Alternative Blog Arrangements
Dear readers:
Good evening from Hong Kong. Our blog has been inaccessible from the mainland for about three weeks, and we are in the process of creating a new one. We hope to send out a link to a new site soon, along with some updates about how to understand the latest bout of inflation in the context of long delayed relative price adjustments, the re-planning of the socialist market economy and other big themes for the next year.
More to follow.
Putting October PMI into Context
The big news so far this week – the increase of China’s purchasing managers’ index (PMI) to 54.7 from 53.6 – may not be quite as big as many are making it out to be. It is, to be sure, an important indicator of future economic activity, but one that needs to be taken in context. Putting this number into the bigger picture – one that includes expectations for inflation and interest rates – the Chinese economy looks softer than this uptick would suggest. It is also important to keep in mind that China’s PMI is based on a sample of firms (fewer than 800 and generally large ones) that is relatively small for an economy as large and diverse as China’s. Looking back at historical leads and lags, PMI thus looks to be a better predictor of things to come when broader underlying trends are strengthening than it is as things slow down.
The knee-jerk reaction of many that have commented on this indicator has been to predict additional interest rate increases by the People’s Bank of China (PBOC) during the coming quarter. We believe that such a move by China’s central bank is possible, but not because the producer side of the economy is on the verge of overheating: if anything supply side inflation data suggests moderation is underway. The PBOC, like other regulators are intent on getting back to a policy course that can be considered more ‘normal’, despite the increasing abnormality of external monetary conditions. That means restoring real interest rates to a course more consistent with this historical band around 3% or so, most importantly as a means of better balancing incentives for investment as China prepares to embark on a new 5-Year Plan that will certainly be investment heavy. With respect to the resistance of asset prices to ‘macro controls’, stronger administrative measures, rather than a punitive cycle of interest rate increases are far more important.
Additional forward looking indicators signal a sustained slowdown to China’s economy, one that we expect accelerate during the coming months. Although the economy was stronger than expected through the third quarter of 2010, it is widely expected that the cumulative effect of controls on money and credit growth, as well as a moderation to inventory driven growth in the US, will be a Q4 growth number of around 9%.
We have consistently noted the decline in the cumulative number of new projects starts by enterprises in China during the first three quarters of the year, and more recent reports indicate a similar slowdown in the real estate sector. Relatively, and somewhat unexpectedly, strong external demand thus seems to contrast with gently sloping slowdown to broad measures of economic activity connoted in the chart above. The pace of this moderation clearly decelerated during the August-September period, but in this broader context the most recent PMI figure does not seem to warrant a reversal of expectations.
One illustration as to why we think the utility of monthly PMI figures declines during the tail end of the economic cycle in China is that it is out of step with fundamental indicators such as electricity production. Growth to monthly electricity output, seen on both a year-on-year (Y/Y) or month-on-month (M/M) basis slowed at the same time that headline PMI has rose. This indicator measures the economy in general, whereas PMI is limited by the shallowness of its sample.
We are expecting the moderation to growth mentioned above to extend into the first quarter of 2011, with industrial activity rebounding with potential vigor starting in 2Q 2011 once new industrial policies and bank lending quotas kick in. As noted in earlier posts, pending industrial policies in China may amount to massive stimulus in the coming years to the extent that plans may have to be scaled back if the economic response to the 12th Five-Year Plan is too enthusiastic. If this is the case it will surely be evident in PMI numbers, but until these policies kick in we are trying to take a broader view of where regulators would likely to tighten things up ahead of efforts at structural changes to the economy.
Planning for a New Industrial World Order
China has recently released the outlines of the most coherent blueprint for state capitalism in recent memory. Presently, there is a general awareness in much of the west about the ideological differences between state capitalism and more market-based systems. In the future, however, foreign governments and capital goods producers alike may be in for a rude awakening when they eventually confront more direct competition from Chinese firms.
Additionally, the release of the proposed “Strategic Emerging Industries Development Plan” (SEIDP) component of the 12th Five-Year Plan (FYP) comes at a time when leaders in advanced economies are looking to expand exports of capital goods to high-growth markets like China, all at the same time. For its part the Chinese government appears intent to reduce its trade surplus to a “sustainable level”, and this will probably include government-supported trade missions to the US and struggling European countries, and possibly even a quantitative target. Nevertheless, the next generation of Chinese exports is intended to come from “a large group of internationally influential firms” that will meet mature foreign competitors in global markets with cheap export financing and China’s brand of commercial diplomacy behind them.
Initial reports cite “more than RMB 4 trillion” as the amount of fiscal support that the central government is prepared to provide for the SEIDP during the next five-years. Based on the recent experience of the combined financial crisis response by central and provincial-level authorities, it is easy to imagine that once fiscal supports for industrial plans at all levels of government are tallied this figure could easily exceed RMB 10 trillion during the next FYP. If this is the case, the RMB 2 trillion per year of investment and related spending could contribute up 1.5 percentage points to annual GDP growth. At its core, the SEIDP is intended to guide an economic transition in China towards a more sustainable and domestically driven growth model. Previous attempts have been unsuccessful, partly because a lack of decisiveness and cohesion among the agencies of government involved. This time around, the fiscal resources behind the rhetoric of the SEIDP signal a high level of commitment to what is being taken as an urgent task.
We stop short of identifying the SEIDP as part of the so-called “Beijing consensus”, mostly because this approach to policy making is more utilitarian than normative. At the heart of it, however, and to borrow Ian Bremmer’s definition of state capitalism, is the use of the power of markets for political gain. That is not to imply that China’s leaders are inattentive to social needs, and in fact the opposite is true. Nevertheless, the framework for the SEIDP confirms that the circular relationship between the control of economic resources, socio-economic development, and the preservation of the existing political order will continue through at least 2020.
Historically, government efforts to mobilize resources in support of output growth targets in China have been highly successful. This success has, however, come at a high price: a highly skewed distribution of national income and excess industrial capacity. With this in mind it is noteworthy that ahead of the SEIDP the State Council is leading another round of forced industrial consolidations in areas where overinvestment threatens “healthy development”, including the automotive, steel and cement sectors. Previous attempts have achieved mixed results. Looking ahead to the SEIDP, central government regulators are poised to make best efforts at preventing overly ambitious and redundant provincial-level economic plans from blowing out the economies of scale that they hope to achieve. They will also be looking to prevent a recurrence of domestic imbalances that have turned economic achievements into social risks.
