Posted on 09/06/2003 5:25:07 PM PDT by Starwind
International Perspective, by Marshall Auerback
China Tightens - The Beginning Of The End Of Global Reflation?
September 2, 2003
There is much anecdotal and statistical evidence to support the notion of an incipient global recovery now underway, in marked contrast to last spring's dire talk about deflation. Germany's IFO index (a leading indicator of business confidence) has now exceeded expectations 4 months' running, Canadian home sales are booming, the UK is still in the midst of a mortgage refi boom, and the economies of emerging Asia continue to upgrade their respective GDP growth estimates. With American economic growth recently revised upward, strong personal expenditure and disposable income figures also suggest a robust quarter or two ahead for the US economy. But there is a potential fly in the ointment: China, which has hitherto played such a crucial role in underpinning much of this growth dynamic, (particularly in Asia), has now signalled a change in course.
China's central bank, the People's Bank of China, has just announced that it will increase the reserve requirement on commercial banks from 6% to 7% with effect from 21st September, so taking an estimated US$19.3bn to $24bn out of circulation, according to Simon Hunt, a leading China expert. The Chinese government had not reached agreement on adopting aggressive tightening policies before the central working meeting which took place last week in Beijing, but it now appears that such a consensus has been reached.
In line with this new consensus, the People's Bank of China has also issued sizeable central bank paper to mop up liquidity - over Rmb50bn two weeks ago (US$6bn) and Rmb60bn last week. Hunt also notes that new regulations on auto financing will be implemented: "They are likely to include investigation of personal credit worthiness being placed in the hands of intermediary companies; banks would be required to share information on individual's credit ratings; and auto distributors, banks and insurance companies all having to take a share of the credit risk." These measures, according to Hunt, will slow the auto market, which has grown at extraordinary rates over the past year.
Furthermore, the banking regulator (CBRC) is considering also changes in banking supervision by focusing more on risk management. It would set up guidelines to minimise financial risks for commercial banks, an important consideration, given skyrocketing bank lending, which has grown by 23% YoY in the first half of 2003. Unlike America's Federal Reserve, China's central bank has duly taken note and acted accordingly.
The implications go well beyond economic policy. According to Hunt,
"They illustrate that President Hu is now firmly in the driver's seat, that ex President Jiang Zemin's influence is declining. As noted in our recent report, it is probable that he will resign from the chairmanship of the Military Commission by year-end. It was largely he that laid out the framework for the extraordinary growth seen in the first half of this year, a period in which fixed asset investment rose by an extraordinary near 33%."
According to National Statistical Bureau deputy director Qiu Xiaohua, approximately 70 per cent of China's GDP growth in the first half of 2003 came from investment. And given the impending shift in the political landscape outlined by Hunt, the timing of Mr Qiu's speech was clearly not a coincidence, and seems likely to reflect the current thinking of the power grouping aligning behind President Hu.
The view that a mere 1% increase in the reserve requirement will fail to stop the Chinese growth juggernaut is now the prevailing market consensus, whereas Hunt expects that the slowdown could come rather more quickly, based largely on his understanding of the political machinations behind such proposed measures. Hunt's view, based on ten years of extensive visits to the country, is also more reflective of the underlying realities of the Chinese polity. This is one which still largely reflects Asia's traditional 'alliance capitalist' model, in which the discretionary inputs from public policy can impact the real economy much quicker than might be the case in a classic, open neo-liberal market. In the alliance capitalist model, common state policies are employed to transfer resources away from 'unproductive' toward 'productive' uses-often in the form of transfers from unproductive groups to productive groups and sometimes in the form of policies to convert unproductive groups into productive ones.
According to Robert Hunter Wade, author of "Governing the Market", creating 'rents' (above normal market returns) by 'distorting' markets through industrial policies is essential in the alliance capitalist model, "first, to induce more-than-free-market investment in activities that the government agreed were important for the economy's transformation, and second, to sustain a political coalition in support of these policies." This process not only helps to explain the extraordinary growth miracle of the emerging Asian economies in the post-war era, but also their comparative resilience following the 1997/98 financial crisis.
