China: 2005 Policy Scenarios
Andy Xie (Hong Kong)
I believe China will raise interest rates gradually and keep its exchange rate stable in 2005. This approach carries the lowest risk to the economy. China is facing the challenges of over-investment, insufficient energy resources, and rising US interest rates. Cost-push inflation and overcapacity-led deflation are unfolding at the same time. The massive amount of hot money in China’s economy makes it vulnerable to the US’s rising interest rate trend. Raising interest rates slowly would gradually cool China’s investment and deflate the property bubble. This approach offers the best chance of the Chinese economy achieving a soft landing.
However, China’s politics have become more complicated in recent years. Now it appears possible for interest groups to affect national policy. The interests of powerful groups may push the country’s policies in a direction that is not optimal for the country but favorable to some. In addition, there is a strong desire among many people to extend this economic cycle to 2008 — the year in which China is to host the Olympic Games. Hence, if the economy decelerates quickly, which would occur if the US Federal Reserve raises interest rates faster than expected, policy may shift unexpectedly.
I see four major policy scenarios for 2005.
1) Keep the status quo
China essentially did not do much in 2004 and allowed the economy to go with the flow. The tightening talk in the spring and one rate hike in October were not followed up with consistent policy actions. On energy consumption, property investment, and trade data, I believe that the economy grew faster last year than in 2003. As a result, China is facing the same challenges now as it did one year ago, except that the investment excess is greater.
Could 2005 turn out to be the same, i.e., no significant changes to either interest rates or currency? I assign a 25% probability to this scenario. China’s economy in such a scenario would unfold according to 1) how much excess capacity affects profitability, and 2) how fast the Fed raises interest rates. For example, if property oversupply is exposed, falling property prices would quickly bring fixed investment to a halt. If US inflation surprises on the upside, the Fed would raise interest rates faster than expected. Higher and faster rising US interest rates would cause hot money to leave China, which would bring down property prices and slow fixed investment.
In such a scenario, China remains mostly a passive factor in the global economy, with emerging excess supply a potential shock. It serves as an amplifier for Fed Chairman Greenspan’s monetary policy, mainly through speculation in the renminbi and Chinese property. The fate of the US dollar depends on how fast the Fed raises interest rates. The global economic growth rate will be inversely correlated with the strength of the dollar.
2) Raise interest rates
In this scenario, China raises interest rates gradually to deflate its property bubble, slow fixed investment, and deflate international speculation in the renminbi. When China’s economy has landed, demand for renminbi will reflect reality and China could float the exchange rate without fearing that speculation would distort the value. It is in China’s best interests to pursue this course, in my view. I give a 50% probability to this scenario.
The Chinese economy would be likely to experience an orderly slowdown in this scenario. The prices of natural resources would cool, which would decrease inflationary pressure in China. The slowdown in investment would contain the creation of excess capacity and improve financial stability.
When China cools its economy by raising interest rates, it would decrease speculation in the renminbi and help stabilize the dollar. A stable dollar and lower commodity prices would give the Fed more time to raise interest rates. It could create the best policy combination between China and the US to achieve a global soft landing.
3) Revalue the renminbi
Under either international political pressure or internal inflationary pressure, China may revalue the currency in line with market expectations (say, by 15–25%). Such an approach is likely to lead to a hard landing as the massive amount of hot money flows out to realize profits. Commodity prices would fall sharply as a result, and the dollar would strengthen. China would immediately suffer deflation as falling commodity prices and excess capacity cause prices to decline. Since this scenario makes little sense for China overall, I give it a 10% probability.
Revaluation logic centres on two fundamental arguments:
1) the need to respond to international pressure, and 2) the need to shift towards consumption-led growth. The former is a political argument that could not be dismissed with logic. However, as far as I can see, international pressure is dissipating in 2005. Outsourcing turned out to be insignificant in the US elections last year. The appreciating yen has decreased pressure on Europe from a strong euro. Developing economies are now more concerned about China’s growth prospects than the exchange rate.
Changing the growth model is a legitimate concern. China has relied on investment and exports to develop its economy. As its exports become large, this model becomes less potent. Consumption has to pick up to sustain the fast development. Revaluing the currency, in theory, gives more purchasing power to households by decreasing consumption prices. I seriously doubt that this would work. China’s consumption weakness is due to 1) a labor surplus that keeps wages down, and 2) a low level of wealth due to a short history of market economics. Revaluation would not solve either problem.
In practical terms, many argue that a revaluation would make natural resources more affordable to the Chinese economy. The argument makes some sense. First, the demand for natural resources is unnaturally high due to cheap money, which generates low-return investments that demand natural resources. China should not support inefficient investment through revaluation.
Second, most investments in China destroy value due to bad decisions or management, not due to high prices of natural resources. The export sector has high returns and creates most of the wealth in China. For example, rising land prices reflect China’s export success. If China revalues to help value-destroying investments, economic efficiency would be further decreased. Hence, financial reforms are far more important than revaluation.
Third, the best approach to help consumption is to return assets under government control to the people. These assets belong to the people in the first place. A higher currency value will only make such assets more valuable abroad.
4) Allow the renminbi to appreciate slowly
This is a tantalising strategy. I see that many interests associated with the property industry are promoting it. The total volume of property under construction probably reached 1.5 billion square meters, or four times sales, in 2004, a year with vastly inflated property sales due to negative real interest rates. As interest rates rise, it will become difficult for all the properties under construction to be sold. Appreciating the currency bit by bit would tantalise foreign speculators and suck in more hot money that would enable the property industry to unload its inventory.
If this scenario does unfold, I believe it would cause another wave of global speculation. Massive speculation would push the dollar down and commodity prices up. China’s actions would essentially extend the Fed liquidity bubble by creating more demand for liquidity under the same Fed Funds rate.
Foreign demand for Chinese properties would indeed rise. However, it would cause property construction to increase even more with another wave of hot money. Six months later, China would face more investment excess, and a hard landing might be inevitable.
Since this scenario helps only the property industry to unload its inventory and no one else, I think it is unlikely to materialize. However, the property industry has become the most powerful lobbying group in China, so I would not dismiss this scenario completely. I assign a 15% probability to it.
Fed policy should remain the dominant factor in how the global economy unfolds in 2005. If the Fed continues to raise US rates slowly, this would keep real interest rates low, the dollar weak, and financial markets bubbly. While such a scenario may increase excesses and the pain of an eventual correction, it would keep the global economy relatively strong in 2005. If the US sees an inflation shock, this would likely force the Fed to raise interest rates quickly, which would cause the global economy and China to decelerate quickly.
China’s actions could change the course of the global economy. If it raises interest rates gradually and keeps its exchange rate stable, the dollar would stabilize, commodity prices would decline, and the global economy might achieve a soft landing. At the other extreme, if China adopts a strategy of appreciating its currency bit by bit, this might lead to further speculation and increase excesses in the global economy.
The global economy is experiencing over-consumption in the US, over-investment in China, and massive speculation in financial markets. In my opinion, only if China and the US both raise interest rates gradually can the global economy achieve a soft landing.
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