As noted below, in 2020 economic planners would like to see 15% of China’s GDP come from the pillar industries included in the SEIDP. This figure does not, however, include mention of likely output multipliers that will take place as supportive firms and sectors grow up around planned industrial clusters. The authors of the Plan seem to have this in when they call for the development of a vibrant SME sector to complement the large-scale multinational firms they would like to cultivate, but do not cite a figure for the total proportion of output and employment that may directly and indirectly depend on government guidance.
We would be remiss if we did not mention the topic of innovation: the term appears more than 30 times in the State Council resolution. The push for ‘indigenous innovation’ has received a lot of attention in recent years, partly for the methods behind it and partly for its relative lack of success. As mention in ‘ ‘Industrial Policy in China and the 12th Five-Year Plan (2011-2015)‘, the central government hopes to promote an ‘experimental economy’, where research and risk taking ultimately result in new technologies that can be commercialized. Still, the general approach seems to be that if adequate levels of investment are achieved that inevitably some innovation has to occur. China does not lack human resources and engineering talent, but the systemic balance of incentives still appears to be working against government goals. Potentially worrying for foreign firms on this topic is the call in the State Council resolution to “strengthen abilities to attract practices and technologies from abroad, digest them, and re-innovate…”
Limiting Old Risks along a New Course
The concept that President Hu Jintao has reportedly pushed for inclusion in the 12th Five-Year Plan is “inclusive growth”, referring to the need to counter the imbalances of China’s growth model of the past decade. Much of the first 30-years of economic reform in China were driven by the geographic strategy to allow some regions of the country “to get rich first”. The initial hope was that the gains from rapid growth would eventually trickle down the economic ladder socio-economically as well as geographically. What recent years of industrial development in China have shown is that concentrations of resources on both a geographic and sector basis can be self-reinforcing. The big get bigger, and the rich get richer. This is a common system of state-led industrial plans, and also one that that will be difficult to reverse in China, especially when the SEIDP itself calls for concentrations of output.
Our recent research on the extent of inter-regional convergence in China has shown that regional development initiatives and a shift from a geographic to an industry-focused system of preferences have begun to reverse years of widening disparities. At the same time, however, imbalances related to the distribution of national income have intensified: the proportion of national income accruing to households has fallen and the inequitable distribution of household income has worsened. Where industrial firms are concerned, a range of indicators make clear that the size and market share of those firms owned by or closely associated with government in China have increased at the expense of greater room for private entrepreneurial activity.
As is clear from the translated passages of the State Council’s statement on the SEIDP below, an operative principle for the next round of China’s industrial development is that ‘government leads, and enterprises follow’. Given the tendency for rent seeking and the concentration of economic resources around administrative monopolies in China, questions remain as to how well the central government will be able to prevent the recurrence of the imbalances that it wants to grow out of. It is not a popular position to take in Beijing these days, but bolder academic commentators have begun warning about the need for stronger countermeasures to prevent the SEIDP from acting as an overly powerful magnet for resources.
Competition under the SEIDP
Domestic media reports are using some interestingly vague phraseology to describe the future relationship between government and markets under the 12th Five-Year Plan. The term most often occurring is 少操心, which literally means to worry less about something. This can be read two ways: it could imply that the government will leave the market outcomes to the results of open competition; it could also imply that economic planners take demand as a given and are confident that a crop of chosen producers will rise to meet it. We expect that the arrangements outlined in the SEIDP tend towards the latter option, and managed competition will prevail.
This issue harkens back to the debate that occurred around the time of the passage of China’s anti-monopoly law regarding the exclusion of large segments of the economy, including the power generation and transmission and telecommunications sectors, for example, from its reach. The rationale for doing so was rooted in national economic security, and it is unclear to what extent the same exalted status will be granted to these strategic emerging sectors. A potential worst case outcome for some domestic and foreign firms in China would be a tacit quota system for the allowable market share ceded to firms outside of the SEIDP’s guidance. These are, of course, industries where economies of scale are essential and entry barriers are high, but for a continental economy with four times the population of the US, attempting to restrict industrial development to a handful of industry clusters would seem to limit inevitably the role of competition in market outcomes. The State Council resolution on the SEIDP specifically cites the size of China’s domestic market as a “great advantage”, and this is one that regulators will hesitate to cede too much of to mature foreign competitors.
It is important to note, however, that the kind of organizational arrangements described above – what we call “upstream monopolies and downstream markets” – can also lead to hypercompetition. For example, China has forced several consolidations of the airline industry, and has effectively banned the formation of new regional and private airlines. At the same time, however, the remaining state-owned carriers continue to compete bitterly on price and service, to the extent that regulators have to step in from time to time to limit fare discounting practices that they know will eventually necessitate government recapitalizations. Consumers benefit from cheap fares, and competing firms battle with each other knowing, or expecting anyway, that when they need government support it will be forthcoming.
To what extent this logic will be evident in strategic industrial sectors once they are up and running remains to be seen, but this kind of competition is already evident in a number of pillar industries that the government has ring-fenced from ordinary regulation. Such an approach is by no means unique to China, but its absolute size and ability to coordinate institutional arrangements spanning, policy, geography, finance and market design could impact the global industrial order far more deeply than ascendant Japan and Korea did in the past, or Brazil and India may in the future.
So what will it mean to “worry less about markets” in the context of the SEIDP? At this point all that is clear is that the government is intent on preventing excessive competition. What remains unknown is the extent to which various levels of government will protect their investments in new industries. For outside participants, domestic and foreign alike, this could mean reduced market access.
It would be easy for some to identify an industrial blueprint like the SEIDP as a blow to globalization, but from China’s perspective its goals for domestic industrial development are, first and foremost, an element of national economic security. This perspective contrasts strongly with the view from more market based systems, where over time corporations have redistributed production and supply chains to reflect shifting geographic realities, and the term “market access” has something of a moral ring to it. Chinese firms in these sectors are, on the other hand, just “emerging”, and the use of this term may put corresponding industrial policies in the category of issues to be treated in a manner consistent with China as a developing country, rather than as an industrial power. If this is the case, the Chinese government will address potential disagreements with foreign firms and governments over the SEIDP in a far different way than it would efforts to reform the international financial architecture, for example. This could well be a manifestation of what we call “face changing diplomacy”: sometimes you meet strong China, sometimes you meet weak China, and who you meet determines the dimensions of the box for negotiations.
