A stopped clock is right twice a day, but it can’t tell time rest of the day. This is worth bearing in mind when looking at the Chinese economy this year. For much of the last decade, some have have predicted imminent doom and gloom for China. Like a stopped clock, they have said the same thing for some time.
Meanwhile, China has continued to go from strength to strength. Its economy has soared. Its influence has grown. Asia has benefited. The question that needs to be asked is whether this is the year that problems in China will emerge. Is this the time when the stopped clock is right?
China’s risks are different from those in the West, where debt problems persist. Across Asia, inflationary pressures are rising and policy needs to be tightened. The challenge for China is that in recent years, it has tied itself too closely to US monetary policy. In doing so, it has kept interest rates lower than necessary and its currency weak. Resolving these issues is vital and is underway.
The US and China both need to set monetary and fiscal policies to suit their domestic needs. The US is doing this. Last year’s second round of quantitative easing, or QE2, was justified, despite the criticism it received outside the US. Facing deflation, the Fed needed to do more.
The government has followed with a huge fiscal boost over the new year. The net effect is the US economy will grow strongly this year, particularly in the first half.
The stimulus has reignited fears about US government debt, but the reality is the US had no choice. A staggering 43 million Americans now receive food stamps, indicating the scale of poverty. Chances are US policy will work to ensure growth, if not to solve all the country’s problems.
All of this highlights the need for Asian policymakers to follow the US. Not by copying US policy, but by setting monetary policy to suit their own domestic needs. The challenge is especially daunting for China. The longer it takes China to tighten policy, the greater its eventual problem.
Last year saw the authorities impose a loan quota. But concerns about growth prevented them from tightening enough. This year, there is no reason to hold back as growth looks set to be strong, boosted by the 12th Five-Year Plan.
Although China’s policy tools worked well during the global crisis, there are risks now. First, the growing size of the economy and of the private sector makes it harder to control the economy from Beijing. Second, there is a need to rebalance the economy away from investment, towards consumption. While investment always sounds good, it is now so high in relation to GDP that not all of it may be worthwhile.
Third, China’s vulnerability arises from its underdeveloped financial sector. Thus, as income rises, there are limited options for investing household savings: into low interest-bearing bank accounts, into equities where governance concerns persist, or into real estate where prices are already sky-high in many cities. This makes the economy prone to bubbles.
China needs to avoid the lethal combination of cheap money, one-way expectations and leverage. A few years ago, the talk in the US was about the ‘Greenspan put’, that interest rates were kept low to support the equity market. China can’t fall into the same trap with property.
All this raises the risk of a near-term setback in China. Rising food prices and wages add to the urgency. Either the authorities don’t address problems sufficiently, delaying the day of reckoning, or, more likely, they tighten policy sharply.
This tightening will entail more loan quotas, rising reserve ratios, sharply higher interest rates, property taxes in some regions and, possibly, steeper currency appreciation than the market expects.
The authorities would not want to derail the economy. But if there was a setback where growth suffered, it would have global ramifications, hitting commodities and trade, among others. Of course, if there was a growth setback, the stopped clockers would say they were right, and there would be speculation about China’s growth being a bubble. That would be wrong.
A slowdown in growth would probably be temporary. It would show the business cycle exists in China, and while the economic trend is up, there will be setbacks along the way. These would provide a buying opportunity and not a reason to doubt the economy’s rise. China’s growth is for real. It is not a bubble economy, but it is an economy prone to bubbles. There is a big difference.
In recent years, the markets have discounted the bad news in the US and finally taken seriously the flaws in the euro area. The near-term risks facing China, like many countries across Asia, need to be taken seriously.
Yet, they also need to be kept in context, as they are unlikely to alter the longer-term positive outlook for growth. In our view, the world economy is in a super-cycle: a sustained period of high economic growth, lasting a generation or more.
The global economy is twice the size it was a decade ago and is already above its pre-recession peak. A central feature of this super-cycle is the shift in the balance of economic and financial power, from the West to the East, led by China.
This was highlighted at the recent Obama-Hu summit in Washington. Soon after becoming president, Obama changed US relationship with China. His predecessor, George W Bush, had a strategic economic dialogue with China. Obama turned it into a strategic ‘and’ economic dialogue. This was significant as it emphasized the relationship’s twin aspects.
As the US recovery has disappointed, there has been less of the strategic and more of the economic dimension of the relationship.
Although the US is the far larger economy, the relationship increasingly resembles one of equals. In modern times, the economic importance of China to the world economy has never been greater. It is vital for the world, for Asia, as well as for China that it addresses its inflation challenges now. This is no time to wait.
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