The impact of China's currency manipulation on emerging economies

The Times points to a recent IMF working paper which suggests that the era of high current account surplus driven external imbalance of the Chinese economy may be coming to an end. The IMF estimates that China's current account surplus, which topped 10% of GDP in 2007, had  shrunk to about 2.8% in 2011 and is estimated to decline to 2.3% in 2012, the smallest since 2001. 

Apart from rising labour costs and the natural shift upwards in the manufacturing value chain, the appreciation of the renminbi over the past decade too has been a contributory factor. Since June 2005, but for period of nearly two years during the 2008 financial crisis, China has allowed the remnminbi to trade in a daily band of 0.5% against the dollar. Since mid-April, 2012, it widened the band and now allws the renminbi to fluctuate up or down in value by as much as 1 percent against a fixed benchmark with the dollar during daily trading. But the central bank continues to set the benchmark for each day’s trading of the renminbi, and it has shown virtually no change this year.

The FT has an excellent interactive graphic that traces the change in the value of renminbi since 2000. It uses four distinct ranges, beginning with before China's WTO entry (January 2000), its first depeg from US dollar (June 2005), its second de-peg from US dollar after re-pegging it during the 2008 crisis (may 2010), and March 2012. The graphic below shows that the renminbi's nominal and real (inflation-adjusted) trade-weighted exchange rates (REER) relative to its major trading partners have appreciated. Further, this appreciation has been higher since June 2005.

However, this appreciation conceals variations. The renminbi has risen steadily against the US dollar, British Sterling, and Japanese Yen over the past decade, but its real appreciation against other currencies from the euro to Brazilian real has been far milder. Accounting for different inflation rates, in real terms while the renminbi has risen by 29% since 2000 against the US dollar, it has actually depreciated against all others - 0.7% against the Euro, 45% against the Brazilian Real, and 30% against the Indian Rupee.

This is also a reflection of the fact that the dollar itself has depreciated against the other major currencies during this period. Therefore, there may be a strong case now for many developing economies that, despite China's exchange rate flexibility since 2005, they are bearing the brunt of China's currency manipulation.  

In particular, India has been amongst the worst affected by China's currency manipulation. In real terms, the renminbi has depreciated by 30% since January 2000. In fact, despite, the rupee's significant depreciation against the dollar, the real rupee-renminbi exchange rate has held steady. In fact, but for India's much higher inflation rate, since 2005, the exchange rate between the two currencies has hardly budged.

In keeping with the trend with others, the renminbi has appreciated in real terms over the past one year. However, it may be premature to consider this as a decisive shift in China's exchange rate policy since this period also conicided with higher than normal inflation in China.

These trends are yet another reason for India to rally other developing countries around an agenda that focuses on China's currency manipulation and its beggar-thy-neighbour impact on other emerging economies. Apart from its substantive nature, this can also add a strategic dimension to India's foreign policy.    

China moves up the value chain

From being the consumer goods factory of the world, China is fast becoming the infrastructure contractor to developing countries. As domestic wages increase and labour market diversifies, China is ceding ground to other lower-cost consumer goods manufacturing countries and moving over to heavy equipment, especially infrastructure-related, manufacturing.

The massive domestic infrastructure investment boom of the past decade-and-half has equipped many Chinese firms, public and some private, with expertise in heavy equipment manufacturing and construction of huge infrastructure projects. The FT describes this push and its implications

Between 1998 and 2010, consumer goods exports from China to the rest of the world grew at a rate of 13 per cent a year. Heavy industry exports to the developing world, by contrast, grew by 25 per cent annually over that period... Chinese companies have had difficulty adding value in high-end consumer products (that) require a complex mix of design, branding and marketing skills that are in short supply in a relatively low-income country like China. On the other hand, using the huge construction boom for the past couple of decades as a training ground for selling excavators and bulldozers to the rest of the world at lower prices than their developed world competitors is easy enough...

The so-called China price now applies to industrial goods, not just consumer goods. Cheap China exports could provide a boost to investment in the developing word, just as they once did to consumption in the developed world... This ought to be a near unalloyed positive for the developing world, except that financing may prove more difficult as the developed world’s banks retreat from lending overseas.

The article also highlights the potential for trade disputes that could arise from this aggressive push with heavy equipment exports. Countries like India, which have their own fledgling heavy equipment industries, are more likely to resist this Chinese push. 

More on China's macroeconomic imbalances

Much has been written about China's economic policies that sought to boost exports at the cost of everything else. It is now very clear that it has come with significant costs and serious external and internal macroeconomic imbalances. Externally, Beijing has aggressively intervened in the market to keep the renminbi undervalued. Internally, it has kept interest rates artificially low which in turn has resulted in severe financial repression and suppressed domestic private consumption.

Economix has an interview with Nicholas Lardy who outlines why these two imbalances, external and internal, are closely linked,

The government adopted a low-interest-rate policy at that time. Deposit rates were held down so that the after-inflation return on bank deposits for savers turned negative. That reduced household income below the path it otherwise would have achieved, leading to a slowdown in the rate of growth of household consumption expenditure. Since most households lack adequate health insurance and retirement programs, they also responded to lower deposit rates by saving even more, so as not to be delayed in reaching their savings goals. That put further downward pressure on private consumption expenditure.

China has adopted a low-interest-rate policy as a mechanism to reduce the costs of simultaneously maintaining price stability and an undervalued exchange rate. The central bank intervened massively in the foreign exchange market to moderate the pace of appreciation of the renminbi, China’s currency. And that intervention led to a large, ongoing increase in the domestic money supply, which the central bank had to offset by the sale of central bank bills and requiring banks to increase their reserves deposited at the central bank. The central bank had to pay interest on these bills and reserves, and the low-interest-rate policy made the cost of these operations less than it would have been had interest rates been market determined.