It is by no means guaranteed that China’s growth model will be as successful in the coming thirty-years as it has been in the past thirty. Assuming that the SEIDP is, however, the clash between China’s brand of state capitalism and the operative principles of more market based economies could fundamentally alter the role and relevance of the current set of multilateral institutions that have thus far helped to mitigate systemic frictions.
The G20 Communiqué, QE and Currency Conundrums
Regardless of the domestic intentions of quantitative easing (QE) in the US and UK, the result on the external side of the equation has to be a weakening of the relative value of their respective currencies. This reality, along with expectations that during the first week of November the US Federal Reserve will begin a new round of QE (and that the UK will implement its own plan the day after the Fed plan kicks in), would seem to make the G20 communiqué irresolute at best. If anything, the next round of QE will only increase incentives for ‘currency wars’ via intervention, however conventional such actions may be.
Be that as it may, where it comes to the global rebalancing of demand that needs to take place, RMB rates relative to the euro and currencies in Asia may be more important than the much publicized level and trend of the USD-RMB pairing.
As we have written elsewhere, when China effectively re-pegged the RMB to the US dollar in 2008, this was a message to trading partners in Asia that the US dollar was “their currency, and mostly your problem”. We use the term ‘mostly’, because the value of China’s US dollar assets has obviously suffered as the US dollar index has fallen. Where it comes to export competitiveness, however, China, as the region’s strongest economy, allowed itself a US dollar-led devaluation. Additionally, with a closed capital account, China is also able to deflect a large proportion of so-called hot money flows that inevitably accompany ultra-loose monetary policy in the US and lesser liquidity centers to more open regional economies. If China had more developed capital markets and was able to absorb a proportion of such funds befitting the world’s second largest economy, the impact on asset prices and currencies around the region would arguably be smaller. China does not get a free pass, however, as the RMB regime means that domestic liquidity still increases in response to monetary easing by the US Fed. China has allowed some limited appreciation of its currency in recent weeks, but this token gesture does little to alter inter-regional demand and monetary relationships.
Taken together, the effects of a relatively cheap RMB and a closed capital account mean that China is passing on a proportion of the costs associated with a global rebalancing of demand onto other regional and large producer economies. This, along with the fact that as the upstream supplier of excess global liquidity the US is returning to a policy mix similar to “our currency, your problem”, implies that currency and trade related tensions may be little altered by the G20 communiqué. For all of its external financial strength and its rank as the world’s second largest economy China has yet to enunciate much of any vision for a reordered and rebalanced global economy. For all of its external financial weakness and rank as the world’s largest economy, neither has the US. The current menu of options include only preventing one interpretation of the mistakes of the past (i.e. The Plaza Accord) or eventually inflating away the excesses of the most recent decade (i.e. QE).
Some have suggested that a short-term dollar rally may soon be upon us, as rising uncertainty lowers the attractiveness of emerging market currencies and assets in favor of ‘safe haven’ assets such as the yen and the dollar. As resistance to structural changes increases globally, the meaning of ‘safe’ has to change as well. If QE causes an adequate amount of backlash, which it well could, the safest thing about the US dollar might becomes its role as a funding currency for carry trades long Asia. As we have said before, inadequate or otherwise faulty assumptions were key contributors to the recent financial crisis, and similar failures of imagination could lead certain bilateral trade and financial relationships into ever more dangerous circumstances.
Don’t Be Afraid of September Inflation Data
The growth and inflation data released today shows that the PBOC was targeting asset prices, not consumer prices with its interest rate increase yesterday. With that in mind the data released today makes the PBOC’s warning shot to investors in residential real estate look a bit timid.
If controlling domestic inflation was a big worry, then the central bank should have raised rates in March and not have waited until October to do so. Remarks from PBOC monetary committee member Li Daokui published by Xinhua, that “worries about soaring prices overwhelmed fears about economic growth”, appear to be simply out of step with the trends evident in the data. That is unless Mr. Li knows more than he is saying and is available to pedestrian economic analysts, and he almost certainly does (we hope).
This is the essential question: if growth is slowing down and controls on the growth to money and credit remain in place, why worry about inflation, or rising inflationary expectations?
The data released today by the NBS puts Q3 GDP growth at 9.6% y/y, slightly higher than expected, but consistent with the moderating trend and with policy intentions. The corresponding growth rate for the first 9-months of the year came in at 10.6%. China’s consumer price index (CPI) was up by 2.9% y/y for the third-quarter, with the corresponding rate for September up by 3.6% y/y.
If we were to look at the charts below outside of the context of the interest rate increase by the PBOC yesterday, it would look like an economy that is yes, running hot, but is past its cyclical peak. The slowdown to growth is the product of credit controls and administrative tightening measures that will remain in place, and the economy appears to be gliding towards a soft-landing. So what is all of the fuss about inflation? Asset price inflation and inflation in the real economy are different animals, and the former does not appear to be driving the latter based on the most recent data.
At the risk of sounding redundant there has been a lot of misguided alarm about inflation. If the economy is slowing down, inflation will probably peak soon, and non-food inflation already has. Expectations for the future are more important than the recent past, and if households are expecting a slowdown to growth (e.g. wage growth) and potential regulatory actions that will dent property prices, these expectations are probably pretty well anchored.
Non-food inflation has not increased in 5-months, and could actually fall. The reason is pretty obvious: if producers of consumer goods did not have much pricing power when the economy was really strong, they are going to have even less as the economy slows given levels of accumulated capacity.
On the supply side of the economy, one would expect to see moderating PPI measures as output and investment growth slows. New project starts by enterprises are down, inventory building is slowing, and overall it looks pretty clear that increases to rates of growth to producer prices are past the cyclical peak.
This leaves continuing increases to real estate prices as the counter-cyclical trend. Recent data on bank deposits does not indicate a major draw down and new loan growth figures look reasonably tame. Thinking back to the US housing bubble, which was fueled by non-monetary credit, or in other words financial innovation, is there a chance that backdoor financial innovation in China is one of the factors stoking residential property prices? We don’t have an answer to that today, but it is something well worth looking into. With this and the charts above in mind, when the real estate cycle breaks, or more meaningful brakes are applied, it is reasonable to expect that moderating trends in non-food CPI and PPI will pick up.
