CoverStory

Slowing down

China’s three decades of miraculous growth is over, soon the table will turn in America’s favour

By Diana Choyleva

This being an election year in America, reports of the death of its economic primacy are exaggerated, as are expectations of future Chinese dominance. The past 15 to 20 years have seen a huge Chinese catch-up with the advanced economies and many experts predict this trend to continue. But the distortions entailed by China’s chosen mode of development now threaten it with a turbulent period of adjustment. Meanwhile, the unwinding of those same distortions will removeartificial barriers to America’s competitiveness and thus fuel future economic growth.

China’s growth and size have produced a meteoric rise to more than 13 per cent of world GDP in 2010 measured at comparable dollar prices. But during the past 18 years of China’s supersonic expansion, Beijing has chosen to attach its economy to the US. It fixed the yuan rate to the dollar in 1994 to stabilise an economy that had just seen inflation accelerate to 30 per cent. At the time, that rate reflected China’s competitiveness. Between 1995 and 2004, China saw 10 years of falling export prices as rural labour was brought into the cities and profitably employed at low wages. America’s modestly positive inflation moved bilateral competitiveness sharply in China’s favour.

At comparable purchasing power, China’s GDP moved from 21 per cent of the US in 1993 to 70 per cent in 2010. The dollar zone created by Beijing’s exchange rate policy is no longer a tiny Chinese moon attached to a huge US earth, but a near-equal pair of seriously mismatched economies. The global market values the combined entity at roughly the right rate, but the result has been overvaluation of the US arising from deliberate continuation of Chinese undervaluation.

In such a zone, the undervalued part (China) will tend to inflation, the overvalued part (America) to deflation. In July 2005 Beijing allowed the yuan to start rising against the dollar and by mid-2008 it had gained 18 per cent. But clearly this was insufficient as China’s current account surplus exploded and China’s consumer price inflation rose to 8 per cent in 2006-2008. The global economy was approaching crisis, driven by imbalances partly resulting from the relative cost shifts between the US and China. The financial crisis provided China with a respite from inflation at the expense of recession. The onus of the adjustment was temporarily shifted to US domestic demand deflation.

Beijing’s response to the crisis was re-fixing the yuan to the dollar in mid-2008 and then a massive monetary stimulus in 2009-10. Inflation accelerated on all fronts. The US Federal Reserve, fearing the onset of deflation, also tried to stimulate the US economy. The second round of quantitative easing sent global food and energy prices up 20 per cent, increasing Chinese inflation further by adding cost-push pressures on top of domestic demand-pull inflation. By the middle of 2011 China’s headline consumer price inflation was up 6.5 per cent.

China’s refusal to let the yuan appreciate was a blunder. Its real exchange rate has gone up hugely, but through the toxic back door of inflation. The adjustment with the US in terms of labour costs occurred even faster than it did for consumer prices. China’s wage inflation increased as a result of the massive stimulus and the shift towards dwindling cheap migrant labour and lower productivity growth. China’s unit labour costs have risen by about 21 per cent in dollar terms since the end of 2007. On the OECD’s estimates, US unit labour costs in the business sector rose by just 0.6 per cent in 2007-10 and were flat to falling in 2011. So the US has seen bilateral competitiveness vis-à-vis China already improve by close to 21 per cent. Not much more is needed for the necessary US real exchange rate rebalancing to be complete.

The chief obstacle preventing a sustainable improvement in US growth prospects has now been removed. America has made substantial progress down the rebalancing route, while China has deepened the excesses on which its growth model is built.

 

BEFORE the global financial crisis America had consumed beyond its income for years, with its private sector building huge debts. But American profligacy was not the key driver in the Beijing-created dollar zone. The surge of China’s domestic savings to an excessive rate due to the yuan-dollar peg caused the build-up of excessive debt in the US. The consistent fall in real interest rates is the key evidence showing the direction of causation. If America’s desire to borrow was the cause of China’s excessive savings the result would have been rising real interest rates.

As long as American households could rack up debt to finance excessive consumption, providing demand for China’s surplus products, the dollar zone was chugging along fine. But the accumulation of debt could not last forever. Once the debt capacity of US households was exhausted, the edifice of strong growth collapsed. The adjustment necessary for both economies to recover sustainably involved, put simply, America consuming less and producing more and China consuming more and producing less.

The effective revaluation of relative unit labour costs between the US and China is now almost sufficient to allow the US economy to see a rise in production as a share of GDP. Renewed American competitiveness will prompt businesses that had moved offshore to return to the US, boosting capital spending, which cash-rich firms can easily finance.