One could add several other consequences of the low interest rate policy. While it has been a major contributor to the promotion of China's investment driven economic growth strategy, it has also generated distortions in resource allocation, the most prominent and of greatest concern being the real estate bubble.

Stripped off all its macroeconomics, China's investment and export based economic growth strategy has been underpinned by massive government inflated bubbles, in multiple sectors. And for much more than a decade now, the country has managed to successfully carry on the strategy. The government kept interest rate and exchange rate suppressed so as to boost investment and exports. Coupled with capital controls, low interest rates, boosted the coffers of the country's public sector banks with cheap capital, which they on-lend to businesses at low rates. Real estate market boomed, which amplified the finances of state entities and local governments which owned all the land. These agencies leveraged the high real estate values to raise resources to finance their massive infrastructure investments. On the external side, the low exchange rate raised export competitiveness, which in turn encouraged massive inflows of foreign direct investment. A sustained period of widespread global economic growth provided all the favorable conditions for China to pursue this export strategy uninterrupted.

There are several dangers associated with this strategy. Lardy himself points to one such transmission channel,

Urban households have piled into property investment in part because of negative real interest rates on bank deposits, and capital controls that prevent most households from investing abroad. The property boom is based on the widespread assumption that property prices will continue to move upward with only brief and shallow price corrections. If this expectation changes, investment demand in residential property could evaporate. Demand for output of steel, cement, copper, aluminum and many other products is driven largely by residential real estate, so if that sector slumps it could usher in a long period of much slower economic growth.

While the rulers in Beijing certainly deserve their share of compliments for the country's spectacular economic growth, it cannot be denied that China has enjoyed more than its fair share of luck and benefited from favorable external circumstances. Now that the consequences of the imbalances, especially the internal ones, are becoming ever more apparent, Beijing ins being forced to re-evaluate its options. Low interest rates are becoming unsustainable for a variety of reasons, making over-reliance on the investment-driven growth strategy unsustainable. Propsects of anemic economic conditions in much of developed world for the foreseeable future puts question marks on the export-led growth approach.

In the circumstances, re-balancing will have to involve nudging the Chinese consumers to play a more central role. This will require rewarding and incentivizing them with higher interest rates and more diversified and remunerative investment alternatives for their savings (read greater financial liberalization). Further, manufacturing wages will have to become more market determined, so that people's purchasing power increases proportionately with the economy's growth. Both these will have to be accompanied by domestic policies that establish a comprehensive social safety net and enabling greater access to affordable urban housing, tertiary education, and so on.

Is China the new #1?

The coming of the Chinese century and the final demise of American hegemony have been announced frequently as a sure thing. I have dealt with several of the issues associated with that, from the misconception of the fears about the dollar as the key currency (yep, will continue to be the unit of account in international affairs for a long time) to the question of the global imbalances (the problem is not that they are big, but the fact that they are not big enough; if the US grew decently and pushed the world economy its trade deficits would be larger).

Here I want just to point out a recent study that looks at corporations. The study shows that a small number of financial institutions basically controls the overwhelming majority of transnational corporations (TNCs). To be precise "only 737 top holders accumulate 80% of the control over the value of all TNCs." These, mostly financial, institutions "are at least in the position to exert considerable control, either formally (e.g., voting in shareholder and board meetings) or via informal negotiations," still according to the same paper.

How many Chinese groups are part of these elite institutions? Well below the list of the top 20.

1. BARCLAYS PLC (UK)
2 CAPITAL GROUP COMPANIES INC (US)
3 FMR CORP (US)
4 AXA (France)
5 STATE STREET CORPORATION (US)
6 JPMORGAN CHASE & CO. (US)
7 LEGAL & GENERAL GROUP PLC (UK)
8 VANGUARD GROUP, INC. (US)
9 UBS AG (Switzerland)
10 MERRILL LYNCH & CO., INC. (US)
11 WELLINGTON MANAGEMENT CO. L.L.P. (US)
12 DEUTSCHE BANK AG (Germany)
13 FRANKLIN RESOURCES, INC. (US)
14 CREDIT SUISSE GROUP (Switzerland)
15 WALTON ENTERPRISES LLC (US)
16 BANK OF NEW YORK MELLON CORP. (US)
17 NATIXIS (France)
18 GOLDMAN SACHS GROUP, INC., (US)
19 T. ROWE PRICE GROUP, INC. (US)
20 LEGG MASON, INC. (US)

The first Chinese corporation is at number 50, the China Petrochemical Group, a resource based State firm. Oh yes, the evil giant vampire-squid is only number 18, but it is on the list. The Chinese economy, like the economies of almost any peripheral country, is partly owned and managed by a network of firms that are fundamentally from developed countries (in the top 20 above, from the US, the UK, France, Germany and Switzerland). The reverse, that is Chinese control of firms in developed countries, is minimal. Yes, sure, China is number one!

China - Irrepsonsible Superpower?

Export restrictions that have pushed prices for the 17 rare earths in markets outside China up to several times the level of prices inside China, giving companies an incentive to move factories to China. These rare earth export restrictions are... about favoring Chinese industry over global industry...

Rare earths are vital to various sophisticated technologies, including smartphones, smart bombs, large wind turbines and electric cars. Tungsten and molybdenum are used to strengthen steel and other industrial materials. China is the world’s dominant producer of rare earths, tungsten and molybdenum, and it has imposed increasingly stringent export taxes and quotas on them for the past two years despite having promised the WTO when it joined in 2001 that it would remove export taxes and quotas on all goods except for a handful of other products.