Signals from the PBOC’s Rate Increase
Most analysis of the 25 bp rate increase on both loan and deposit rates by the PBOC that we have seen starts off with something about controlling inflation or housing prices. These conventional arguments do not explain much in our view, as there has historically been an inconsistent relationship between the level of interest rates and core inflation in China. The same has generally been the case for property prices. With that in mind we interpret this move by the central bank as first and foremost a signal to the supply side of the Chinese economy, with secondary signaling value to the US and the rest of the world.
The first question that we think needs to be answered in understanding this move by the PBOC is who did the central bank want to tax with this rate increase? Our quick answers: no, not households; yes, corporates who may be investing too much in the wrong things at this stage in the economic cycle; yes, local government financing vehicles; no, not currency or stock market speculators; maybe some marginal buyers of residential property.
Rates of output and investment growth remain higher than the PBOC and other would like to see at this point. With the State Council set to implement its “Strategic Emerging Industries Development Plan” in 2011 as an important component of the 12th Five-Year Plan, central economic authorities want to send a clear message to producers and regional governments that they should be prepared to heed warnings on “blind investment” in excess capacity. A 25 basis point rate increase alone will not exactly send shivers down the spines of China’s biggest borrowers, and administrative measures are sure to follow in the coming months as part of efforts to get important economic actors in line ahead of the Plan. Interest rates in China are an important political variable as well as a market one.
Where real estate markets are concerned, this rate increase is probably targeted more at companies who continue to drive up land prices by raising their cost of carry (or funding costs for trust companies who have been funding developers) more so than buyers of residential properties with a mortgage. It is worth noting that during previous tightening efforts by the PBOC commercial banks did not increase mortgage rates by the whole margin of the increase to base lending rates. That may or may not turn out to be the case this time. After this rate hike the monthly payment on a RMB 1 million, 20-year mortgage would increase by about RMB 116 depending on the terms. This is not a huge margin for households, even on the margins of affordability. This move follows additional signals from the government that further administrative measures to control property price increase are in the works.
A possible secondary message to the US (and others ahead of the next meetings of the G20): don’t push too hard on the exchange rate and trade measures because when we act suddenly and counter to market expectations it roils markets everywhere. The US stock market dropped along with commodity prices overnight following the announcement by the PBOC. An unintended consequence? Probably, for the most part, but it is not hard to imagine that some in the bureaucracy in Beijing took some degree of delight in the global market response to the PBOC’s announcement.
The message to the world: the real economy in China has decoupled from other majors, and policy makers are prepared to move according to China’s own needs. This is nothing new really, but authorities in China are more unapologetic than they used to be about such things. This includes the exchange rate. Although these two policy variables are adjusted according to slightly different calculations, China probably wants to demonstrate policy independence from outside pressure.
Does this change the outlook for growth in the coming year? Probably for Q4 and the opening quarter of 2011, but not much for full-year 2011 and the medium-term. Stronger than originally expected growth for Q3 would give regulators more room to step up production curbs in energy intensive and polluting industries for the remaining months of the year. However, the start of the new year will mean fresh lending quotas for commercial banks, so 1Q 2011 may well show a seasonal firming up of output growth. Although controls on credit growth are expected to extend through the end of 2010 and an additional rate increase before the end of the year cannot be ruled out, this does not mean that economic regulators’ comfort zone for GDP growth consistent with a soft-landing has shifted. For its part the PBOC would like to see a stronger relationship between interest rates and risk, as well as more efficient allocation of bank credit, but determinations as to the politically acceptable pace of growth remain questions for the Party leadership.
Will additional ‘hot money’ flows in response to the rate hike complicate economic policy management? Possibly, but additional measures to control the property market – property tax trials for example – and other avenues for speculation will be a splash of cold water on speculative inflows. China’s foreign exchange regulator can make life very difficult for shorter-term capital flows, and increasing regulatory risks will help to balance out expectations for combined yields on RMB assets. Capital flows are a reality they will have to get used to if China really aspires to be home to an international capital market, which it does. The hot money phobia that pervades the domestic media in China is a bit of melodrama in our view, as the domestic equivalent to hot money has to be the bigger fear. Nevertheless, efforts to tighten up the leaks in China’s capital controls are reportedly in the works.
The argument that asset price inflation will eventually show up in consumer prices is a bit of a stretch, in our opinion. Prices in financial markets and the real economy are simply different animals. Indexes for some non-food consumer goods have remain within a comfortable range – viewed on either a month-on-month or year-on-year horizon – despite continued growth in property prices, and have always moved in accordance with market supply conditions rather than in step with producer or asset price increases. When China’s stock market crashed a few years ago it had little discernible impact on consumer prices, and the same appears to be true as other asset prices rise. China’s stock markets have hardly been swept away by ‘irrational exuberance’ during the past year, so it is unlikely that this rate move was targeted at domestic bourses.
12th FYP GDP Growth Target: “Above 7, below 8”
The GDP growth target for the next 5 years most often cited in domestic reports is 7-8% per annum. Given the additional goal of doubling per capita GDP from around US$ 4,000 to $8,000-$10,000 by the end of 2020, a slightly lower target rate of growth is assumed for longer-term forecasting (as well as RMB appreciation). This number has to be evaluated in perspective: the target for the 10th FYP was 7%, but the actual average number came in at 9.5%, with the 7.5% target set for the 11th FYP having turned into average annual growth of 10%. Policy makers always like to set targets that they can exceed with relative ease, but this time around there is good reason to believe that they are sincere in their efforts to rein in excessive industrial capacity and inefficient investment by provincial governments. There are, of course, significant institutional barriers to doing so, but the opening salvo of forced industrial consolidations begun by the State Council in September looks like a promising start.
As mentioned above better distributing national income to increase the household share and reduce various measures of income inequality will be priorities under the 12th FYP. This will take the form of doubling down on regional development initiatives to reduce inter-regional economic disparities, such as the Great Western Development Project and Revitalization of the Northeastern Industrial Rustbelt (both of which have been in place for about 10 years), and the Rise of Central China. Provinces included in these schemes are expected to grow at 10%-12% annual rates given the probably scale of government-led investment initiatives. As mentioned earlier, the central government may spend “more than RMB 4 trillion” on its new and emerging industry agenda, a figure which could easily balloon to RMB 10-15 trillion once regional governments nationwide spend whatever they can. If central government efforts to control industrial capacity growth in favored sectors at the provincial-level are unsuccessful, annual GDP growth rates could easily surpass targets. We have not heard much (yet) about possible money and credit growth targets for the 12th FYP period, and these will be important inputs for expectations for fixed asset investment growth.
