Martin Wolf of FT on China. Important information

The Irish Times – Wednesday, April 4, 2012
China beset by internal imbalance

Inside track: Q&A
Road Warrior


ECONOMIC COMMENT: CHINA’S ECONOMY is changing. Indeed, it has to
change, as I argued two weeks ago. The good news is the scale of the
external rebalancing. The bad news is that this is at the cost of
larger internal imbalances.

China’s balance of payments has been on a rollercoaster. Thus, between
2003 and 2007, the current account surplus rose from 2.8 per cent to
10.1 per cent of gross domestic product. The surplus then fell
sharply, to 2.9 per cent, by 2011. Over the same period, the share of
exports and imports in GDP exploded upwards and then fell once again.

In orthodox theory, the level of current account surpluses and
deficits reflect voluntary decisions to save and invest – countries
with surplus savings, such as China, export capital while countries
with a deficit import it. Surplus countries enjoy a higher return on
savings; deficit countries enjoy a lower cost of investment.
Everything is for the best in the best of all possible worlds. It
seems peculiar that a poor country exports capital to rich ones, as
China has done, but there is no reason, in this view, to question the
wisdom of the underlying choices.

Unfortunately, this Panglossian view is hardly plausible after the
repeated shocks in international finance over the past three decades,
which culminated with the crisis in high-income countries that broke
out in 2007.

The US, in particular, proved incapable of using its capital inflows
wisely – they financed fiscal deficits and the construction of
unneeded houses. Of course, the US is largely to blame for such a sad
outcome, as are other capital importers. But large external deficits
also have a contractionary impact on demand. This did not seem to
matter when the latter was strong. It matters a great deal now, when
it is weak.

Beyond these general points, specific issues arose over the past
explosion in China’s surpluses. These were partly the consequence of
interventions in foreign currency markets and consequent accumulation
of foreign currency reserves. The latter rose from $170 billion in
January 2001 to $3.2 trillion at the end of last year. One tool in the
policy box was to sterilise the monetary consequences of these
interventions. All these are mercantilist policies.

Moreover, if a country is to have a huge investment boom and a strong
external position, consumption normally has to be repressed and
savings encouraged. This is what happened – private consumption fell
from 46 per cent of GDP in 2000 to just 36 per cent in 2007. Public
and private consumption together fell from 62 per cent of GDP to 49
per cent, while gross saving jumped from 38 per cent of GDP to 51 per
cent. A substantial part of these savings was invested in low-yielding
foreign assets, at great cost: China’s external reserves are $2,300
for every man, woman and child, or as much as 40 per cent of GDP.

Thus, a reduction in the external surpluses has been in the interests
of both the rest of the world and China. So how happy should the
results make us? The answer is: not ecstatic.

First, even a decline in the current account surplus, as a share of
GDP, might mean a rising surplus, relative to the rest of the world’s
output. In 2008, China’s surplus was $412 billion, or 9.1 per cent of
GDP. By 2011, it was just under half of the 2008 level, at $201
billion. But the share of China’s GDP fell to 2.9 per cent. Suppose
the share remained at 2.9 per cent: the surplus would exceed $400
billion by 2016 if China’s dollar GDP grew at 15 per cent a year. That
is a plausible rate, since China’s real exchange rate is likely to
appreciate. If you want to assess the adjustment imposed on others,
look at surpluses in relation to their GDP, not China’s.

Second, the domestic counterpart of the external adjustment consisted
of ever-higher investment as a share of GDP: between 2007 and 2010,
the share of investment in GDP rose by close to 7 percentage points.
In every year since 2007, real fixed investment has grown faster than
GDP. The OECD made the point in China in Focus: “Thus far, the
adjustment towards domestic demand has almost entirely reflected
strong public infrastructure investment that has been financed
off-budget”. Wen Jiabao, the premier, has himself frequently described
China’s development as “unbalanced, unsustainable and unco-ordinated”.

Unfortunately, the process of eliminating one important imbalance, the
external surplus, has exacerbated the most striking of the internal
imbalances – the extraordinarily high investment.

Suppose that China were to grow over the next decade at the still high
rate of 7 per cent a year. Suppose, too, that investment (including
investment in inventories) fell from 50 per cent of GDP to a still
very high 40 per cent, because a smaller rate of investment was needed
to support lower growth. Suppose, too, that the external surplus
remained 3 per cent of GDP. To achieve the expected 7 per cent GDP
rate of growth, consumption (public and private) needs to grow at a
real rate of 9 per cent while investment grows at 4.6 per cent. This
would be an astonishing reversal. It would be impossible, without a
big shift in the distribution of income towards households.

That, in turn, would require comprehensive reforms in the financial
system, in corporate governance and in China’s power structure.
Moreover, there is a risk such reform lowers investment more than it
adds to consumption. The result could be a very hard landing.

China has done a far better job of eliminating its huge current
account and trade surpluses than I expected. The principal domestic
cause of this shift has, however, been a surge in investment to still
dizzier heights, assisted by appreciations in the real exchange rate.
But that makes the domestic adjustment now required even bigger than
before the crisis. If the external surplus is to remain a constant
share of GDP, while the rate of economic growth slows, an
extraordinary turnround in relative rates of growth of consumption and
investment is essential. To put it bluntly, the growth dynamic of the
past 15 years must be reversed.

Is that feasible? Perhaps. But it requires a huge expansion in
consumption relative to investment. Will that happen, while the
economy grows strongly? Quite possibly not. – (Copyright The Financial
Times Limited 2012)

The Irish Times – Wednesday, April 4, 2012