But there is a corollary as well, which clearly has relevance in the current Chinese context: Disciplining rent-seeking so that it remained consistent with these two objectives is also essential. An authoritarian regime or, at least one with a tightly circumscribed democracy, can more effectively limit the scope for those seeking rents in unproductive activities from paralyzing the polity until they get their way.
China, Taiwan, India, Sri Lanka, Bangladesh, and Pakistan were little affected by the 1997/98 Asian financial crisis. The biggest difference between them and the crisis-afflicted countries lay not in homegrown things like 'cronyism' or 'government-directed investment' or 'transparency' or 'soundness of bank regulation,' but in the openness of the capital account. The countries with positive growth had a more or less closed capital account and did not develop a structure of financial claims vulnerable to investor pullout. That China has largely retained this structure gives it a degree of policy flexibility today far greater than most 'liberalised' emerging Asian economies which accepted IMF/US Treasury reforms. The country's comparative resilience in the face of a huge economic onslaught by short term Western portfolio speculative capital during that time, largely facilitated a reasonably quick recovery for emerging Asia as a whole, as well as acting as an important source of global import demand at a time when the rest of the region was experiencing depression-like conditions. Given China's increasing role as a major economic locus for Asia, any slowdown in this growth momentum, even if only the hoped-for 'soft landing', must be particularly troublesome to a US administration desperately trying to extricate the rest of the world from its perpetual reliance on the American consumer to sustain growth.
China's economy appears to have overcome the effects of the severe acute respiratory syndrome crisis, but unlike US authorities, China's monetary officials have demonstrated a record of tackling potential problems before they become insurmountable bubbles (as evidenced by their approach to monetary policy during the early 1990s, where officials confronted a similarly overheated real estate market). In contrast to America's current Fed chairman, China's leading monetary officials do not deny the existence of a bubble in the real estate market, with the central bank recently noting in a disapproving way that cumulative housing lending in Shanghai was now Rmb134.8 billion ($16.3 billion), with the Rmb21.7 billion provided during the first half of this year, representing a 61% year-on-year rise.
China is not operating on an election timetable per se, but an Olympics timetable.
Per the Market Intelligence report:
"This temporary economic slowdown will set the stage for another boom in the late 2004-2008 period, running right into the Beijing Olympics. By the time the worlds' athletes reach Beijing in the summer of '08, this economy, and particularly the infrastructure, will be transformed. Transportation systems, hotels, power infrastructure, and technology are all features of the Chinese economy, which will be highlighted to the world at the Beijing Olympics, much as Tokyo did during the 1964 games."
The attempt to tighten now must be understood within this context. It is also important to note that even if China's economy continues to grow, the composition of that growth is invariably going to shift more toward externally-led growth, hardly an attractive scenario for the US or the rest of Asia, which will invariably look westward again to supplement the expected slowdown in export momentum to China. And with the Chinese determined to uphold the renminbi peg, it hardly seems conceivable that a major dollar devaluation can mitigate this problem.
Nor will the Chinese contemplate a major revaluation, despite ongoing pressure from both Washington and (now) Tokyo. The state banking sector non-performing loans are estimated to be greater than Japan's as a percentage of GDP and the government still feels the need to avoid further social unrest by creating jobs for hundreds of millions of marginal Chinese farmers, now migrating to the great urban centres, such as Shanghai. At most, we could envisage nothing more than a one-off revaluation, with the possible introduction of a two-tier rate for the domestic and export markets (whether such a regime could survive a WTO challenge is another matter). But, a completely free floating currency would never come in advance of capital account liberalisation, the onset of which would introduce another huge destabilising variable into the Chinese economy at this time.