Another dimension will be to reduce the rural-urban income gap: according to official figures, which are wildly inaccurate, urban per capita disposable income was 9,757 RMB for 2009, compared to just 3,078 RMB for rural per capita cash income. This gap has been widening because of the relatively faster pace of price increases in rural areas for a range of reasons. According to great research by Wang Xiaolu with China’s National Economic Research Institute,once “grey income” is factored into this equation, the actual gap is probably well over 20x, compared with the 3.2x based on the official figures.
This inevitably means taxes. According to our analysis the bulk of this burden is going to fall on state-owned enterprises (SOE) and other companies, rather than households. Yes, a property tax of some form is likely, but in general the government does not want to reduce household spending power any more than it has to at a time when it wants to encourage consumption. A larger share of the mountain of retained earnings on SOE balance sheets will be paid out annually to the Ministry of Finance in the form of dividends, and companies will probably have to expand some contributions to social welfare and retirement programs in the form of payroll taxes.
All in all, economic planners would like to see private consumption account for 55% of GDP by 2015. Greater planned investment in social services, such as efforts to make basic medical services universally accessible, may help to increase household confidence. However, with so much uncertainty about the actual level and distribution of household income – even within semi-official circles – a policy gambit closer to “Friedman’s helicopter” might be more effective.
One last target worth mentioning is that for research and development (R&D) spending. As part of efforts to create an “experimental economy”, policy makers would like to increase the current level of R&D spending economy wide from the current level of around 1.5% of GDP to 2%-2.5% by 2015. For “new and emerging industries”, reports indicate that they would like to see this figure come in at around 5%-6% of total industry sales. If output growth averages 8% during the next 5 years, then this would mean that in 2015 overall R&D spending could top RMB 1 trillion.
Media reports in China have cited “more than RMB 4 trillion” (US$ 606 billion) as the amount that the central government is preparing to spend on its “new and emerging industries plan” during the 12th Five-Year Plan. This news comes out on the same day as new trade figures showing that the US deficit with China is not getting any smaller. Taking these news items and broader political realities into account, it would seem that additional trade tensions between China and major foreign partners may be a foregone conclusion. We don’t say that lightly, and believe that this will be a function of irreconcilable differences between China’s industrial policy ambitions and aspirations for greater exports in the US and other advanced economies.
Industries set to receive support under this plan include: new energy, new and composite materials, IT, biotech, new energy, environmental protection, aerospace, marine technologies and non-specific advanced manufacturing. Related services will also receive some level of support.
In economic terms this kind of industrial support program is indistinguishable from stimulus. With this in mind, we might infer from the size of this likely spend that economic planners are counting on a relatively large level of support necessary to balance out other aspects of China’s pending structural transition. This includes the consolidation of the automotive, steel, cement and other sectors already underway, and could also mean that new regulations targeting environmental protection and energy efficiency are also in the works.
As was the case with the financial crisis response stimulus plan, RMB 4 trillion will probably easily turn into RMB 10-15 trillion once regional governments announce their own plans. As a regional economy Shanghai is reasonably small, but has announced its own plans to spend RMB 100 billion on its own industrial policy package. With 30 more administrative regions yet to go, a number of which have populations pushing 100 million people, the overall RMB 10-15 trillion level should not be difficult to achieve.
The main reason why it would seem that trade tensions are inevitable is that Chinese government entities – central and local – will probably seek to protect their investments in new industries the way just about any government would. Additionally, the sectors cited so far are those in which the US and major EU producer nations are industry leaders, which means their exports will face obstacles regardless of the assurances of market access that are likely to come out of Beijing.
The catch phrase that we are going to be hearing a lot about in the coming months, and years, is “inclusive growth”, coined by President Hu Jintao. Depending on how things play out a future growth model that is more “inclusive” domestically could easily run the risk of perceived as “exclusive” by foreign firms in the mainland. The key question will become how and when industrial policy is perceived as a form of trade protectionism.
Thinking about China (and the RMB) as an OCA
The answer might well be ‘no’. Nevertheless, we have been giving some thought to whether there are parallels that can be drawn between structural issues in the EU that have contributed to sovereign woes and inter-EU economic imbalances and inter-provincial economic trends in China. There are obvious limitations to such a comparison, but looking at this general question according to the criteria of the theory of the optimum currency area (OCA) might offer some insights into potential plays on the next generation of economic growth in China based on some aspects of the European experience with economic integration.
The rebalancing that needs to take place within China’s domestic economy is as much about economic geography as it is about adjusting the relative contributions of expenditure-side components of GDP. Additionally, the potential for tensions over the level of the RMB exchange rate to flare up, this framework may shed some light on how the potential shock of a currency/trade war scenario would be distributed throughout the domestic economy in China.
The OCA context
First and foremost, an OCA is an economic grouping where overall efficiency is maximized when the grouping shares a common currency and monetary policy. This term and analytical framework is generally applied to groupings of countries, such as the eurozone, but we like the analytical framework it provides for a large and highly diverse continental economy like that in China. At the national-level China’s exchange rate regime has worked well to promote exports and promote domestic price stability. However, at the provincial level, the costs and benefits of the exchange rate regime (as well as the monetary policy choices necessary to sustain it) have served some regions better than others over time.
It goes without saying that individual provinces in China do not have the ability to “opt out” of the RMB, as a member of the eurozone does with respect to the single currency. However, as economic planners in China renew focus on political economy considerations such as reducing intra and inter-regional wealth disparities, the inland migration of coastal industries and urbanization, the policy calculus for variables such as the exchange rate, suitable targets for inflation and interest rates may shift. In recent days a report from the China Academy of Social Sciences (CASS) advocated raising the annual inflation target from 3% to 4%. The underlying logic of such a change is that it would allow greater room for relative price adjustments and in doing would improve the distribution of the resulting income flows. The same logic offers support for the creation a meaningful adjustment mechanism for the RMB exchange rate.