American non-financial firms were in good shape before the financial crisis, yet they restructured aggressively and improved profitability by slashing jobs and pay. Their finances swung into a large surplus. Initially they used the surplus mostly to buy back their own stock. This supported the liquidity-driven upswing in the equity market, but prolonged the household adjustment. The support the equity market provided to household wealth delayed or dampened the necessary rise in the household savings rate.

A much better use of firms’ free cash flow would have been investment in new capacity, especially if the investment did not substitute capital for labour. But the yuan-dollar peg prevented fast dollar devaluation. The US has now clawed back its competitive edge, which should encourage productive investment. Building new capacity as part of bringing production back to the US is also much more likely to be accompanied by a boost to employment growth.

The US business sector that particularly needed to restructure was the financial sector and in particular the banks. The uncertainty about the banks’ exposure to the toxic subprime debt caused a major bank liquidity crunch. The Federal Reserve was right to alleviate the liquidity squeeze with the first round of quantitative easing measures, which worked to arrest the panic.

But the fundamental issue was solvency and the capital destruction in the banking sector caused by the US housing market crash. This, together with continued pressure from excessive global savings and the yuan-dollar peg, created a peculiar situation in America. In this context the slashing of policy rates by the Federal Reserve was counterproductive as it worked against the necessary increase in the national savings rate, but the central bank had no other means of enforcing the necessary dollar devaluation.

The primary need of the US after the financial crisis was to be able to generate growth by stimulating net exports. The best policy route for this would have been to devalue the dollar but raise domestic interest rates. This would have allowed the national savings rate to rise and excessive debt to be paid down without depressing domestic demand, growth and employment too far. But here again the yuan-dollar peg put a spanner in the works. Instead, the Federal Reserve had to slash interest rates to create the necessary real effective exchange rate adjustment by exacerbating the natural tendency towards inflation of China’s undervalued economy.

Money became even cheaper in the US as interest rates plunged to zero, but it was scarce because banks had to rebuild their capital and were not willing to lend. Cheap money discouraged households from saving, but at least scarce money pushed along household deleveraging. Scarce money also meant that the revival in equity prices was driven by reduced risk aversion and lower demand for holding money, making it a hostage to investor sentiment. This meant the recovery in household financial wealth was temporary as shown by the collapse of equity prices in 2011. At the same time low interest rates did little to stimulate business investment, while scarce money meant that non-financial firms were keen to rebuild their own savings despite their relative balance sheet health before the financial crisis.

It seems that when money is scarce low interest rates lack their stimulatory effect, especially when the return to healthy output growth is predicated on a higher household savings rate. But the good news is that US banks have made substantial progress increasing their capital, boosting profit growth and improving their net charge-off rates. They seem willing to lend now, whether to the private or public sector. The Federal Reserve’s second round of quantitative easing measures has also helped support US overall liquidity. In fact US broad money growth has picked up speed fast in recent months, so it may finally be on the road to becoming plentiful.

US households were the key excess borrowers and needed to make the biggest adjustment. Positively, the household story is also one of significant improvement. As mentioned above, there were two forces pulling in opposite directions. On the one hand, the initial increase in the household savings rate and scarce money ensured that households began paying down debt and the debt-to-income ratio has fallen. But on the other hand, the ultra-low interest rates and the liquidity-driven equity market upswing worked against the necessary continued increase in the household savings rate.

Even so, household debt fell to 113 per cent of household disposable income at the end of last year from a peak of 130 per cent in mid-1997. Based on historical experience and a return to normal interest rates, the sustainable level of household debt is around 110 per cent. So households are not particularly overleveraged any more. This should start to help put a floor under house prices, which in real terms have fallen by between 15 and 25 per cent. But with the household debt build-up overshooting during the boom years, it is likely the deleveraging will undershoot during the correction phase. Hence, households could well continue to pay down debt further. Moreover, current levels of net household wealth are historically associated with a higher household savings rate than the current 4.6 per cent. So the household sector is not fully out of the woods yet, but there has been a major shift in the right direction.

The biggest remaining adjustment is to prevent government debt spiralling out of control. The public sector took the baton from the household sector in the wake of the financial crisis and perpetuated the borrowing and spending pattern on which output growth was previously based. The US has now engaged in sharp fiscal deflation that will dampen growth in 2012, especially given external weakness such as Chinese growth slowing down fast and the euro area in recession. Even sharper fiscal deflation is in the pipeline for 2013, but by then US growth could start to surprise on the upside.

The necessary public sector deleveraging and rising household savings suggest the next two to three years are unlikely to see any rapid increase in American domestic demand but a rising US production share of what demand there is should ensure reasonable overall GDP growth.

