Some notes on China’s economy

As the world’s third largest economy, the dynamics of China’s development have a strong impact on the rest of the world. As one example of a country that relies on export-led growth (although this has been contested), and needs to change the balance of its development, it provides an interesting case-study. If indeed China’s enormous current account surplus has had a malign effect global financial processes, despite representing in another sense tremendous progress, how is it to be reduced in a sustainable way, and also with the minimum of social and political upheaval? How is China to reorient its growth towards domestic demand and consumption?
China is distinctive among large economies in that it is relatively open and exports constitute a relatively large proportion of GDP. The current slowdown in world economic growth, in credit-driven consumption in the US and other major economies, seems to be impacting China strongly. It’s tightening of monetary policy to prevent inflation in recent years may also have had an effect. It is also notable that China’s trade surplus has in fact grown despite the slowdown in export growth. This is partly due to the fact that 50% of imports are are used to produce goods for export. In addition, the construction sector has experienced a marked slowdown, and it is a heavy user of imported materials. Lastly, the fall in commodity prices has also reduced the value of imports.

China’s eastern seaboard acts as an industrial dynamo for the economy, with its export processing zones acting as magnets for foreign and domestic investment. As mentioned above, companies import materials and components for use in production and export the goods once assembled. The global slowdown has hit manufacturing industry particularly hard. The credit crunch has made it harder for firms to obtain credit for payment in advance for their inputs. Since one firm’s inputs are another firm’s outputs, the whole supply chain is affected.

The slump in international trade has left 20 million migrant Chinese workers unemployed in towns and cities. Many of them will be forced to return home to their families in the countryside, since welfare protection is minimal. This is likely to reduce rural incomes too, as the remittances sent home by urban workers will be falling.

It is clear that China needs to boost domestic demand to combat the recession, and it is taking steps to do so with a fiscal stimulus package, the size of which has been disputed. Maybe structural reforms are needed too, for the longer term reorientation of the economy towards domestic consumption. This would likely accelerate the emergence and growth of a consumer society in China, which seems inevitable. In addition, not only must growth be sustainable economically, but also environmentally.

The Economist argues that the structural reforms must include raising government expenditure on health, education and social welfare and to shift their economies away from capital-intensive manufacturing towards labour-intensive services. This should have the effect of reducing household saving and increasing consumption expenditure. They have argued that some liberalisation of finance would boost the growth of credit and from there consumer spending as a proportion of GDP. But China should be careful with how it sequences and times reforms, as it has been in the past. It is still a poor country in terms of income per head and has a long way to go to catch up with the West materially. A too rapid freeing of finance could lead to unsustainable bubbles as has been the case in many countries, rich and poor, and any subsequent collapse could slow GDP growth for years, hitting the population hard, especially so with no welfare safety-net in place.

Measures to enable a more rapid growth of rural incomes and productivity in China are also important. These would likely allow further rural-urban migration and could help to slow or reverse the rampant inequality in the country. China still seems to have substantial surplus labour in terms of the ‘Lewis Model’ of development which keeps rural wages down and encourages migration to urban and industrial regions. It also predicts that wages in industry are kept down by this process. As surplus labour is gradually exhausted, a process that has been set back by the current slowdown, competition among employers will bid up wages in industry and newly-developing services and stimulate increased consumption in the economy and new sources of demand and growth.

750 million people still live in rural areas in China, out of a total population of over 1 billion, which indicates that the country has a long way to in its continuing industrialisation and urbanisation. It is not clear that China needs to fully liberalise (whatever that means) its economy yet, as the past thirty years have been dramatically successful in terms of a number of development goals (increase in incomes, reduction in poverty etc).

Rebalancing global growth: maybe it is not China’s problem?

In my previous entry I argued that China needs to rebalance its growth towards consumption in order to help rebalance the global economy and reduce the total sums of current account deficits and surpluses worldwide. I also considered the argument that this may not by itself reduce the US current account deficit which is more the ‘fault’ of US consumers and government behaviour. Put simply, the US is not saving enough as a whole and this situtation needs to be put right. Is China saving too much? And are these two linked? This is the ‘savings glut‘ debate.

The US has been acting as a ‘consumer of last resort’ by running large current account deficits and thereby stimulating global aggregate demand growth. Stiglitz has argued that this has been made possible by the dollar’s status as a reserve currency. The growth in US consumption and demand from the rest of the world has helped to underpin a rapid growth of exports in East Asia. The latter was underpinned by the devaluations of currencies in the region after the Asian crisis of 1997-98 and the subsequent fixing of these currencies to the dollar. Some oil-exporting countries have tied their currencies to the dollar in recent years and they have also been running current account surpluses. Ultimately this combination of policies has been inflationary for the world economy. A commodity price boom was triggered in the 2000s which peaked in 2007, and consumer credit and house prices boomed in many rich countries during this period. These processes have proved to be unsustainable and their unwinding has been part of the current crisis.