The impact of the recent financial crisis on China’s macro economy, the government policy response and the aftermath provide a natural experiment for the application of OCA theory applied to China. The plunge to exports that occurred following the onset of the crisis in major export markets can be equated to an ‘asymmetric shock’ that undermined the real economies in China’s handful of large exporting regions. With this in mind, the government policy response to pump the economy full of new credit via large state-owned commercial banks would appear to have been more beneficial for those regions of the country most dependent on external demand than the rest. We have to keep in mind, however, that such a policy was geared towards demand substitution, and providing inland regions isolated from the trade shock with extra funds – some of which was spent on output from hard hit regions – accomplished this quite well. The efficiency of many of the new projects started with this sudden inflow of new credit has been questioned by government regulators and analysts alike. Nevertheless, this policy and the common currency across regions allowed the impact of the shock to be spread across a wider geography and over the future.
Observations on economic optimality and convergence in China
If economic efficiency in an OCA is improving, one would expect to see evidence of “convergence” in economic performance across regions. The concept of “optimality” is a relative one, and some notes on economic realities in China relative to OCA criteria are provided below.
China may be a major pole in the ongoing debate regarding global economic imbalances, but policy makers in China are appear to be assigning higher priority to addressing domestic economic imbalances that are a consequence of its growth model. How, why and where China’s domestic economic imbalances intersect with global ones is a topic for further consideration. Various manifestations of income gaps are among the most widely discussed domestic imbalances in China, some of which are related to the concentration of output and exports in a relatively small number of regions of the country. The latter appears to be a natural result from the special economic zone (SEZ) policy in the 1980s and Deng Xiaoping’s famous “let some get rich first” approach, and it seems reasonable enough to conclude that various policies and institutional arrangements implemented decades ago – many of which are still in place – were designed to support such an outcome. .
In other words, the policy mix – including the exchange rate regime – has for many years been oriented towards a certain ordering of the political economy that is not entirely consistent with a domestically driven growth model. Relative to the current geographic distribution of output, the current set of guiding policies make some sense. Relative to geographic distribution of population and employment, however, it makes less sense. As a result, policy makers in Beijing have been struggling for years with the question of how to create mechanisms that will distribute a larger share of national income to households. There are two dimensions to this: distribute household income more equitably in absolute and relative geographic terms. Success in this policy space would help to drive convergence within the domestic economy.
We ran some basic convergence tests looking at relative rates of investment and output growth (both in absolute and per capita terms) and reached one interim conclusion is: despite the fact that rates of investment and output growth in central and western provinces are generally higher than those in coastal regions, “bigness” still matters for growth. In other words, the large initial absolute size of output in coastal regions is still a significant determinant of future growth. The same appears to be true when this question is viewed in per capita terms. If exports, gross and net, have been disproportionate drivers of growth in coastal regions compared to central and western ones, does that mean that the RMB regime is designed for minority of the population?
There are two separate questions here: first, whether institutional arrangements and incentives in China as a unified currency area are promoting increasing optimality, and second whether this would be enhanced by adjustments to the exchange rate itself. We would propose the following answers: as measured by the distribution of investment activity and growth economic efficiency is improving in China, and additional gains would result from the gradual strengthening of the RMB exchange rate. There is certainly plenty of waste and inefficiency that results from skewed incentives (some of the created by the exchange rate regime), but trends in some areas appear to be heading in the right direction.
In “RMB Flexibility and Trickle Down Demand” we made the following case: anchoring exchange rate policy to protect the export multiplier has come at the expense of a wide range of entrepreneurial activities and consumption that would have been possible if the relative purchasing power of the RMB increased more consistently over time. New imports of goods and services have been shown to produce a similar multiplier effect: businesses that start off by importing to meet local demand later become competitive at producing locally. In other words, imports can contribute to new sources of jobs, private income and competitiveness.
In the context of this discussion we might add that the creation of a consistent mechanism for the adjustment of the RMB exchange rate, taking into account increases in productivity and effective household purchasing power, would help increase economic efficiency in China.
OCA criteria applied to China
Some notes on the principle criteria used as measures of the degree of ‘optimality’ in a given currency area and their manifestations in China are provided below. Data limitations, especially those related to wages and inter-regional trade and investment flows, get in the way of this kind of analysis, but the tentative conclusion that we have reached is that China may be turning a corner where it comes to reducing inter-regional economic disparities.
Labor mobility – including the ease of movement of workers and families, as well as the portability of access to public services: Overall, China scores relatively low according to this criterion, despite incremental progress in the right direction. The phenomenon of migrant labor in China is one of historical proportions, but the ability of members of rural households to find employment in a far away city has not been matched by their ability to integrate fully with their new economic surroundings. Restrictions originating with China’s household registry system mean that access to basic social services, such as health, education and general welfare services, for themselves and family members is still tied to their original residence. Policy experiments and pending reforms will probably make some headway in improving overall intra-provincial labor mobility, but inter-regional labor mobility will continue to face significant obstacles.
Automatic fiscal transfer mechanisms to support those regions hit by asymmetric shocks, as well general redistributive mechanisms in support of poorer regions: Credit policy responses in China inevitably take on a quasi-fiscal character. Fiscal response mechanisms are mostly ad hoc, in the form of subsidies and tax rebates. They are generally swift in their arrival, however. Where it comes to more general redistributive fiscal arrangements, inter-governmental transfers from the central government to poorer provincial governments have become an increasingly important feature of China’s public finance landscape. However, the 1994 fiscal reforms enshrined a generally regressive form of tax sharing between the central and provincial governments, in that those regions that are large in economic terms (overall output) were rewarded for being so. Poorer provinces within China have become reliant on fiscal transfers over time, arguably at the expense of developing their allowable local revenue sources, and there is a clear correlation between provincial dependence on fiscal transfers and slower long-term economic growth.
As a bit of an aside, it would appear that geographic restrictions on the transfer of local deposits to fund loans and investments in other regions impose a constraint similar to fiscal ones. Deeper and more accessible capital markets would better distribute funds to those regions of the country that have higher growth prospects in the medium-term.
Factor openness, including wage and price flexibility and capital mobility: This is an area where significant progress has been made in recent years, and one that will benefit from government efforts to spur the migration of certain industrial activities from more mature coastal regions to inland areas. Inter-regional wage and price differentials are pull factors for investment in lower-cost regions. Administrative barriers, in the form of local protections for favored sectors and firms are a reality, but mechanisms for the allocation of resources across regions have improved over time.
