China Quarterly Update, December 2008

China has a lot of things going for it. Chinese families (though not necessarily the government) invest a lot in their children’s education. China has a particular model of globalization: it is very open to imports and direct investment, but not to portfolio capital flows. Right now, this looks a pretty smart strategy. China also has a pragmatic approach to infrastructure: the cost of power and using expressways and ports is relatively high compared to other developing countries. The result is that infrastructure pays for itself and the country has been able to expand its networks very quickly. See my paper on lessons of China for more details.

The November 9 stimulus package contains commitments to carry out projects infrastructure projects on public housing (RMB 280 bln), rural infrastructure (RMB 370 bln), transport (rail, airports, and roads) (RMB 1800 bln), health and education (including building schools and hospitals) (RMB 40 bln), the environment (including water and sanitation, sewage facilities, and restoration projects) (RMB 350 bln), technological innovation (RMB 160 bln), and post earth quake reconstruction (RMB 1000 bln). The number in (brackets) are estimates by the government on spending in these areas.

We think that the stimulus package will be very important in supporting growth in China in a very difficult year internationally. Our GDP growth forecast for 2009 is 7.5 %. It is always difficult to make comparisons. But at least we can say that the projects that are secured and advanced by the November 9 decision will be important to support growth in the short run and, in the long term, help China support some important long term objectives and improve people’s living standards. These measures in this package are not directly geared at helping industry, although it is fair to say that they may help industry indirectly (better railways, better education).

We have received several good questions on health: the formal 4 trillion Yuan package has only a modest amount for health: about 10% will go to health and education. But the package is mostly for infrastructure construction and the need to construct new health and education facilities is not great. There will be a separate decision soon about the total budget for 2009. In recent years the central contribution for health has been rising rapidly, and I expect that to continue in 2009. One difficult year of growth will not affect that. If, however, China has several years of slower growth then that would inevitably affect the provision of services. This global downturn is an opportunity for China to focus more spending on domestic needs, of which a stronger, more rational health system is a great example. If the government spends more recurrent budget on health and education that will be a direct stimulus to the economy and also lay a solid foundation for the future by making people feel more secure and building up the country’s human capital. So, I think that it is important to continue the health system reform and put more central resources into it.

China stimulating its economy and maintaining a healthy growth rate is very good for the rest of the world. Because China is quite an open economy in terms of imports, part of its stimulus will spill over and create demand in other countries. Some of China’s imports are parts for processing and then re-export, so they are based on final demand elsewhere. But the majority of imports is not of this kind and is related to China’s domestic demand. Based on the stimulus package, our forecast for 2009 has domestic demand growing at 8.9%, and import growth (excluding processing) at 10.7%. The World Bank forecasts that global trade overall will decline 2.5% in 2009, so China is definitely a bright spot in terms of providing stimulus to the world economy. Its demand will help the wide range of countries that export to China – products from petroleum and minerals, to food, to high-tech machinery and software. An important note of caution, though: China is not important enough in global final demand to fully offset the declines that are projected for the US, Europe, and Japan. China’s continued healthy growth makes things better than they would otherwise be for the world economy.

That is a good question. In our view “strong macroeconomic fundamentals” mainly refers to (i) strong fiscal and external positions and cushions; (ii) the capacity to growth at relatively high rates without showing the symptoms that emerging markets often suffer from: high inflation and/or external deficits. As to your second question, I would say that, in terms of the ability of policy to respond to boost growth in the short run, income gaps do not really come into play. However, income equality, especially between rural and urban areas, is one of the major issues, or “imbalances” that the medium term project to “rebalance” the economy is meant to address. In short, “rebalanced” growth, growth that relies more on services and consumption, instead of industry, investment and exports, is more labor intensive. That means that it will create more urban jobs, draws in more migrants from the country side, and thus raises labor productivity and income of those left on the country side. In particular, “rebalancing” measures such as increasing government spending on health, education, and social security help boost disposable incomes and living standards in the rural areas.

Most of the steps taken in China to prevent direct impact of the present global financial crisis have actually been taken in the past. China’s banks did not buy significant amounts of "toxic" assets. Moreover, China has capital controls, which means that the pressures on international financial markets do not exert a strong influence onto China’s financial system and sector. Very high national saving for an extended period of time is reflected in high foreign reserves and a lot of liquidity in the banking system. China’s real economy is open to the world, however, and this is were the spillover of the international crisis enters China, via lower exports and reduced confidence. The main response of China’s government to the downward impact this will have on overall growth and employment is too shift to expansionary macro economic policies, with an easing of the monetary stance and, importantly, expansionary fiscal policy, with substantial increases in government-influenced spending and some tax cuts. The aim of these policies is to boost domestic demand, in order to offset in part the netative influence coming from the international crisis.