Such policies are also another reason why China cannot be considered a responsible power. The sanctity of a contract with China is dependent on the whims and fancies of those who rule Beijing. For example, China halted shipments of rare earths to Japan for two months in the fall of 2010 during a dispute over contested islands in the East China Sea. This propensity to employ its trade policy blatantly to arm-twist its trade partners as part of strategic diplomacy is a sign of an insecure superpower.

Such flippant actions are all the more likely with autocratic regimes like China, where domestic pressure is unlikely to play a countervailing role against such whimsical policies. Contrast this with India's U-turn on cotton exports ban due to domestic political opposition.

For a more detailed discussion on China's rare earth's policy, see this.

China fact of the day

China today creates the equivalent of another Greek economy every eleven and a half weeks, and one-tenth of another eurozone economy every year.

HT: Jim O'Neill

Is China really opening the capital account?

Martin Wolf tells us in a recent column that China is opening up its capital account, according to a report from the People’s Bank of China, and that it is taking a gradual approach. Reform will be in three steps:

"The first, to occur over the next three years, would clear the path for more Chinese investment abroad as ‘the shrinkage of western banks and companies has vacated space for Chinese investments’ and so presented a ‘strategic opportunity’. The second phase, in between three and five years, would accelerate foreign lending of the renminbi. In the longer term, over five to 10 years, foreigners could invest in Chinese stocks, bonds and property. Free convertibility of the renminbi would be the ‘last step’, to be taken at an unspecified time."

Wait what? What this says is that they are going to lend more in yuan, given the retreat of American and European banks, and will eventually allow some amount of foreign ownership of assets denominated in yuan. This, by the way, is just trying to expand the international role of the yuan, something aptly called the yuan diplomacy by Kevin Gallagher, who notes that already: "China became the largest source of finance for Latin American governments."

Yet, only the last step, the one to be taken at an unspecified time, would constitute opening the capital account. So basically they announced that they want to increase the international use of the yuan, getting more developing countries to borrow in their currency, while maintaining a strict control of the supply of their currency. In fact, The Economist tells us that Sheng Songcheng, head of the central bank’s research department and the lead author of the study cited by Wolf said that: "If you wait for the exchange rate and interest rates to be fully liberalized ...  you may wait forever." I guess then never is when the capital account will be fully open. That's slow enough, and is a capital account liberalization I would recommend too.

China fact of the day

If you thought that the China story was all about manufacturing exports, here is a reminder about its consumption market

In 2010, Chinese consumers purchased 19 percent of all PCs sold throughout the world, 18 percent of the LCD TVs, 14 percent of the mobile phones, and 26 percent of the automobiles (all by unit volume).

What drives globalized manufacturing to emerging Asia?

Conventional wisdom would have it that the low labour cost in emerging Asia is the driving force behind outsourced manufacturing. The Times has an excellent article (see also this interactive video) that questions this belief with the example of iPhone. It argues that abundance of mid-level manufacturing skills and the advantages with the dynamics of production in massive scale are the reasons for the rapid growth of outsourced manufacturing to Asia.

Various academics and manufacturing analysts estimate that because labor is such a small part of technology manufacturing, paying American wages would add up to $65 to each iPhone’s expense. Since Apple’s profits are often hundreds of dollars per phone, building domestically, in theory, would still give the company a healthy reward.

But such calculations are, in many respects, meaningless because building the iPhone in the United States would demand much more than hiring Americans — it would require transforming the national and global economies. Apple executives believe there simply aren’t enough American workers with the skills the company needs or factories with sufficient speed and flexibility. Other companies that work with Apple, like Corning, also say they must go abroad.

Apple's iconic iPhone is the exemplar of modern day globalized production,

Though components differ between versions, all iPhones contain hundreds of parts, an estimated 90 percent of which are manufactured abroad. Advanced semiconductors have come from Germany and Taiwan, memory from Korea and Japan, display panels and circuitry from Korea and Taiwan, chipsets from Europe and rare metals from Africa and Asia. And all of it is put together in China.

Among the emerging economies, China has an unparalleled comparative advantage as the electronic products assemly line of the world. Its advantages as the assembler are numerous...

The entire supply chain is in China now... You need a thousand rubber gaskets? That’s the factory next door. You need a million screws? That factory is a block away. You need that screw made a little bit different? It will take three hours.

... and in leveraging its massive labour force with mid-level manufacturing skills...

China provided engineers at a scale the United States could not match. Apple’s executives had estimated that about 8,700 industrial engineers were needed to oversee and guide the 200,000 assembly-line workers eventually involved in manufacturing iPhones. The company’s analysts had forecast it would take as long as nine months to find that many qualified engineers in the United States. In China, it took 15 days.

... finally, China has companies like Foxconn, which can mobilize massive numbers of diligent workers in quick time to deliver on any electronic assembling activity. It writes about the Foxconn City,

The facility has 230,000 employees, many working six days a week, often spending up to 12 hours a day at the plant. Over a quarter of Foxconn’s work force lives in company barracks and many workers earn less than $17 a day... Foxconn employs nearly 300 guards to direct foot traffic so workers are not crushed in doorway bottlenecks. The facility’s central kitchen cooks an average of three tons of pork and 13 tons of rice a day.

Foxconn Technology has dozens of facilities in Asia and Eastern Europe, and in Mexico and Brazil, and it assembles an estimated 40 percent of the world’s consumer electronics for customers like Amazon, Dell, Hewlett-Packard, Motorola, Nintendo, Nokia, Samsung and Sony. They could hire 3,000 people overnight.