Business cycle synchronization: As discussed above, our basic convergence tests indicate that despite the persistence of inter-regional barriers to domestic trade in China, the gradual convergence of the level and pace of economic growth in China has improved the synchronization of the domestic business cycle. Excessive capacity development in some sectors and regions, as well as efforts by local governments to protect their local industries, has gotten in the way of this process, but based on available data the trend appears to be heading in the right direction.
Hong Kong would be an interesting front in a potential currency war between the US and China. The economy of the Special Administrative Region (SAR) has become increasingly dependent on mainland demand, but its monetary system is still firmly anchored to the US dollar. Underlying monetary arrangements imply that when and if China retaliates against pressure for the appreciation of the RMB or trade protectionism in the US, Hong Kong would be caught in the crossfire.
Where it comes to the real economy, Hong Kong’s fortunes are increasingly linked to the mainland: its manufacturing base is located across the border, in 2009 mainland tourists accounted for well over half of all arrivals and spending, exports to the mainland accounted for more than half of the total, mainland purchasers accounted for about one-fifth of real estate demand, and mainland firms accounted for more than half of total issuers and market capitalization in the Hang Seng. Mainland monetary and credit policy are thus of crucial importance for local financial markets and the financial services firms that are a pillar of Hong Kong’s services economy.
At the same time, Hong Kong remains “a vital testing ground for the liberalization of our nation’s national account”, to quote SAR chief executive Donald Tsang. Taking this statement a step or two further, Hong Kong’s economic future and the status of its capital markets depend as much, if not more on the pace and scale of capital account liberalization on the mainland as they do on US Federal Reserve monetary policy and the status of the US dollar. We expect that the Hong Kong dollar exchange rate will continue to function under a currency board for the indefinite future. However, a combination of shifting economic and political realities begs the question of when and how the Hong Kong may one day adopt the currency of its sovereign parent as the anchor for the SAR’s money supply.
Joseph Yam, now former head of the Hong Kong Monetary Authority (HKMA), has at times waxed to the local media about a day when the RMB circulates on the streets of Hong Kong as a unit of ordinary exchange. In certain cafes on Hong Kong Island and in the tourist traps in Kowloon Yam’s vision is already slowly becoming a reality. To date, institutional similarities between Hong Kong and the US, not to mention the paramount importance of free convertibility, have made the US dollar a suitable base for the SAR’s monetary system. However, on the economic side of the base currency equation, Hong Kong’s real economy is now clearly driven by the mainland, as are its financial markets. As growth prospects between China and the US diverge, the relative cost of the current currency board system in terms of the relative purchasing power of the Hong Kong dollar will rise. The HKMA have been good stewards of the SAR’s financial economy, but the future may hold political and economic reality that are entirely out of the hands of the SAR government.
A Legacy of Policy Credibility
Hong Kong has maintained what is perhaps the world’s most credible exchange rate peg – the Linked Exchange Rate System (LERs) with the US dollar – for more than 25 years. Globally, dozens of currency boards have broken down during this time. Since 1983 the Hong Kong dollar has been pegged to the US dollar under a rule-based currency board system that stipulates that Hong Kong’s monetary base must be completely backed by US dollars held by the monetary authorities. Hong Kong inherits US monetary as a result of the dollar peg, and historically there has been a natural correlation between interest rate and business cycles in the two economies. Assuming that currency and trade tensions between the US and China do not escalate too much further, there is no urgency behind any adjustment of the LER mechanism. They could, however, and as economic cycles between the SAR and Hong Kong continue to converge it will probably become increasingly uncomfortable for the HKMA and citizens of the SAR to remain sandwiched between two of the world’s dominant central banks.
Hong Kong’s economic structure is a natural fit for a pegged currency: a small, high income and highly open economy. On institutional grounds, the US dollar, even in 1983 and the early stages of its proliferation as the world’s reserve currency, was an obvious fit for the SAR. Then as now, the micro-economic benefits of reduced exchange rate uncertainty and lower average annual rates of inflation have outweighed the macro economic costs in the form of in the form of forgoing monetary independence and other traditional macro policy tools. Conservative fiscal management by the SAR government and reserve accumulation has sustained market confidence in the LERS system. This structure has endured Hong Kong’s return to the mainland and the gradual relocation of the SAR’s manufacturing base to Guangdong. More broadly Hong Kong’s growth story has been part and parcel to that of globalization and increased trade and financial links between the world’s major economies, perhaps most notably between the US and China. However, the reality today is that the relative contributions to global growth from these economic poles will be very different: China will continue to contribute a share of global growth far above its share of output, whereas the contribution to growth from the US will lag its global output share considerably.
Real Values and Welfare Gains
So far, capital account controls in the mainland have allowed authorities to prevent the normal tendency for rapid output, productivity and income growth to result in exchange rate appreciation. This cannot go on forever. As a historical window to China, Hong Kong has served as a pass through point for producer and consumer price differentials between China, the US and other major trading partners, with the Hong Kong dollar (and in reality local real wage levels) absorbing the difference. China effectively pegs to the US dollar on the downside, and manages the real appreciation of the RMB on the upside, both of which are trends that would be compatible with the trade competitiveness of a Hong Kong dollar more directly linked to the path of the RMB.
The Hong Kong dollar is pegged to the currency of a mature sovereign while Hong Kong’s real economy is tied to a global out-performer. With this in mind, it is not surprising to observe that wage and productivity growth in Hong Kong began to diverge around 2002: employers in Hong Kong, especially in manufacturing and services sectors, were able to benefit from the rapid productivity growth and low wages on the mainland, while at the same time granting wage increases to Hong Kong staff more in line with output and inflation trends in the US.
Most of the literature on large adjustments to or regime transitions away from a pegged exchange rate focuses on predictable effects of real overvaluation: excessive borrowing, investment and consumption. On the flip-side of such a scenario, it is natural enough to imagine a scenario where persistent undervaluation would stifle domestic demand in reverse fashion: real purchasing power of local residents is depressed, making investment in domestically oriented sectors less profitable than externally oriented ones.
As noted above, we expect positives differentials to growth, consumer and producer price trends between China and the US to persist in the medium-term. From a welfare perspective, the crux of the issue then becomes the extent to which producers and consumers in Hong Kong may have to absorb these differences. It could well be the case that wage levels in the SAR remain effectively anchored to US productivity growth, while at the same time overall productivity growth in Hong Kong becomes increasingly tied to mainland per capita GDP growth, which is expected to grow at a multiple of the corresponding US rate. From a relative wealth perspective, the accumulated wealth of Hong Kong residents, as well as their future income flows, could potentially be worth more if they could follow the path of the Chinese economy and the RMB rather than being weighed down by the performance of the US economy.