Currency policy is complex, with many considerations playing a role. We think that China’s decision to strengthen the link with the US dollar while the dollar was appreciating strongly against most other currencies globally contributed to financial and economic stability internationally (just like a decision not to devalue played a similar role in the wake of the Asian crisis 10 years ago). Going forward, we think that, at a time of a very weak international outlook, China is right to focus on stimulating domestic demand. We also think that China’s fundamental competitiveness position is still good. Therefore, we think it is not very useful to try to “crowd in” market share by lowering export prices on international markets resulting from exchange rate depreciation.

The World Bank has a useful role to play in the current global economic conditions. The Bank’s capital base is sound and we can borrow easily on world capital markets, so that the President of the Bank has said that we could double or triple our lending in 2009 if necessary. There are quite a few developing countries that have fundamentally sound policies but that are having trouble refinancing their external debt in the current market conditions. The Bank can be part of the lending to these countries to get them through the troubled times. Some of that lending will be directed to specific projects in infrastructure and the social sectors to help ensure that development investments proceed despite the global downturn. I also think that the analysis and advice from the World Bank is extremely useful to developing countries in this unique situation. The advice covers both macroeconomic policies, but also important structural issues such as how to strengthen the safety net for the many workers and farmers who will be adversely affected.

The purpose of the SWF is to earn a better long-run return on the large amount of US dollar assets that China has accumulated because of several years of large trade surpluses. Because of the downturns in many equity and property markets worldwide, this is actually a good time for SWFs to purchase assets. It is always a smart strategy to diversify your portfolio, so I would encourage the SWFs to invest in both developed and emerging markets, and in different kinds of assets such as common stocks, real estate trusts, and corporate and public bonds. If SWFs buy assets now, they will play a useful role in helping stabilize these markets, and they will meet their objectives of getting a good long-term return.

I don’t think it is fair to blame developing countries such as China for loss of jobs in developed countries like the U.S. The total net job creation in a developed country is primarily the result of the country’s own macroeconomic and structural policies. If an economy is not generating enough jobs, there are macro and micro tools to correct this. My own view is that job creation depends primarily on the incentives for innovation and long-term growth. In the case of the U.S., things that would help would be reform of healthcare to take the cost off of the employer, immigration reform to ensure a steady flow of workers with different skills (especially the high-tech skills in short supply), fiscal policies and incentives to raise the savings rate, and expanded investment in critical infrastructure (both hard infrastructure such as transport and soft infrastructure such as universities). In the short run trade can accelerate shifts from one type of job to another and that can be a serious problem for particular workers and communities. I favor a forward-looking policy of helping workers adjust. Trying to preserve particular jobs through import protection has always failed in my reading of history.

Right at this moment China faces a serious challenge to quickly reorient its economy away from exports toward domestic needs. In retrospect, China should have started this sooner. If China had more aggressively pursued policies to encourage consumption in the past few years, it would not have built up so much capacity in the export industries and would not have such a difficult adjustment now. Looking beyond the next year, the biggest challenge for the country is natural resource scarcity and environmental degradation. China can turn this crisis to good purpose by using its stimulus package to build for the future economy not for the old model. The infrastructure spending that will go to high-speed passenger rail, public transportation, waste water treatment, environmental clean-up, health, and education will stimulate the economy immediately and also lay a foundation for a greener economic development in the future.

We think that among the key challenges are (i) to ensure that the selection, preparation, and execution of the projects is as rule-based and efficient as possible, with an eye to long-term development needs instead of short term visibility. This task is made more difficult by the large size of the overall package and the speed with which it is meant to be executed. (ii) to make trade offs with regard to the key criteria with which measures should be judged: large short term impact on growth and support for medium and long term objectives. For instance, creating demand for the steel industry is currently a very effective way to boost short term growth. But it does not really help China meet its medium and long term objectives.

I think that so far the slowdown in China is caused by weaker fundamentals. Consumer confidence has held up pretty well so far. But in terms of fundamentals, the property market got overheated and the government put on the brakes. At the same time, processing exports started to slow down. The result has been a sharp drop in the heavy industries related to construction followed by declines in the processing export sectors. It is possible that consumer confidence will now weaken, which would be unfortunate. Hopefully the government's fiscal and monetary stimulus will boost confidence. It is hard to predict when the housing market will turn around. In the prime cities prices have gone up a lot and there needed to be a correction. Now there is a lot of unsold commercial and residential space. If the market works well, prices will come down in response to this slack market. The long-term demand for housing in Chinese cities is high, so I am convinced that if prices come down to reasonable levels that the market will resume. The risk is that developers and banks are reluctant to accept losses and keep prices high in the face of excess supply. In that case the slump could last a long time. Let's hope China learns from Japan's experience with the property slump in the 1990s. It is better to take the losses and move on rather than cling to unrealistic valuations.

