With a second interest rate hike in four months, China is upping the ante in an effort to contain its overheated economy. The success of this operation transcends the direct impacts on the Chinese economy. It bears critically on China’s ever-expanding global supply chain – especially commodity producers, the energy complex, and Asian component manufacturers. Moreover, China’s tightening actions could reinforce the normalization campaigns of major central banks in the developed world – buttressing the case for a global soft landing. Can China pull it off?
There can be little doubt that China’s macro decision makers are taking the overheating problem seriously. President Hu Jintao and Premier Wen Jiabao have taken to the bully pulpit repeatedly in urging a shift to slower growth. The People’s Bank of China has led the way, moving to raise both interest rates and bank reserve ratios two times in the past four months. While this is twice the degree of monetary tightening that was imposed in 2004, the last time China was overheated, I agree with Andy Xie that these measures are not sufficient to slow a white-hot Chinese economy.
On other counts, Chinese policy actions have been relatively limited. While currency managers have tolerated greater volatility of the renminbi versus the dollar in recent days, there has been little movement in the central tendency of China’s foreign exchange rate. Similarly, while some administrative actions have been announced in recent months aimed at containing investment projects in selected overheated sectors, the scope of such measures still appears relatively narrow. In that same vein, little has been heard recently from Chairman Ma Kai of the National Development and Reform Commission (NDRC) – China’s chief economic planner and the key point person on the administrative side of its policy equation.
China’s overheating economy: the problem of regionalisation
Inasmuch as China remains very much a “blended economy” – a combination of a state- and market-directed system – the verdict on its current tightening campaign is far from convincing. A shift in monetary policy achieves traction only when the banking system and financial markets are fully developed – something that is still very much lacking in China today. At the same time, state-owned enterprises – which continue to account for between 30-40% of the Chinese economy – behave very differently than private and publicly owned businesses. The former are not motivated by market signals nor influenced by policy actions designed to impact markets.
The persistent regionalization of the Chinese economy also complicates any macro tightening campaign, leaving a highly fragmented China largely insensitive to Beijing-directed cooling off measures. Recent punitive actions aimed at regional officials in Inner Mongolia pay lip service to this aspect of the problem but do little to challenge the runaway growth still concentrated in coastal China.
The lack of macro control over a still fragmented Chinese economy is a major glitch in the recent tightening campaign. Hyper-growth in eight of China’s 31 provinces has taken on a life of its own. These regions, which collectively contain about 40% of China’s total population, have accounted for 72% of total Chinese GDP growth since 2000. I have been to many of these areas myself and witnessed first hand their explosive growth in infrastructure, urbanization, and capital investment in new plant and equipment. I have also spoken with regional leaders in many of these provinces – provincial governors, mayors, and bankers who speak of open-ended growth for years to come irrespective of cycles in the national economy. Beijing’s macro policy adjustments have done little to arrest the micro aspects of overheating.
A decentralized banking system remains a critical stumbling block to effective macro control of the Chinese economy. The regionalization of hyper growth is fully funded by independent local branches of nationwide banks, as well as by largely autonomous regional banks. By contrast, the blunt instruments of monetary policy achieve traction only if branch lending is tied to deposit growth and funding costs of the parent bank. Moreover, increases in bank reserve ratios, such as the two that have been announced in the past four months, do nothing to limit bank lending capacity for a system whose major banks have long maintained an excess reserve position.
Largely for these reasons, overall RMB-based bank lending growth continued to surge at a 16% y-o-y rate in July – well in excess of the central bank’s targeted lending path. Over the first seven months of 2006, overall loan creation amounted to fully 94% of the bank lending targeted for the entire year. In other words, the People’s Bank of China has little to show for its tightening campaign that began in late April.
China’s overheating economy: fixed asset investment
Nor are there any visible signs of a slowing in investment growth. Gains in total fixed asset investment – a sector that rose to fully 45% of Chinese GDP in 2005 – held at an astonishing 31% y-o-y rate in July. The same regionalization phenomenon is at work here as well, augmented by special tax incentives long provided for foreign direct investment in so-called special economic zones. That, in turn, has long fueled rapid export growth. China’s so-called foreign invested enterprises – Chinese subsidiaries of multinational corporations and foreign-invested joint ventures – have accounted for fully 65% of cumulative growth in total exports over the past 12 years.
In short, by conscious design, China is a well-oiled export- and investment-led growth machine driven by powerful micro forces operating at the regional level. The macro tightening initiatives announced by Beijing, which focus mainly on the price of credit, do not address this key aspect of the overheating problem. That puts the burden increasingly on the central planners at the NDRC and their administrative edicts that can be used to control the quantity of investment, exports, and industrial activity. So far, such actions have been surprisingly limited. That must change – and probably quickly – if China’s cooling off campaign is to have any success.
China’s overheating economy: a three-pronged strategy
I am confident that is exactly where China is headed. The alternative is a wrenching boom-bust cycle, and in my view, the stakes are simply too high for the Chinese leadership to condone such a devastating endgame. I look for a three-pronged cooling off strategy to be unveiled shortly: One, an expansion of administrative edicts aimed at controlling excess investment is likely. So far, restraints have been imposed on just a few industries – namely, aluminum, cement, ferrous alloys, coal, coking coal, carbide-based PVC, and speculative activity in residential property construction. I expect the NDRC to expand this list shortly.
Two, the pace of banking system reform and the related centralization of the big banks must accelerate if China is to have any hope of achieving traction for monetary policy. The “corporatization” of state-owned policy banks is central to this process; two of the four large policy banks have now been publicly listed and the other two are likely to follow in the months ahead.
Three, further macro restraint is needed for both monetary and currency policies: Monetary policy restraint is the functional equivalent of a rhetorical straight-jacket for an undisciplined banking system, while currency reform should be aimed at tempering foreign political pressure and defusing protectionist risks.
China’s overheating economy: ensuring sustainable growth
Success will likely be measured in two ways – a slowing of industrial output growth below the 15% threshold and a rebalancing of the mix of Chinese GDP growth away from exports and fixed investment toward private consumption. Only if those conditions are satisfied can the sustainability of China’s growth imperatives be assured. Under the presumption that such a slowdown comes to pass, there can be no mistaking the implications for the rest of the world.
The energy and commodity-producing complex will be on the leading edge of feeling the impacts as China’s commodity-intensive growth drivers, such as investment and exports, give way to more of a commodity-efficient growth dynamic driven by private consumer demand. China’s regional trading partners – especially Japan, Korea, and Taiwan – will also be effected by a slowdown in Chinese output growth that sparks concomitant reductions in demand for manufactured components by Asia’s increasingly China-centric supply chain.
The big risk in all of this is that Beijing refuses to bite the bullet and instead delays going for restraint. Concerns over social stability – long the most worrisome repercussion of reforms – could well tempt risk-averse leaders to let the economy run hotter for longer. This would be a recipe for disaster, in my view – triggering a lethal combination of runaway investment leading to excess capacity, runaway exports leading to protectionism, and runaway excess liquidity leading to asset bubbles. Reining in the excesses of China’s overheated economy is an increasingly urgent challenge to senior Chinese leaders. But it will take a good deal more in the way of restraint to pull off a Chinese soft landing. Without such moderation, the case for a global soft landing could be in tatters. Fortunately, time and again over the past 10 years, China’s reformers have risen to the occasion, and I am confident that will be the case this time as well.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum