A study of the Chinese economy and stimulus in light of the economic crisis: A Comparison of the Chinese and American economic policies to counter the recession.

Abstract

The current economic crisis is said to be of a magnitude not experienced since the Great Depression. Not only has it affected developed nations, but the phenomenon of globalization has allowed it to creep across the world. World Bank forecasts provide a bleak outlook for the global economy. Real GDP is expected to decline 1.7% in 2009. Developed countries could face a recession with their GDP’s contracting by 4.2% while developing economies are projected to grow at a mere 1.2%. The United States, which was at the epicenter of the crises, has a broad spectrum of problems at hand such as failure of financial institutions, collapse of housing market, unemployment and high debt both at household and economy level. By contrast, China is uniquely positioned to take on a significant role on the world stage. It enjoys twin surpluses in its current and capital account, has $2 trillion foreign reserves, limited connection with foreign banks and a budget that is in surplus thus offering considerable room for State spending. It is the clear outlier in GDP forecast, with its GDP expected to grow at 8% in 2009. Historical growth in China has been fuelled by high levels of structural saving which are recycled into high investment levels resulting in an investment driven growth. Since market reforms in 1978 China’s economy has grown at 9.9%, reaching 12% in 2007, before the crisis hit. Chinese exports have been badly hit, with analysts projecting that 2009 may well be the first year in more than a quarter of a century to see a full?year decline in exports. This has led to loss of jobs and drop in production. However, it is a misconception among many that China is heavily dependent on exports. This much touted about component of GDP is actually amongst the smallest. While gross exports account for 34% of the GDP, much of these are processing exports. Thus, in value added terms, after reducing the cost of imported materials, exports account for only 14% of GDP and employ only 10% of China’s workforce. In fact growth in China has been fuelled by high rates of investment. Investment accounts for 42% of GDP. Some of the common factors cited for the growth of investments have been the government policies promoting investment, low capital costs, easy availability of credit and reinvestment of profits by companies encouraged by the State. The ratio of urban fixed asset investment to national fixed asset investment has been growing. At similar income levels as China, the Gross Capital Formation as percentage of GDP has been much lower for other countries. Even as investments continue to rise, efficiency of investment has fallen from 90% to 60% questioning whether historical growth rates can be sustained through investment in the long run. To maintain growth the government will have to turn to private consumption. Share of private consumption in China is the lowest of any major economy. While China’s capital spending is close to that of America, its consumer spending is only one?sixth that of USA. Savings rate, which has reached 50%, is among the highest in the world. One of the main reasons for this is the inadequate social security provided by the Government. The proportion of people covered by unemployment insurance, workers compensation insurance, pension and health insurance is less than 15%. Also inadequate liberalization of the property sector has failed to create a strong wealth effect. While consumption spend has been increasing by 8% y?o?y this has not kept pace with the growth in investments. Imbalanced growth does not bode well for the economy. In China investment growth has been fuelled by government policy which provided for low cost capital and development subsidies. However this ended up creating excess capacity in key industries, bringing down prices and hurting all players. As profits fall, non?performing loans of banks also tend to increase. Additionally the efficiency of investment continues to fall. Also, much of the growth has been captured by industrialists leading to income inequalities amongst Chinese people. Employment has grown by only 1% p.a. in the past 15 years as much of the investment driven growth was capital intensive. Heavy industries employ fewer people per unit of capital than do consumer goods sector or the services sector. They also tend to increase pollution levels. China is amongst the biggest green house gas emitter in the world. Also, the growth of China has mainly been concentrated along its Eastern coastal provinces, while Central and Northern provinces have for a large part been neglected. However the economic crisis appears to be reversing the trend. With much of the East badly hit due to a fall in exports, growth in this region has slowed down. Also, the infrastructure?heavy stimulus is skewed towards needier inland provinces. While much is being done, the government can do more to encourage the private sector to develop inland where at present the state sector still dominates. Such a balanced growth would do a world of good in reducing income inequalities, raising the standard of living and overall building a socially healthy climate. All these measures would in the long run work towards raising consumption demand. So it is evident that imbalanced growth is not good for the economy. However, though the Chinese government has woken up to the fact that its economic growth has so far been imbalanced the measures taken so far have not been very impactful. More measures are needed to reduce savings and boost consumption demand. In the long run, increased provision of health care, unemployment compensation, and workers’ compensation through the government budget can be expected to reduce precautionary saving on the part of households. Similarly, greater government provision of educational services and old age support could lead to a reduction in savings associated with lifecycle events, such as children’s education and retirement. Perhaps now is the time for China to make its move. Having enjoyed surpluses in its balance of payments account and due to its low debt China is favourably positioned to tide over the current crisis and emerge stronger. In fact China enjoys a surplus in both capital and current account. The current account surplus has arisen as imports have fallen due to the investment driven growth creating excess capacity in key industries and exports risen, as China’s membership in the WTO has increased its attractiveness as an exporter. Also, strong inflows by investors wishing to tap into China’s growth story have led to capital account surpluses. China is in a much better position to raise capital through government bonds than its developed counterparts and can accordingly spend on its fiscal stimulus on infrastructure and industrial projects, allowing the country to emerge stronger from the global downturn. China has already announced a stimulus package of 4 trillion yuan. The spending would be spread across two years and is one of the biggest stimulus packages (as a percentage of GDP) in history. The stimulus plan has 10 major spending items. These include projects for the construction/expansion of railways, highways, airports, city subways and nuclear power plants. Besides physical infrastructure, it also focuses on social infrastructure such as public health care systems, education, subsidized housing, environmental protection and technological innovation. It hopes to encourage domestic consumption by reducing unemployment and boosting rural incomes through