China’s exporters of consumer goods are undoubtedly going to face a tough year, with global demand going into slowdown. This means that pressure increases on these producers to upgrade their production process and production package, and cut costs. While this is part of a productive process to restructure and upgrade the economy, it leads to strain and dislocation for the firms and workers involved. In my understanding, the impact of these pressures will be felt largely in China itself. One thing that some countries may feel would be pressures if Chinese firms move up the ladder and become competitors in certain products and markets that they were not active in before.

China’s government is encouraging export firms to upgrade, develop brands, and make other improvements. In addition, the VAT rebates that exporters receive—which are full in most other countries but have traditionally in China only been partial—have been increased recently for several types of consumer goods.

I think that the new land reform is basically positive. Over the next 15 years it makes economic sense for another 150-200 million people to move from the countryside to the cities because they will be much more productive in urban work. China could produce the same amount of food as it does now with far fewer workers. The land reform helps this transformation in two ways. First, to produce with less labor will require consolidation of land into larger farms and mechanization. The new land rules will permit this. Second, many families will want to permanently sever their links to the countryside. Under the new rules they can sell out and move to the city with some money to help set themselves up. There is a risk of a new class of poor landless laborers being created. The best solution to this is to continue to strengthen rural education and health so that everyone has good basic human capital. China has also developed an urban and rural minimum income support program that can be an effective safety net if it is properly funded.

We are often asked whether China can "save" the global economy from going to a recession. Our answer is "not really". China will likely outgrow most other parts of the world in 2009, and China’s growth will be a very substantial contribution to overall world growth in that year. However, China’s economy is—at about one-fourth of the US economy—too small to carry the global economy forward. Forecasts for 2009 are subject to a lot of uncertainty and risk, including the one for China. However, the projection that China will outgrow most other parts of the world in 2009 is in our view quite robust to these uncertainties and risks. Therefore, we think China’s growth will generate a net positive contribution to world growth.

Everyone recognizes that weaknesses in the regulation of complex financial instruments such as derivatives have contributed to an economic crisis that keeps accelerating. But I also like to emphasize that poor coordination of macro policies among the US, Europe, Japan, and China created underlying weaknesses. Without those underlying problems, I don't think that weak regulation by itself could cause such a crisis. That's why financial bailouts in the US, Europe, and Japan seem to have stabilized things to some extent, but yet we don't see much rebound of real economic activity. To really get the global market growing again at a healthy rate will take, first, coordinated stimulus in all the big economies. Second, following the stimulus, emerging markets such as China will have to play a greater role in global final demand. That means more private consumption in China and more government spending on recurrent items such as health and education. The US in turn will need to increase its savings and reduce its trade deficit. With well-coordinated policies, the worst of the global slowdown should be over by the middle of 2009, and the global economy should pick up as we move to 2010.

You are right that cautious Chinese households are likely to reduce the growth of their consumption spending in 2009. We have built this into our forecast - lower growth of private consumption than during the boom years. However, no one can predict for certain how much retrenchment there will be. China can still grow at 7.5% in our view, with healthy growth of household income. Hopefully the government's fiscal and monetary stimulus will boost consumer confidence and convince Chinese people not to pull back too much. Too much worrying could cause a self-fulfilling downward spiral.

Going forward I expect gradual appreciation or stability of the effective exchange rate (that is, the weighted average against the dollar, euro, yen, etc.). So, depending on what happens among the dollar, euro, and yen there could be movement either way in the dollar-yuan exchange rate. But it would be surprising to see any big depreciation of the yuan against the dollar for several reasons. China will still have a large trade surplus in 2009 so it is hard to see any argument for devaluation. Its trading partners are not likely to welcome any such move. In the next few years countries like the US have to reduce their trade deficits and save more; that means surplus countries like China will need to reduce their surpluses. Gradual appreciation to support that is the most likely move.

Good point that the interest rate decline is the biggest in 11 years. I do think the government finds the current global situation more risky than the 1997 Asian crisis. In 1997 the crisis was largely confined to emerging markets and the US economy was still in good shape. What is different this time is that the crisis starts in the US and spreads to Europe and Japan. The coordinated downturn in these three big economies is unprecedented. So I think it is smart for China to respond quickly with fiscal and monetary stimulus. Our forecast of 7.5% in 2009 assumes that the government will respond to the changing conditions. So, we will not change our forecast based on this new interest rate move. That is the kind of good policy response that we built into our forecast. We were also careful to say in our quarterly that policy making for 2009 was not finished: meaning that the changing global situation may call for more stimulus from China.