China, Growing but Frothy

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Global Trade, Macroeconomics

So far, China has weathered the storm well according to Chinese Premier Wen Jiabao in a recent Bloomberg article. Bank lending and stimulus measures would continue he said and the economy which grew at 7.1% in the first six months is expected to average 8.3%  in the second half  and 9.4% in 2010 according to the FT. But even Wen Jiabao admitted not all in the garden is rosy. There are both short and long term structural issues with the Chinese economy that are getting worse over time, which if they are not addressed, will cause considerable pain for China down the line.

Encouraged by a 4 trillion RMB (US$580 bn) stimulus package unveiled in late 2008 and 7.4 trillion RMB (US$1100 bn) in bank lending in the first half of this year, the economy has surged. According to the Economist Intelligence Unit, Chinese household consumption is forecast to grow by 9.3% this year, exactly as intended. But that is only a small part of the overall growth numbers. In an interview with the FT, Stephen Roach of Morgan Stanley said 88% of Chinese growth is coming from fixed investments which are forecast to grow at 14.8% this year. If so it will have grown faster than GDP in 9 of the last 10 years. This rising ratio of investment to GDP, from an already high level, is not a strength but a weakness. It suggests declining returns on capital and it risks creating ever rising excess capacity. Moreover, when growth rates finally fall, the collapse in investment is going to knock a huge hole in demand. Many also fear the surge in credit and money supply, much of which has leaked into housing, asset and commodity speculation will lead to rising bad debts and asset bubbles. For the time being, the Chinese authorities are happy to supplant exports with housing as a means of growth. But it isn’t a long term solution when, “The average urban property price per square metre is the same as in the US while the US per capita income is seven times (that) of China’s urban per capita income.” Andy Xie, an independent economist based in Shanghai  is quoted as saying to AFP. That sounds like  a bubble.

One bright spot is China’s current account and trade surpluses have shrunk as both export and imports have fallen but the fall in exports has been greater. However China is still sitting on over US$2 bn of foreign currency reserves, equivalent to 40% of GDP. The continued accumulation of such surpluses is untenable in the long term and can only be addressed by an appreciation of the currency. But the longer the authorities artificially hold it down, the more painful the adjustment will be because at a higher exchange rate those dollars are going to be worth less than they are today. The more dollars you have, the bigger the loss. Internal consumption will always be hampered by the effects of currency manipulation and the state keeping interest rates low to avoid capital inflows. By reducing individual earning power and transferring wealth to corporations and abroad (by buying low yielding foreign assets), China’s efforts to stimulate domestic consumption create more effort than they should because of these existing distortions in the economy.

The FT article concludes with the statement that the explosive rise in trade and current account surpluses of the mid 2000’s is an unrepeatable event. Lets hope so. The question is when will China begin to free up currency and interest rates to make the changes?

–Stuart Burns

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