contain it, using such measures as removing supply bottlenecks, stabilising prices through controls and subsidies (particularly fuel subsidies), increasing imports, and curbing speculative activities.

Inflationary expectations

HIGHER food prices are actually good for farmers, as they reverse the terms of trade in their favour and thus transfer more resources to rural development. If the government could tolerate annual inflation at between 5 and 6 per cent, then officials would not be worried about economic overheating. But the fact is that Beijing finds 4 to 5 per cent inflation unacceptable.

The Politburo has already adopted tighter macroeconomic control measures. Whether or not the present rate of core inflation is actually serious is now a matter of semantics.

The Chinese people, who have been used to years of low inflation or even deflation, are understandably sensitive to even mild inflation. Urban dwellers are easily agitated over food price hikes, and these areas still have a large number of low-income people, notably migrant labourers.

But inflation can hurt even the members of the more affluent middle class, who now have to cope with negative interest rates. In fact, some have started to withdraw their savings to invest in the stock market and the property market. This is a sign of rising inflationary expectations, which will, in turn, fuel further inflation.

For a leadership known to have a strong fear of social instability, recent policy shifts targeting economic overheating and inflation are certainly rational and timely. What remains to be seen is the effectiveness of the policy package. Given Beijing’s strong vested interest in high growth, the strength of the government’s commitment to reducing overheating also remains to be seen.

Viewed from the demand side, inflation is a monetary phenomenon. Because of China’s persistent current and capital account surpluses, the People’s Bank of China has been unable to stem the rapid growth in money supply. This is despite the fact that the central bank raised interest rates six times and the reserve requirement ratio for commercial banks 10 times last year.

Because the yuan is grossly undervalued, the government’s ‘proactive, controllable, and gradual’ exchange rate reform is evidently not working. This is partly because of leakages in the capital control system and partly because of the increasing cost of sterilising large foreign capital inflows.

Last year, the yuan appreciated by about 6.9 per cent against the US dollar (compared with 3.4 per cent in 2006) and 1.8 per cent against the yen; but weakened by about 4.2 per cent against the euro. Overall, the yuan has risen about 13 per cent against the US dollar since July 2005, when the fixed exchange rate regime ended.

But the yuan’s lack of flexibility provides an opportunity for the influx of speculative capital, as well as a major source of excessive domestic liquidity. The central bank’s recent move to widen the yuan’s trading band gradually is not expected to be very effective. It could even invite more speculative capital inflows, given the big gap between the yuan’s nominal rate and effective exchange rate.

Underlying the yuan’s problems are China’s acute external and internal macroeconomic imbalances. These are, in turn, the cumulative results of the country’s high growth based on over-savings, over-investment and over-exports combined with under-consumption.

The Chinese government is not oblivious to these fundamental economic problems. In fact, the 11th Five-Year Programme is supposed to address such long-term issues. The central government has also emphasised the importance and urgency of more ‘balanced’ growth. However, the leadership, with its penchant for stability and the late Deng Xiaoping’s gradualist approach to reform, has become politically and institutionally incapable of undertaking bold reform measures.

This means that the government’s recent attempts to reduce overheating will only provide a breather. This year will not mark the end of China’s era of high growth. High growth (at around 10 per cent) will continue.

The fundamental problems associated with long-term high growth will also remain.

Professor John Wong is Research Director at the East Asia Institute.

Source: The Straits Times 18 Jan 08


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