Global: China Tradeoffs
Stephen Roach (New York)
China’s hike in interest rates is good news, in my view. It is a plus for an overheated Chinese economy, and it is a positive development for an unbalanced global economy. But there are always winners and losers when a nation opts for policy restraint. China is no exception. Three such tradeoffs loom particularly important in assessing the domestic and global implications of China’s monetary tightening:
Policy strategy. China’s tightening campaign is now over a year old. Up until now, the Chinese authorities have relied mainly on administrative measures to slow their overheated economy. Such actions, which included increased reserve requirements on some banks, as well as targeted restrictions on the availability of funds by sector and region, borrow a page from China’s central planning script. These are largely micro tools designed to have an impact on the quantity of credit -- the only way really to control the State-owned segment of the economy. The interest rate move, by contrast, determines the price of credit. As such, it is a much broader macro instrument, having a more pervasive impact on the increasingly important market-driven piece of the Chinese economy.
These tradeoffs -- between micro and macro instruments, as well as between the State- and market-driven segments of the economy -- have long been important considerations to the Chinese policy balancing act. China’s recent history tells us that its blended economy cannot be effectively controlled without a combination of both types of instruments. The lessons from the last Chinese overheating of the early 1990s are especially instructive in that regard. Back then, the overheating was far more of a destabilizing threat. Not only was there a boom in investment, as is the case today, but there was also excessive growth in private consumption; in addition CPI-based inflation hit 22% in 1994, four times the current elevated pace of 5.2%. Even though the market-sensitive piece of the Chinese economy was much smaller ten years ago than is the case today, China engineered a successful slowdown by deploying both micro and macro instruments. The architect of that downshift was Zhu Rongji -- at the time, Governor of the People’ Bank of China. Zhu knew full well that macro stabilization of the Chinese economy required a balanced approach to policy restraint -- a lesson that served him well when he later became Premier.
While I have long been very optimistic on prospects for the Chinese economy, I recently expressed serious concerns over the apparent reluctance of the authorities to raise interest rates (see my 27 September essay, Collision Course). I argued that in light of the dramatic “marketization” of the Chinese economy over the past decade, the blended approach to stabilization policy -- deploying both micro and macro instruments -- was even more appropriate today than it was back in the early 1990s. Fortunately for China, today it has another gifted central banker -- Dr. Zhou Xiaochuan -- who fully comprehends the imperatives of a balanced approach to macro policy control. The interest rate action of 28 October is a very encouraging development on the Chinese policy front and tempers the concerns I expressed a month ago.
Soft or hard landing? In my view, the interest rate signal is also an important milestone on the road to a Chinese soft landing. In the absence of any interest rate adjustments, there was a growing possibility of a boom-bust endgame to China’s increasingly overheated economy. The prospects of rising interest rates reduce the probability of such an outcome. That assumes, of course, that the recent rate hike is but the first step of many. As our China team points out, China has a history of long interest rate cycles; the 1-year benchmark lending rate went up by a total of 342 basis points over the 26-month tightening campaign during the May 1993 to July 1995 interval (see their 28 October dispatch, “Growth Reacceleration Triggered Rate Hike”). As seen in this context, the latest policy action is only a modest down payment on what could well turn out to be a measured, but drawn out monetary tightening campaign.
Such a likely policy path points to further moderation in the Chinese growth dynamic. That would come as welcome relief for a still-overheated economy. Relative to peak growth rates in the early months of this year, most of the major indicators of Chinese economic activity have slowed -- some more than others. Deceleration has been especially pronounced for imports, bank credit growth, and fixed investment but only limited for industrial output and GDP growth. Moreover, many of the indicators picked up a bit over the August-September period -- pointing to a potential reacceleration in the economy at just the point when a further slowdown was needed. Andy Xie believes that this recent rebound had a material impact on the timing of the interest rate action.