raising the minimum purchase price of grain, increasing subsidies to farmers and redeveloping the earthquake torn Sichuan province. In addition industry specific packages have been announced for 9 key industries focusing on technological innovation, reducing excess capacity, consolidating fragmented players, boosting demand and encouraging brand building. These packages have a twofold agenda. They wish to create multiplier effects through investment spending and also promote domestic consumption through increased subsidies. The focus on infrastructure is a clear signal from China towards its long term focus. The improved facilities and infrastructure will attract investment, promote industrialization and facilitate entrepreneurship in the long run. Also, it will have immense social impact by improving the standard of living in less developed regions of the country. In the short run, the massive construction projects will create employment and demand for commodities. Of the 7.9% growth in GDP recorded till June 2009, investment accounted for 6.2% of the growth. Results of the stimulus are already beginning to show with urban fixed?asset investment rising to 7.8 trillion yuan during the first half of the year. Investment in infrastructure grew by 57.4% and rail transport by 126.5%. Domestic demand has also been growing. Retail sales, in real terms were 16% higher than a year ago, auto sales grew by 31.7% and property sales by 17.7%, the first growth in a year. The government has extended $3 billion to encourage rural residents to buy light goods such as televisions, refrigerators and air conditioners. A further 7 billion yuan has been allocated towards auto replacements and household appliances upgrades. Consumers are being given loans without any collateral for buying durable goods such as appliances and electronic products, and for other private consumption including travel and education. Home buying has been encouraged with margin deposits being cut by half. 600 billion yuan of the stimulus package has been allocated for social infrastructure improvements. On a monetary front, following the announcement of the large economic stimulus of 4 trillion Yuan, 2.8trillion of which was debt financed, the PBOC has aggressively expanded the credit availability. The benchmark interest rate for loans was cut 5 times to 5.31% and for deposits to 2.25%. Besides, the government has also loosened credit. New loans issued by state banks and others were 5.5trillion Yuan in the first quarter, which was more than the whole of 2008. By June 2009 China had already disbursed 7.37trn Yuan and is expected to overshoot the estimate of 8trn yuan by the year end. However there is criticism that the excessive credit has led to speculation. Chinese stock markets in the first six months jumped up by 85%. Price to earnings ratio of the stock market stands at 32 times for 2009, and is as high as 45 times for small cap stocks (which are more susceptible to speculation). The justifiable PE level is only 25 times. While in the short term the steps taken by the central bank are in line with the stimulus plan, the money supply must be kept in strict check to prevent undesirable repercussions of excess liquidity in the system as these could lead to large non?performing assets, risk of inflation, unwarranted asset market inflation. Also, the central bank should dismantle the credit quota system permanently and let market forces determine the best use of available capital. The immediate effects of the stimulus are being felt because of the greater control that China has over its banking system and on its State Owned Enterprises (SOE’s). Hence policy measures taken by the government can be transmitted in a much faster manner through the economy. Also the capacity of the country to better absorb infrastructure spending, especially in rural provinces, makes the stimulus package much more effective than those of some developed countries. However, with almost 50% of the stimulus package geared towards infrastructure spending, in the coming years the economy will be continue to be powered by growth in investments and in capital formation, thereby exacerbating the current imbalances in growth in China. What the government should do to boost consumption is to speedup land reforms. At present, tracts of rural land are “collectively” owned and can only be leased to peasants on 30?year contracts. The government is attempting to make efforts to organize the land?use rights market and also to facilitate trading in such rights. This reform is a welcome step to improve the rural markets, thus making peasants wealthier. Greater participation of private enterprises in growth especially in the services sector which contributes to greater employment should be encouraged to move Chinese economy towards a balance of manufacturing and services sectors. This can be done by removing the imbalances in the tax system and subsidies for the two sectors. The government has been reluctant to raise domestic interest rates since this move could reduce carry costs for foreigners investing money in China in the anticipation of an appreciation of the RMB and authorities fear that raising domestic interest rates could cause capital inflows to become unmanageably large. A more flexible exchange rate policy will give the Central Bank the lee?way to adjust interest rates to suit the demands of the economy. On the foreign exchange front, China has intervened aggressively in the currency markets to prevent appreciation of the Yuan. These actions, in addition to its large trade surplus, have led China to become on the world’s top 5 holders of foreign exchange reserves. China thus became the largest creditor of USA and holds 30% of US treasuries. Off late, the Central Bank has been trying to move away from the dollar, pegging the yuan to a basket of currencies thus allowing it to appreciate by almost 20%. It has also arranged and carried out currency swaps with many countries across the globe. Fears of US dollar devaluation have made China called for the use of SDRs (IMF Special Drawing Rights) as a global super currency to replace the US Greenback. The inter?linkages between China and US as seen with the currency holdings are inevitable. Chinese people save allowing Americans to borrow and spend more than they earn. American consumers buy products made in China, keeping Chinese workers in jobs. The dollars earned from these exports go flooding back to America, pushing down interest rates there, raising house prices and encouraging Americans to borrow even more to buy Chinese goods. If China were to suddenly stop buying US Treasury bills, it would plunge America into a fiscal crisis. It could also spark a collapse in the dollar and thereby wipe out a big chunk of China’s foreign?currency reserves. So both sides have an interest in preventing this from happening. These inter?linkages mean that America will stand to benefit from the stimulus package of China, which already appears to be happening. China has reacted to the crisis in a well measured and strategic manner. It finds itself in a position where the erstwhile super power is struggling, while China is being seen in a new light by other nations of the world. Many economists believe that China will pull the world out of this recession just like the US pulled the world out of the slowdown in the early 90’s. The stage is set for China to launch itself into a position of world power and domination, and all eyes are on them. If they play their cards well, this will be the point of inflection in the world order where China will be treated at par or possibly more powerful than the US in the years to come.