A rebalancing of global growth is necessary in order to make it more sustainable in the future. Is this China’s problem? It may help if China were to reduce its domestic savings rate and increase the proportion of domestic consumption in years to come. As its huge domestic market increasingly makes the transition to a consumer society, and its average wages levels rise, different countries will become the new emerging markets and perhaps engage in some form of export-led growth as they sell cheap goods to the rest of the world. So while China could change its structure of demand and production, the US may remain as global consumer of last resort, continuing to import increasingly sophisticated goods from China, but also importing goods from a new wave of emerging markets or Newly Industrialising Countries (NICs) which have lower productivity and wage levels than China is likely to have as it continues to develop and grow in years to come. Thus the US and other rich countries could still be running substantial current account deficits despite adjustment from China and other East Asian economies.

However, even the scenario outlined above may not come to fruition quickly. There are strong forces working against the adjustment of East and South East Asian economies, namely their governments’ wish to insure themselves against future financial crises by building up large foreign reserves, ironic in the sense that they have helped to precipitate the current crisis in doing so. It seems that the way that one crisis (that of 1997-98) developed and was handled by the IMF set in train processes which allowed new crises to develop. Stiglitz has argued in ‘Making Globalization Work’ that the global reserve system needs to be reformed in order to counter these processes and mitigate the possibility of future major financial crises.

So perhaps it is the world financial system as a whole that needs reform. China’s adjustment is perhaps inevitable as it moves up the value chain and its society transforms to one more geared to consumption. As such a large economy this adjustment will affect the development and trajectory of the global economy dramatically. But the current crisis is not wholly the fault of the East Asian build-up of foreign reserves, let alone China doing likewise. China has a part to play in global adjustment, but it is still the US which has the larger strategic role, in offering leadership and coordinating this adjustment, if global prosperity is to be sustained.

Changing the balance of China’s growth: moving the world onto a more sustainable footing

It has been argued by some that among the deeper causes of the current financial crisis are the enormous economic imbalances that have built up in the world, particularly that between the US and China, but also between the former and other East Asian countries, as well as some of the oil-producing countries of the Middle East. The large current account surpluses of these countries, and the corresponding large deficit of the US have as their corollary flows of capital from emerging markets to the rich world which, it is claimed have contributed to inflated asset-prices and fuelled the credit and housing bubbles which subsequently led to bust and the crisis in which we find ourselves. The economies of East Asia, particularly China, and also the Middle Eastern oil-exporters accumulated large foreign reserves, which were invested in large part in US Treasuries, which raised their prices and lowered their yields and the key long-term interest rate affecting the US economy. The monetary policy of the Federal Reserve from 2001 to 2005 has also been loose. This discouraged saving and promoted borrowing, which financed consumption and housing booms. These in turn sustained the growth of exports in the East and elsewhere, and hence the whole process.

The Economist magazine has also argued that economies in East Asia have become too dependant on export-led growth and with the end of the US-led boom, they need to rebalance their economies towards domestic demand and consumption, and somewhat away from exports. This rebalancing of the world economy may in turn help to prevent such a major crisis from occurring again, at least until the next bubble, which is bound to take on a different form.

Despite all this, Alan Greenspan in his memoirs and Joseph Stiglitz in a recent book ‘Making Globalization Work‘, have argued that if East Asian, and maybe oil-exporting countries were to revalue their exchange rates, relative to the US dollar, all else being equal, they may well reduce their current account surpluses, but in the medium-term, some production would shift to lower cost countries whose exports would increase, particularly to the US, and simply replace the supply to those markets lost to the countries that had revalued. In other words, the current account deficit of the US is the fault of the US low saving rate, both by private households and by government. The running up of debt by the US is also partly caused by the dollars role as a reserve currency, and the structure of international finance and payments needs to be changed, according to Stiglitz. Greenspan admits that US debt levels are unsustainable, but predicts an orderly unwinding of imbalances thanks to his belief in the rational collective power of private agents. 

What is needed as well as a shift in relative currency values, which only redistribute purchasing power between countries and, other things being equal, do not raise global demand overall, is a change in saving propensities within countries, by households, firms and governments.

Returning to our central topic: that China needs to help rebalance the global economy by reducing its excess domestic savings as a counterpoint to the US and some other Western countries increasing theirs and thereby reduce the sum of global current account imbalances, there are policies on both the demand and supply-side that can help. China can allow its currency to appreciate although it has already done so to some degree. It can loosen fiscal policy, which it is also doing, and can allocate increased public expenditure to health, education and welfare, as well as in rural areas particularly. These would help to shift aggregate demand towards domestic consumption. Would China’s productive system be able to respond to such a shift? The latter is likely to be helped by structural policies, which help the development of agriculture on the one hand, helping rural incomes to rise, and the service sector on the other.