The article highlights the critical importance of a large base of mid-level manufacturing skills and the presence of a broad-range of manufacturing supply-chain in the success of any economy. They are essential ingredients to the development of a large manufacturing base. The United States which had these capabilities for many decades has seen them get eroded and has now ceded way to China.

Countries like India, which are waiting in line to emulate the Chinese growth miracle, would do well to appreciate the vital role played by these factors. India has nothing comparable to Foxconn and suffers from acute shortage of mid-level skilled technicians. Attempts to build up supply-chain capacities through growth clusters and special economic zones have borne limited success and that too only in a few sectors. Unless these deficiencies are bridged, India's growth potential will remain just that, potential.

Update 1 (26/1/2012)

NYT investigation reveals serious problems with working conditions in Chinese factories supplying components to consumer electronics firms like Apple. Here is the list of Apple's suppliers.

Perverse dependence on Asia

By Luiz Carlos Bresser-Pereira

Published originally in portuguese in the Folha de S. Paulo, January 16, 2012

In his last column, Martin Wolf mentioned the fact that, since 2007, the fast-growing Asian countries have grown by 60%, whereas rich countries have grown by 3%, and he pinned the world's economic hopes in Asia. Brazil, in the same period, grew by modest 16%. Brazilians also depend on the increase in Asian demand to achieve their growth. Brazilian economy is not stagnant as the economy of developed countries, but, in terms of growth, it is closer to them than to countries such as China and India.

Read the rest here.

The competition dynamics beneath China's economic success

Enlightened public policy, intended or otherwise, has surely played a major part in China's economic success for the past nearly quarter century. However, there remain serious debates about what specific policies contributed to this success.

In this context, a NYT article points to the positive role played by public policy in unleashing fierce economic competition among its city states and the central role of urban development in driving economic growth. Though these city states - semi-autonomous regions within large provinces - are built around a huge urban metropolis, a major portion of its population lives in the rural areas surrounding the city. It writes,

"When it comes to economics, China is more a thin political union composed of semiautonomous cities... than an all-powerful centralized government that uniformly imposes its will on the whole country. And competition among these huge cities is an important reason for China’s economic dynamism. The similar look of China’s megacities masks a rivalry as fierce as that among European countries.

China’s urban economic boom began in the late 1970s as an experiment with market reforms in China’s coastal cities. Shenzhen, the first "special economic zone", has grown from a small fishing village in 1979 into a booming metropolis of 10 million today. Many other cities, from Guangzhou to Tianjin, soon followed the path of market reforms.

Today, cities vie ruthlessly for competitive advantage using tax breaks and other incentives that draw foreign and domestic investors. Smaller cities specialize in particular products, while larger ones flaunt their educational capacity and cultural appeal. It has led to the most rapid urban "economic miracle" in history."

Each of these city states has a municipal government, which administers both the urban and rural parts. A very tightly enforced hukou (household registration) system limits migration into cities. Those living in the countryside are also registered as farmers and receive various welfare benefits. Though the focus of the city governments have hitherto been confined to the urban center, it is now shifting to the countryside, partly in an effort to retain people in the suburbs and villages so that the city does not get too congested and its growth gets choked. Some municipal governments have set up development zones composed of small firms (mainly export-oriented) in the rural areas.

China's experiment has important lessons for India's federal system. Drawing a parallel with Beijing's policy towards city governments, is it possible for the central government to align policy incentives in a manner that helps create an environment that promotes competition among states? What should be the elements of such a policy framework that does not conflict with India's federal system? What should be the support that the central government should provide for each of these elements?

Trade protection in solar power

As India embarks on an ambitious program to rapidly expand its solar generation capacity to 20000 mW by 2022 under the Jawaharlal Nehru National Solar Mission (JNNSM), there are several important policy issues that need to be carefully addressed. I had blogged earlier about the uncertainty associated with the recent solar auctions due to the extraordinarily low tariffs quoted by successful bidders.

Another issue that needs to be addressed immediately involves the extent of policy protection permissible to local manufacturers without infringing on the WTO commitments. In recent months, Indian solar panel manufacturers have raised the pitch by accusing Chinese manufacturers of dumping and have called on the government to provide trade protection against them. The Indian firms are seeking anti-dumping duties on Chinese exports and also a 15% tariff on imports of thin-film solar panels (where American firms lead and which is the preferred choice for Indian developers). They complain that US and Chinese imports can be brought into the country tax-free, whereas Indian manufacturers have to pay duties on raw materials to make the same products. They also argue that Chinese firms benefit from cash grants, raw-materials discounts, preferential loans, tax incentives and cheaper currency.

The JNNSM provides for protection to domestic industry so as to catalyze the development of local panel and cell manufacturers. It mandates use of only indigenous crystalline silicon solar panels and solar cells. Furthermore, domestic content (equipment and technology) requirement will gradually increase under the mission. It exempts thin-film panels, which is more sophisticated and has limited Indian production capacity, from the indigenous production requirement. However, this local production requirement has not helped trigger much domestic manufacturing activity in solar sector.

Low-cost Chinese rivals like Suntech and Trina Solar Ltd (TSL) and US firms backed by preferential trade finance including First Solar, the world's largest thin-film panel maker, have reaped most of the equipment orders for 1,100 megawatts of plants to be built by January 2012. Indian suppliers such as Tata BP Solar India, Indosolar Ltd and Moser Baer India (MBI) have received almost no orders from developers building plants in India and are producing far below their factories’ full capacity.