Looking down the road, I continue to believe that the industrial production profile is the best metric to judge progress on the China slowdown front. After peaking at a 19.4% Y-o-Y comparison in the first two months of 2004, growth slowed to 15.5% in July before reaccelerating to 16.2% in September. In my view, China will achieve a soft landing if the industrial output comparison slows into the 8-10% zone over the next year -- a halving of peak growth rates. To date, China has achieved only about 30% of the necessary deceleration. Now that interest rates are finally in play, there is good reason to look for further slowing in the months ahead. There are those who believe that the magnitude of China’s investment and property bubble is already so advanced that a hard landing is still inevitable. I don’t share that pessimism. China’s blended approach to stabilization policy -- combining both macro and micro instruments -- gives it plenty of leeway to fine-tune along the way. A hard landing poses the greatest threat to China -- instability. Chinese authorities will do everything in their power to avoid a destabilizing endgame. Their track record over the past dozen years shows they are very adept at pulling off soft landings in periods of macro adversity. I am betting on the same result this time, as well.
Global tradeoffs. There are two main channels by which fluctuations in the Chinese economy are transmitted to the broader global economy -- through trade linkages and commodity markets. The two impacts are of opposite signs: A China slowdown reduces import demand, thereby inhibiting the export growth of China’s major suppliers. By contrast, a China slowdown also results in a reduction of commodity demand and a falloff in commodity prices -- providing relief from input price inflation on the production side of the global economy. The trade effects lower global growth, whereas the commodity effects work the other way. The key for the global prognosis is to assess the balance between these two opposing forces.
In my view, the negative trade effects will predominate. China’s explosive import growth has had a dramatic impact in boosting export growth in most of the world’s major economies. In Japan, for example, rapidly expanding shipments to China accounted for fully 43% of total export growth in 2003. The China factor accounted for 48% of total Korean export growth in 2003, 68% in Taiwan, 27% in Malaysia, 28% in Germany, and even 21% in the United States. Unless these countries have alternative markets to sell their exports or a backstop of improving domestic demand, the China slowdown will be a distinct negative. Unfortunately, that’s precisely the case with the countries enumerated above -- with the possible exception of the United States, where growth support has been more diversified, at least up until now. Chinese import growth has already been cut in half -- from 40% in 2003 to 22% on a Y-o-Y basis in September 2004. I don’t think it’s a coincidence that export growth has already begun to falter in recent months in Korea, Japan, Germany, and the US. With the China slowdown only in its early stages, the impacts on global trade should intensify a good deal further.
That’s not to minimize the industrial commodity effects -- a potential decline in demand and pricing that had an immediate impact on the share prices of industrial materials companies. In the developed world, however, commodities account for a relatively small portion of value added -- somewhere in the 10-15% range. If commodity inflation slows further on expectations of a China soft landing, this should provide some relief to pressures on profit margins -- a plus for business earnings. However, given the persistent lack of CPI-based pricing leverage in recent years, any break in input price inflation is unlikely to be translated into lower product prices. That would limit the impact on inflation-adjusted purchasing power and aggregate demand in the broader global economy.
Oil may be a special case for China. While oil prices fell sharply in the immediate aftermath of the Chinese interest rate hike, that may have been an over-reaction. For starters, China continues to be plagued by widespread energy shortages and power disruptions. That suggests even in the event of a further slowdown in economic activity, China’s oil and energy demand could remain surprisingly resilient. Moreover, China is a very inefficient user of energy; relative to the average developed country in the OECD, China consumes 2.3 times as much oil per unit of GDP. This is yet another reason to believe that the China slowdown could play a surprisingly limited role in pushing oil prices lower.
Adding up. The interest rate hike announced by China’s central bank on 28 October is an important development for China and the rest of the world. It gives me confidence that Chinese policy strategy is now more balanced and, therefore, on the right course to cool off an overheated economy. That’s good news for the China soft-landing case. The global economy will not be without pressure, though. While somewhat lower commodity prices could provide a temporary windfall of purchasing power, any such impetus is likely to be swamped by the far more powerful impact of China’s trade linkages. In my view, a China slowdown does not appear to be a growth-friendly event for China, the rest of Asia, and the broader global economy.
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