 

THE same cannot be said of China. Its export-led growth model is rendered obsolete by America’s inability to continue to run huge current account deficits on the back of excessive domestic borrowing. Its huge size, compared to other export-led economies, notably Japan, is a major problem. Export-led growth is a dud strategy now the US is unlikely to be the easy market of first resort. In short, China is the one left standing as the US music stops.

China’s miraculous growth era is over. Real GDP growth in the next 10 years is likely to be at most half the 10 per cent growth rates achieved in the past 30 years. The challenges that Beijing faces in changing its growth model are huge. The next few years will see heightened economic and financial turbulence, fundamentally changing investors’ perceptions of China. But the assumption is that Chinese policymakers will do the right thing, eventually. Hence, the 5 per cent average growth rate is the positive long-term scenario.

After Mao, the Chinese people had nothing but sheer determination to succeed. The disbanding of agricultural communes and the shift of capital and labour to low-end manufacturing meant the first two decades of reform saw substantial productivity gains, which was mostly for export. China’s growth model has continuously relied on a relentless increase of its global market share. The strong export income and a high domestic savings rate allowed the economy to industrialise at breakneck speed.

Savings are vital for an economy as they provide the financial resources needed for investment in homes, factories, machines, roads and schools. The more savings are used for investment, the faster incomes grow and the easier it becomes to save more. This was the virtuous cycle that the thrifty Chinese enjoyed. But savings can turn from tonic into toxic. Investment is ultimately derived from demand. It depends on consumption and export growth. The more people want to save, the less they spend on clothes, phones and cars. Saving more to invest more is a dead end when there is no increase in the desire and ability to consume or export. Such investment becomes unprofitable, at the end of the day hurting company profit levels and people’s income. This is why excess savings dampen demand.

Investment in social infrastructure is different, but it also has limits. Building roads to nowhere can continue for a long time. But if the cost of building infrastructure exceeds the implied productivity gain, ultimately financing such investment becomes unbearable. Either the taxes people have to pay become too high or public debt begins to spiral out of control.

However, the usual limits to investment have not applied to China. In China private and state-owned firms alike are not driven by profitability. Private entrepreneurs are focused entirely on the short term, exploiting arbitrage opportunities with little regard for strategic planning. It is no wonder that the production of fake goods is so widespread. State-owned ‘national champions’ appear profitable but enjoy a raft of subsidies or monopoly positions.

The most important subsidy is access to mispriced cheap loans. China’s exorbitant investment rate has been sustained and increased for years because the state uses government owned banks like an ATM to finance its massive expansion plans. Beijing controls the direction, amount and cost of loans, and keeps borrowing costs low. If state firms can’t pay their debts, new loans are dished out to keep them going. Banks accumulate bad loans. But the expectation is that strong output growth will diminish those bad loans over time. Banks may be insolvent, but as long as the closed exchange controls prevent capital outflows—thus keeping domestic savings at home—state companies never default and banks can’t go bust.

China’s ability to industrialise quickly has driven supply, but the final demand for China’s surplus products has come from abroad. At home, a rising savings rate has meant that the share of household consumption has declined to an ultra low 34 per cent of GDP last year. Meanwhile, China’s investment rate was already at 43 per cent of GDP in 2004 and not only was this sustained over the next six years, but increased to 49 per cent in 2010. The key question is what has changed to prevent the investment rate from being pushed up further in coming years, to, say, 55 per cent in six years’ time. The answer is the financial crisis, which has fundamentally changed the rules of the game.

China can no longer rely on good fortune abroad. The rest of the world will struggle to achieve strong growth. Reducing the debt excesses of the past decade will take years. This export shock will undermine the sustainability of China’s investment strategy. Moreover, China has exhausted the easy productivity gains from shifting labour from agriculture to low-end manufacturing. It is simply too big. And the world is not big enough for China to reach US real income per capita levels via catch-up growth and value-added chain. Whatever it does, China cannot reasonably expect to make all the world’s manufactured goods.

 

BEIJING has realised the need to rebalance growth away from wasteful investment towards domestic consumption. But the authorities will have to contend with the social and political consequences that come with slower growth. The pressure to fall back to what seemed to have worked best in the past—state-directed, credit-fuelled investment binges will be strong.

But it will not work this time. Monetary and fiscal ease will do more to boost inflation and create asset price bubbles than to achieve a sustainable boost. The more China goes down this route, as it did in the wake of the global financial crisis, the more it risks blowing up like Japan, which spawned a real estate and equity bubble in the 1970s and 1980s. But given its size, China does not have 20-more years to be blowing bubbles like Japan.

The more inflationary China’s cycle becomes, the more difficult it will be for Beijing to use the banking sector indiscriminately to bankroll fiscal expansions and hide the bad loans. China’s export and investmentled growth model has reached its use-by date and this will become increasingly clear over the next few years.