India’s total manufacturing capacity is about 1,500 MW of panels and 500 MW of cells. Indsolar, India's biggest cell company, stopped production in June and has defaulted on 2.75 billion rupees ($52 million) of long-term bank loans as its business became "unviable". Cell prices have plunged 62% to about 52 cents just in 2011 alone on the back of intense Chinese competition and declining demand in Europe where governments have cut subsidies.

The global trade in solar power equipment making in particular and renewables in general have been marked by acrimonious accusations of unfair trade practices. For some time now, US manufacturers have been lobbying hard for imposing anti-dumping duties on Chinese imports. India's local production requirement for solar equipments has been criticised by US, EU and Japan.



It is important that any national policy to facilitate the development of domestic industry are in conformity with India's WTO obligations. However, it would appear that the prevailing policy support to promote local production stand in contravention to WTO provisions. Unlike cash-rich China, where government provides direct subsidies to manufacturers, the fiscally strained Indian government has preferred to mandate local production requirement.

The WTO’s Article III: 4 of Trade Related Investment Measures (TRIMS) and General Agreement on Tariffs and Trade (GATT) III prohibits protectionism and discriminatory treatment against imported products and in favour of domestic products (the national treatment rule). It cannot mandate a private project developer to use only domestic content, though if government is the procurement agency, it can choose between domestic and imported content.

However, Article III 8 allows for payments of subsidies to domestic producers and consumers. This means that the government's purchase of electricity at high price and provision at a lower rate to the consumer is itself not violative of WTO treaty provisions. But, with the Chinese, this subsidy is provided directly to the producer. It is this exemption given to subsidizing domestic producers that has enabled Chinese exporters to avoid infringing WTO regulations. In 2010 alone, Chinese Development Bank gave $30 billion in low-cost loans to top five domestic solar panel manufacturers.

Interestingly, given that direct subsidy to its producers is its preferred method of industrial policy, China is able to skirt around the WTO agreement and massively subsidize its exporters. Such top-down direct subsidies and forcing them to compete for global market share is possible because China has deep pockets. Other countries cannot afford an industrial policy that subsidizes their domestic producers and therefore prefer to impose regulatory restrictions on foreign competitors and imports.

It is ironical that this provision of the WTO regulations which now the Chinese invoke with such devastating effect was itself the preferred route of industrial policy for the western economies for many years. Now the shoe is on the other feet. China has the comparative advantage with subsidizing its domestic manufacturers while the US and India are left to fend the Chinese onslaught with regulatory restrictions - higher tariffs or anti-dumping duties.

Given the changed dynamics of the global economy, it may now be in the interest of developed countries and emerging economies like India to propose renegotiating Article III 8 of the WTO treaty so as to restrain China's industrial policy. If tariff protection and subsidies are two sides of the same coin, then there is a strong case in favor of establishing some balance between Article III 4 and 8 of the WTO treaty.

China real estate market facts of the day

FT points to the danger posed by a cooling property market to local government revenues in China,

"Local governments owed Rmb 10,700bn at the end of 2010, and 53% of that must be paid back before the end of next year, according to the national audit office... land sales formed 74% of their revenue base in 2010, up from 10% in the late 1990s."

It is not just local governments, the economy itself is heavily reliant on real estate activity,

"Property construction accounts for 13% of GDP, so if property slumps so does the economy as a whole."

The capacity addition in residential property market has been truly staggering,

"The country’s 80,000 property developers own enough land to build nearly 100m apartments. Add this to vacant apartments for sale... and China already has the capacity to satisfy housing demand for up to 20 years."

China on the verge?

It has become increasingly common to suggest that on top of the European debacle and the sluggish recovery in the United States, China might be on the verge of a collapse, and with it the last bastion of economic growth in the world economy would also be gone. Not only the center is stagnant, but also the periphery of the global economy is very fragile. But the probability of a Chinese slowdown is greatly exaggerated.

Paul Krugman, who has been correct about the need for fiscal expansion in the United States, and about the European Central Bank (ECB) mismanagement of the Greek crisis, for example, has suggested that China is in the middle of a housing bubble that can burst at any time (see also Jayati Ghosh and C. P. Chandrasekhar here for a similar, but broader view of the dangers in 2012). This view insinuates that growth in China is fundamentally dependent on domestic demand, but that the sources of the expansion are fragile. It, further, suggests that China now looks very similar to the US before the Lehman Brothers crisis in September 2008.

Read the rest here.

Why the retail trade issue is more nuanced?

So India has, atleast for now, turned its back on retail trade liberalization. It has been rightly criticized for this decision since the case for liberalization has been widely discussed and is largely obvious.

Alex Tabarrok weighs in with the argument that if it is to improve the standard of living of its people, India needs workers to move from less productive sectors like farming, retail, and so on to other more productive and higher value added industries, and retail trade liberalization hastens this process. I agree with the first point. The second, about retail trade liberalization hastening the process, though may be more contentious and needs a more nuanced appreciation.

It is surprising that Alex does not explore the argument further since he does acknowledge the perils of liberalization - the painful labour market transition and the fact that, atleast immediately, the losers generally outnumber the winners. He simply confines his analysis to a standard line - transitions always involve some pain; creation always involves some destruction; growth always involves change; the alternative, however, is stagnation.

I think this is pretty lazy, even specious, scholarship. Unfortunately, it is also widely prevalent in academic discussions on reforms. There is a reluctance or inability to think through the real world problems that come in the way of pushing through such reforms, especially in democracies. It is all the more surprising since these supporters do identify the potential challenge. But they refuse to think beyond stage one.