One facet of the prevailing wisdom regarding the success of Asia’s export-led development model has been the fundamental proposition that over-valued exchange rates are bad for growth. However, the converse statement – that an undervalued exchange rate is beneficial for growth – may not necessarily fit a high-income services exporting economy, such as Hong Kong. That is to say that the undervaluation of the Hong Kong dollar means that the SAR is to some extent borrowing demand from elsewhere at the expense of the reduced wage levels and purchasing power of local SAR citizens.
Undervaluation has also meant that Hong Kong has been able to borrow purchasing power from mainland and European tourists. However, narrowing the purchasing power gap between the Hong Kong dollar and RMB via an adjustment to the exchange regime would not necessarily reduce incentives for mainland shoppers to splurge while visiting Hong Kong in the future: any appreciation of the RMB relative to other major world currencies would increase purchasing power for imported goods, like flashy watches and designer handbags. Additionally, the mainland authorities’ management of the RMB real exchange rate has meant that when the US dollar sinks in value relative to other major currencies, the RMB falls too. If the Hong Kong dollar were more closely aligned with the RMB the SAR would remain an attractive shopping destination for mainland tourists when the RMB strengthens. At the same time, when the US dollar weakens, authorities on the mainland would work to preserve the general competitiveness of the currency relative to the rest of the world, supporting Hong Kong’s exports.
Practical Options?
Re-pegging the Hong Kong dollar to the RMB would be a potential means of hedging the negative wealth effects that would occur in Hong Kong if there were a US dollar crisis, for example. Additionally, in its own explanation of the potential consequences of such a one-off adjustment to the value of the Hong Kong dollar relative to the US dollar, for example, the HKMA acknowledges that this could alleviate the pain of the price and wage adjustments required to maintain the LER. For the time being, however, such a step would be counter to the overarching policy goals of stability and free convertibility. One practical matter – the relatively small scale of total RMB deposits in the Hong Kong banking sector – has been cited as a practical obstacle to the conversion to an RMB-based monetary system in the SAR. This argument is, in our opinion, rather spurious, as, for example, any country that has ever acceded to a currency union did not have to wait until it accumulated an adequate level of the right deposits or reserves in the financial system before they could transition towards new monetary arrangements. If the SAR and the mainland wanted to pull off such a conversion the infrastructure (not to mention political will) is adequate for this to be achieved swiftly and decisively provided there was adequate alignment between real economic cycles in the two regions.
Another oft cited intermediate option is the creation of a currency basket regime to guide the adjustment of the value of the Hong Kong dollar. Although such a mechanism would likely help to preserve the relative purchasing power of local wages – especially relative to the euro – it would not solve the underlying problem created by growth divergence between the mainland and the OECD, and greater convergence between the mainland and Hong Kong economies. Additionally, the removal of the US dollar anchor (or the absence of such an anchor, USD or RMB) would subject the Hong Kong dollar to new speculative pressures without a hard option for responding to them.
Numerous households and companies in Hong Kong have acquired assets on the Mainland, in part as a hedge against the long-run depreciation of the Hong Kong dollar relative to the RMB. The HKMA’s Exchange Fund, however, does not have the luxury of being able to hedge in favor of an appreciating RMB or against a large and sudden depreciation of the US dollar. So what if a real currency war broke out? Not one where countries intervene to hold down the relative values of the currencies, but one in the spirit of Lenin where countries try to overturn the “existing basis of society” by debauching the currencies of their rivals? In a grandiose act of magnanimity the mainland could offer to swap RMB for foreign currency assets of Hong Kong citizens, but this would leave it with even more unwanted foreign paper and could serve to strengthen, rather than weaken the US dollar. In the absence of some sort of engineered financial protection from the mainland, little Hong Kong (and for all of its sophistication and glamour, it is, after all, little), could be toast.
Curiously, demand for real assets in Hong Kong has been strongest from Mainland purchasers, serving as an indicator that the RMB is a long way from being a “safety play”. At the same time however, citizens of the SAR have been big buyers of real estate throughout China, and demand for RMB denominated insurance and other financial products in the SAR has been growing quickly. One has to distinguish, however, between the potential revaluation to assets in Hong Kong linked to the mainland associated with the appreciation of the RMB, and trends in household income in the SAR. For example, shares of companies whose core assets and operations are on the mainland but whose shares are listed in Hong Kong may benefit from a stronger RMB. A stronger RMB would also make property investments in Hong Kong relatively cheap for mainland buyers. However, as described above, household income flows (as opposed to stocks of financial or real assets) have not performed more like those in the US than those in the mainland in recent years.
Looking Ahead
In the longer-term, the mere question of increasing competition between Shanghai and Hong Kong implies that the regional financial hub of the future could be the one that provides the best RMB financial services at the lowest cost. To meet this challenge, economic policy makers in Hong Kong have proposed that the SAR can become an offshore RMB center, similar in function to the role that London plays as an offshore financial center for the US dollar. While this is a possible outcome that Beijing appears to be considering, it presupposes that the RMB will have become adequately convertible for capital account transactions (a large assumption), and that the flow of RMB transactions in Hong Kong’s capital markets will no longer be dependent on the preferences of regulators in Beijing. Frameworks to enable the growth of RMB securities business in Hong Kong are in place and local banks are staffing up ahead of this prospective market, but to date the deal flow has been sporadic.
Suppose for a minute that the RMB eventually becomes adequately convertible to create on or off-shore markets for RMB securities more successful than those for the yen, and that global issuers (including mainland ones) can freely choose the timing and location of their RMB deals. If these conditions are met, then the underlying rationale for the US dollar as the anchor for Hong Kong’s monetary system would be even more of a political determination than it is now.
As we have written elsewhere, thinking about currency wars and arrangements in simply economic terms is inadequate: there has to be some accounting for the underlying politics, which do not have to (and rarely do) follow strict economic logic. Hong Kong is and will be a highly useful laboratory for experiments related to the incremental liberalization of the RMB. When that utility is exhausted, however, it could well be the case that mainland authorities decide that ‘one country, two currencies’ has outlived its political usefulness.
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