As Robert Wade notes in the context of his analysis of the Asian alliance capital model:
"[T]he government must maintain a cleavage between the domestic economy and the international economy with respect to financial flows. Without control of these flows, with firms free to borrow as they wish on international markets and with foreign banks free to make domestic loans according to their own criteria, the government's own control over the money supply and cost of capital to domestic borrowers is weakened, as is its ability to guide sectoral allocation ("Governing the Market", Chapter 11)."
That is to say, high levels of debt, which can be a source of strength (by enabling higher levels of investment than could be financed from retained earnings or sale of equity), can be a source of vulnerability if the government gives up coordinating investment, curbing excess capacity, and maintaining the economy's external liabilities within its capacity to repay. Which is another reason why the Chinese have tended to frown on real estate speculation: strongly vested interests in the domestic property market, where it is possible for well-placed individuals and companies to make very high short-run returns, have tended to push the government to give them unimpeded access to cheaper foreign financing, and hence to lift restrictions and prudential regulations on capital inflows, which is clearly contrary to the government's long term interest right now. Instead of letting a real estate bubble drive macro policy, the Chinese authorities have wisely opted for the reverse.
It is always possible that another source of growth to offset China might be found. Little noticed after many false starts, but the outlook in Japan is beginning to improve. We have previously noted the huge pay down of debt reported by non-financial Japanese corporations, noting that such pay downs imply enhanced corporate cash flow, thereby enhancing the probability that a sharp profits recovery will accompany an economic recovery in Japan. Of course, the process of paying off such debt has in fact contributed to the underlying deflationary undertow in the economy and retarded the stock market's recovery, as well as that of the underlying economy. The effects of such corporate debt pay downs, therefore, had to be mitigated by a more accommodative monetary policy.
Which is in fact what we appear to be witnessing in Japan today. Fiscal policy has hovered between neutral and slightly contractionary, the monetary policy at the Bank of Japan has turned more accommodative since the appointment its new Governor, Toshihiko Fukui, last April. This is most unexpected, as Fukui's appointment initially disappointed the markets, which interpreted it as the maintenance of the prevailing status quo under previous BOJ Governor Hayami. But Fukui has demonstrated marked reflationist tendencies: since he took charge, the Bank of Japan has increased the liquidity it supplies to the Japanese economy. As money flows into Japan have intensified, especially during the second quarter of 2003, the Bank of Japan increased its purchases of dollars in order to prevent the yen from appreciating. During the January thru July 2003 period, Japanese dollar buying totalled about $75 billion-a record level. The previous highest intervention level was $65 billion during all of 1999.
The increased foreign exchange intervention by the Bank of Japan was left largely unsterilised. That means that when the Bank of Japan purchased dollars in the foreign exchange market, the yen proceeds of those dollar sales by Japan's private sector were left in the system with the result that the monetary base expanded more rapidly. This unsterilised intervention by the Bank of Japan can probably be credited with slowing Japan's deflation rate during the second quarter. If continued, it might provide some offset to the impending Chinese slowdown, but it is still too early to adjudge the BOJ reflationary policy a genuine success, given the mixed history of previous such efforts.
After so many years of false starts, it can hardly be comforting to contemplate a reliance on Japan as a potential offset to China's growth, but this is the best-case scenario. The worst case is that China proves rather too successful in pricking its domestic real estate/capex bubble, and Japan's current growth momentum proves to be yet another false dawn. At a time when America's own external imbalances becoming so extreme, the maintenance of the existing status quo is hardly something the markets should greet with unmitigated glee, as they appear to be doing today. We leave the final word to the Financial Times:
"The accumulation of foreign exchange reserves in Asia is unsustainable. The appetite of foreigners to fund US consumption can last quite a while but not forever. At some point the well of finance will begin to run dry, putting downward pressure on the dollar, raising long term interest rates in the US and damping growth."
China and Japan effectively constitute the 'fuel' that has allowed the US motor to continue to run. But if either of these countries decides to slow down the supply of economic gasoline through their tolerance of ever expanding deficits, the game is over. That's why what China decides today will matter in the rest of the world tomorrow.
Our loss...it's valuable when you can give it.
Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.