The case for any liberalization measure proceeds something like this. First trumpet the benefits of liberalization. Then gain enough support to liberalize regulations. The benefits start to flow, but accompanied by the pains of transition. Then rationalize that any liberalization will have losers, who may even be large in numbers, but "today’s losses and gains are fleeting, the permanent winners are the workers and consumers of the future who will know only the benefits of productivity".

India's tryst with retail liberalization has resonance with similar structural transformations across other sectors, both in India and elsewhere. The fundamental issues bear striking similarity with the conditions when China liberalized its markets and encouraged foreign investments. The newer firms ended up competing with large and uncompetitive public sector units (PSUs) thereby generating the risk of lay-offs by these PSUs. The US economy too, as Joe Stiglitz pointed out in his New Year essay in Vanity Fair, faces a similar labour market challenge as it transitions from manufacturing to productive services.

In all these cases, the key to successful transformation is the effectiveness in managing the losers or those displaced during the process. Traditionally, academicians and policy makers pay disproportionate attention to the reforms themselves while ignoring the more important issue of getting the mechanics of the transition process right. What needs to be done to rehabilitate those affected by the changes? What are the immediate and medium-term measures?

As democracies become increasingly politically divisive, effective rehabilitation strategies will become even more important if governments are to push through such reforms. China appears to have managed the transition effectively, albeit less efficiently. It kept the large and failing PSUs running with heavy state support. The spectacular economic growth in other sectors helped the government with the resources required to backstop this transition hemorrhage without curtailing the progress of the reforms. Now that the transformation has stabilized, the government is slowly removing its support for the PSUs.

Since the pains associated with the transition invariably comes in the way of the effective implementation of the reforms, it is critical that the mitigation cum rehabilitation plan gets the required focus. However, assuming that governments rarely get the transition plan right, a second best option would be, as the Chinese have done, to let the existing public systems continue to maintain life-support till the transition takes strong roots. While this has its costs, it will mitigate the hardships and ease the reform path.

In India's case, it is important that those likely to be displaced from retail trade be absorbed elsewhere in the labour market. This will not happen by itself and merely through the dynamics of economic growth and resultant job creation. It will require enabling policy frameworks and massive investments in education, especially in the acquisition of vocational skills. It will also require policies that encourage the creation of large enough self-employment opportunities.

Most importantly, it will need a universal social safety system that can atleast partially cushion those losing out from the bitter pain and social dislocation that follow. In any case, this social safety net is an essential pre-requisite for cushioning those most vulnerable from the vagaries of liberalization and increasing integration with the global economy. Unfortunately, the opportunity to establish a comprehensive social safety net is being side-tracked by the obsession with populist, inefficient and even wasteful piece-meal interventions.

Krugman is wrong about China

If you believe Krugman's last column, you would think that China is like the US (or Japan he says; I would add Spain or Ireland), i.e. growing as a result of a housing bubble. His analogy seems to follow from the 'weakness' of consumption, that is, the fact that consumption is only 35% of GDP. He says:

The obvious question is, with consumer demand relatively weak, what motivated all that investment? And the answer, to an important extent, is that it depended on an ever-inflating real estate bubble.

He forgot to check real wages. The graph below shows that, in contrast to the US, Chinese wages have expanded incredibly fast. Since the Asian crisis, real wages have grown at more than 10% per year.

Consumption as a share of GDP remains low simply because a lot of investment is State driven and exogenous, and incredibly large. Even if there is a real state estate bubble, growth is led by government spending and by rising real wages. And by the way, there is no significant foreign debt, so a collapse of a bubble could be handled by domestic authorities without a sweat. Krugman is just wrong on this one.

PS: Data is from the Economics Intelligence Unit (subscription required). Check also ILO's Global Wage Report.

China and US - Contrasting paths to structural imbalances?

In many ways, China and US are classic examples of how both free-market capitalism and statist capitalism, through contrasting routes, have produced severe macroeconomic imbalances that have brought the later to its knees and threatens the former. The graphic below insightfully captures the respective problems of the American and Chinese economies.



It was unbridled financial market liberalization and sustained expansionary monetary policy, which fuelled massive property and financial asset bubble and debt-financed household consumption binge, that is the source of much of America's current woes. Notional household income share of the GDP rose on the face of the twin bubbles. Households spent as though there was no tomorrow, running savings down to the bottom. Finally when the bubble burst and the recession took hold, households faced the brunt of the slowdown and even after four years, recovery remains uncertain.

In China, the policies enacted in late nineties, in response to bankruptcy problems facing state-owned companies and banks, looks set to have much the same impact in not the distant future. Beijing assumed tighter control over interest rates and exchange rates, keeping them artificially low to finance cheap loans to businesses and government agencies and increase external competitiveness so as to drive its preferred export-led and infrastructure investment driven economic growth model. This period also coincided with the government abandoning the communist era policies of life-long employment and liberal social safety nets, thereby forcing households to increase their savings to meet educational, health care and housing needs for themselves and their children.

These policies amounted to a huge transfer of wealth from the households to businesses, both government and private, and government agencies. Banks and state-owned companies staged excellent recoveries. But all this was at the cost of households - household consumption, already among the lowest at 45%, fell to just 35%, and savings rate rose sharply to about 40%.



As the Times and the FT point out in two excellent essays, this model worked well so long as the export markets were vibrant and the infrastructure deficit was filled, and the government was able to control the supply and price of credit and thereby keep cost of capital artificially low. As the two primary growth drivers weaken, as is happening now, and the unregulated shadow banking system assumes an increasingly dominant role (it now supplies more credit to the economy than the formal banking system) thereby weakening Beijing's ability to control credit, the sustainability of this growth model becomes doubtful. The sliding property market which financed a major share of the investment spending, especially by local governments, is yet another source of concern.

George Magnus writing in the FT has this to say about China's rebalancing strategy from an investment-centric and credit hungry model to one built around consumption,

"It involves a redistribution of income from capital and profits to labour and wages; radical changes in the role of the exchange rate, interest rates and capital markets; and strategies to counter the high propensity to save by households, corporates and central government. It is also politically divisive because power and economic privilege have to be wrested from party elites, state enterprises and banks, and given to new beneficiaries such as private companies, households, college graduates and rural migrant workers."

It is increasingly inevitable that China can sustain its high growth rates only if its domestic consumers can step into the space being vacated by the traditional growth engines. The question is whether Beijing has the stomach to embrace the required structural reforms to enable this transition?

On China and Jobs

It is true that whenever the economy grows trade deficits tend to become larger, and the United States, which has had persistent deficits since the early 1980s, is particularly prone to those. Dean Baker has been the most vocal defender of a weak dollar (mostly as measure to boost local manufacturing jobs, since a depreciated currency protects local production; here for example a recent piece). Krugman too has recently argued for a more depreciated dollar and also for trade restrictions against China (see here for a recent one).

In all fairness, I have a few concerns with these line of thought, and not because I am (or ever was) a "free trader", like Krugman (by the way Free Trade is a terrible misnomer and there are serious problems with the conventional arguments for it; theme for another post, I guess).

First, in the case of China, the exchange rate has appreciated a lot since the crisis as can be seen in the graph below (Data from the Economist Intelligence Unit).

Further, when measured by changes in wages (labor costs) the real appreciation since 2007 has been of around 27%, 10% more than when measured by prices, since real wages grow relatively fast in China. Further, China has grown since 2007 at an average of 10.5% per year. In other words, China is growing and revaluing its currency; not sure what more can be expected on that front. Blaming China for lack of fiscal stimulus in the US seems, not just futile, but wrongheaded.

Another important point often missed in these discussions of the exchange rate is that a depreciated currency, everything else constant (economists do like a ceteris paribus condition) implies lower real wages, since imported goods tend to be part of the workers' consumption basket. Hence, if you favor a depreciated dollar, but tend to be for workers (which are getting to bear the brunt of this crisis, as is always the case), then compensating measures are needed to increase real wages without reducing competitiveness (other costs must be reduced, or profit margins would have to be squeezed; that's just the algebra).

Finally, my perennial question, raised before here, so if US deficits are larger, but we give the Chinese dollars, and they hold dollar denominated assets, what's the downside again?

PS: Concerned about the dollar? Go here.

The "inevitable superpower"?

Arvind Subramanian bites the bullet and takes his call on the inevitability of China setting the pace in the years ahead, just as America did for the past half-century or so. He questions the persistent conventional wisdom in the US that "if the United States can get its economic house in order,it can head off the Chinese threat". He writes,

"During the 1956 Suez crisis, the United States threatened to withhold financing that the United Kingdom desperately needed unless British forces withdrew from the Suez Canal. Harold Macmillan, who, as the British chancellor of the exchequer, presided over the last, humiliating stages of the crisis, would later recall that it was "the last gasp of a declining power". He added, "perhaps in 200 years the United States would know how we felt". Is that time already fast approaching, with China poised to take over from the United States?"

He defines economic dominance thus,

"Broadly speaking, economic dominance is the ability of a state to use economic means to get other countries to do what it wants or to prevent them from forcing it to do what it does not want. Such means include the size of a country’s economy, its trade, the health of its external and internal finances, its military prowess, its technological dynamism, and the international status that its currency enjoys.

My forthcoming book develops an index of dominance combining just three key factors: a country’s gdp, its trade (measured as the sum of its exports and imports of goods), and the extent to which it is a net creditor to the rest of the world. GDP matters because it determines the overall resources that a country can muster to project power against potential rivals or otherwise have its way. Trade, and especially imports, determines how much leverage a country can get from offering or denying other countries access to its markets. And being a leading financier confers extraordinary influence over other countries that need funds, especially in times of crisis. No other gauge of dominance is as instructive as these three: the others are largely derivative (military strength, for example, depends on the overall health and size of an economy in the long run), marginal (currency dominance), or difficult to measure consistently across countries (fiscal strength)."

He analyzed the world economy, beginning from 1870, based on these factors and finds that by 2030, the "relative US decline will have yielded not a multipolar world but a near-unipolar one dominated by China". In fact, based on his index, he already finds China ahead. It will have close to 20% of world GDP compared to below 15% for the US; and will generate 15% of global trade, twice that of America; and the yuan will be a credible rival to the dollar as the world’s premier reserve currency. His assessment of the gap between China and the US by 2030,

"My projections suggest that the gap between China and the United States in 2030 will be similar to that between the United States and its rivals in the mid-1970s, the heyday of US hegemony, and greater than that between the United Kingdom and its rivals during the halcyon days of the British Empire, in 1870."

He addresses the conventional explanations of how China may find it difficult to focus its energies externally given the need to improve the living standards of its citizens (even if it reaches half the US per capita income), raise resources for projecting its military power, or in the absence of any soft power. In particular, he points to China's already considerable influence among many Latin American and African countries, where the Chinese government has not hesitated to use its massive foreign exchange resources to virtually buy off these countries.

More convincingly, he points to a scenario where the US economic conditions do not improve much, China continues to grow at about 7% a year and satisfactorily maanges its transition to a stable middle income country, yuan becomes an accepted global reserve currency. In such conditions, he argues, the fate of the world economy, including that of the US, will be largely determined in Beijing.

Update 1 (14/9/2011)

The Economist has this review of Arvind Subramanian's book.

China's Local Government Debts

One of the most intriguing questions for Indians marvelling at China's spectacular economic growth is about how its government manages to finance a never-ending shelf of mega infrastructure projects entailing extraordinary investments. For all its governance failures, corruption, resistance to reforms and recent political paralysis, the fundamental problem for a chronically infrastructure deficient India remains paucity of resources to finance its massive infrastructure requirements.

The contrast with a flush-with-funds China is stark. However, as the Times points out in an excellent article chronicling the challenges facing China's increasingly infrastructure investment dominated economic growth push, things may not be as rosy as it appears across our northern borders.

As the Great Recession took hold, the Chinese government stepped in with a mssive $580 bn stimulus package. Local governments across China borrowed heavily from state-owned banks and pumped money into infrastructure. Infrastructure replaced exports as the engine of economic growth.

The Times reports that spending on so-called fixed-asset investment (infrastructure and real estate projects) is now equal to nearly 70% of the nation’s GDP, a sign of dangerous over-dependence on infrastructure spending. It is a ratio unheard of in modern times for any nation, with the ratio being just 35% for Japan during its 1980s building boom and 20% for US for decades now.



Now this model is becoming unsustainable as local government debts, cleverly hidden from the local government balance sheet through accounting tricks, mount and repayment strains start appearing. The National Audit Office recently released figures showing that the local governments had amassed 10.7 trillion yuan ($1.65 trillion) in debt as of the end of December, amounting to 26.9% of GDP in 2010. Of this debt, local governments are explicitly responsible for repaying 62.6%, have guaranteed 21.8%, and are required to partially repay 15.6%. Worryingly, the report writes that nearly half the debt was accumulated in just two years by way of the loan-powered fiscal stimulus of 2009-10. This debt, mainly owed to state-run banks, poses serious risks for the Chinese financial system.

Most local governments borrow through special investment corporations set up by them and their debt shows up nowhere on its official balance sheet. Such local government financing vehicles (LGFV) were set up to get around rules forbidding them from borrowing directly from banks and raising funds through municipal bonds and also conceal the true extent of local government debts. These LGFVs were set up to finance light rail projects, bridges etc. It is estimated that there are more than 10,000 of these local government financing entities in China.

In fact, the audit office said 46.4% of the debt is held by such intermediary vehicles. Another recent report from the People's Bank of China had said that local government financing vehicles had taken out loans worth up to 30% of total outstanding bank loans or 14 trillion yuan. The collateral for many loans is local land valued at lofty prices that could collapse if China’s real estate bubble burst.

An earlier estimate by the Northwestern University Prof. Victor Shih found that the total local government financing platform debt was around 11.4 trillion yuan ($1.75 trillion) at the end of 2009. His latest estimate of total local governmental debt ranges between 15.4 trillion yuan and 20.1 trillion yuan, or 40% to 50% of China's 2010 GDP. He also estimates that LGFV interest payments are at least 1 trillion yuan a year, and realistically more than 2 trillion yuan.

Another report by Moody's says that the audit office's data fails to account for about 3.5 trillion yuan, or about $540 billion, of loans to local governments. It also estimates that the Chinese banking system's nonperforming loans could reach between 8% and 12% of total loans. This is in stark contrast to the official ratio of non-performing loans of 1.14% at the end of 2010.‬

The biggest concern is a possible rise in inflation, which would force the central bank into raising interest rates. In fact, yesterday the People's Bank raised interest rates for the third time this year in order to cool the sizzling pace of economic growth, estimated to touch 11.9% in the seond quarter. Inflation is up 4.4% for June, the highest rate in more than two years and above the 3% target set by central bank.

In fact, the threat of the whole pack of cards collapsing when faced with higher interest rates is also behind the reluctance of authorities to rein in the bubble. As Prof Shih argues, the only way to cool down the continuously inflating debt bubble and credit flows is by engineering a credit crunch. Unfortunately, this would entail raising interest rates, with all its possible adverse consequences.

There have been rumors that the government is considering write-off about 2-3 trillion ($300-470 bn) in debts owed by local governments to the country's China's top banks. Though this would force losses on banks, local and central governments, it should reduce the risks that cloud the Chinese economy. Fortunately, a banking crisis would not have the sort direct impact on consumers as witnessed in the US since the Chinese citizens save heavily and have limited exposure to mortgages and other financial investments.

The debt build-up also amplified the already frothy real estate market, which was pushed up further by the stimulus spending in 2010 and 2011. A large share of this spending was routed into real-estate related infrastructure. Chinese state-owned banks, on government orders, lent about $3 trillion mostly to giant state-owned enterprises and local governments to fight the effects of the downturn. Though intended at infrastructure, a substantial share of these loans wound up financing real-estate purchases by government agencies.

Further, in the absence of financial alternatives to beat inflation, Chinese savers piled into real estate and drove residential property prices up by half to about 9% of GDP between 2006 and 2010. In that period, real-estate prices in major cities in China roughly doubled.

The continuing paucity of investment avenues coupled with exceptionally high savings rates and the reliance of local governments on land sales for revenue means that property prices could go higher before the bubble bursts. The Standard Chartered estimates that about 50% of China's GDP is linked to the fate of its real-estate market (it affects construction, steel, concrete, power and appliance industries), making a potential bust extremely damaging. A banking crisis would be inevitable.

See also this Times Room for Debate on China's local government debt.