Features : The perils of prosperity


As the dust settles after the Olympic games, China is facing a less certain economic future.


Relentless progress: Construction work in Beijing’s booming central business district.

China opened the 29th Olympic games on August 8 with a grand display of music, dancing, acrobatics and pyrotechnics. But while Chinese acrobats performed for the world and Chinese gymnasts competed for gold medals, a less publicized contest of skill and balance was taking place in China’s economy. This contest continues today, and the stakes involved could be far more important than China’s final Olympic medal count.

The primary participants in this contest are China’s policymakers, and their task is to carefully balance monetary pressures and economic growth against the backdrop of a struggling global economy. The challenges involved are not new, but the swelling size, growing influence and increasing complexity of the Chinese economy have made the balancing act much more difficult than in the past.

One of China’s key tools in this act is monetary policy. China has a lot of money, and more of it arrives every day. The reasons are straightforward: Foreign companies like to invest in China. Foreign direct investment has soared in recent years, with an increase of 42% year-on-year in the first eight months of 2008, according to China’s finance ministry. Exports also play a huge role. China produces and exports much more than it imports and consumes. The revenue from these export sales generally returns to China, where it is often re-invested in expanding capacity.

China’s relatively rigid exchange rate regime is the final piece of the puzzle. Although China has allowed the yuan to appreciate moderately over the past three years, the government retains tight control over the exchange rate. Most analysts, academics and investors believe the yuan is still undervalued and that further appreciation is likely. For this reason, those with deposits in yuan are reluctant to change them into foreign currencies. The longer they wait, the better the exchange rate will likely be. It is also bringing so-called hot money to China, as speculators bet the currency will continue to strengthen.

Awash in cash, China is inevitably suffering from inflation and a potential for over-investment. Chinese banks hold much of the country’s money and, by the nature of their business, face pressure to lend it. Many of these loans flow into real estate, a sector that has recently shown signs of overheating (see box). Other loans go to companies that invest the money to expand capacity. In the past, this expanded capacity would supply global markets. But this capacity has already grown rapidly in recent years, and global demand may be slowing.

To limit inflation and over-investment, China’s central bank has maintained a tight monetary policy in recent years, raising the interest rate six times last year alone. Whether a result of these tightening measures, an easing of external pressures or cyclical corrections, inflation decreased in August to 4.9%, its lowest rate since June 2007.

Not all the signals are so encouraging, however. Producer price inflation is on the rise, with a 10.1% year-on-year increase in August, its highest level since 1996. William Hess, manager of the Greater China team for research and consulting firm Global Insight, explains: “We think growth in consumer prices will continue to go down through the end of the year, with total CPI settling around 7% for the year. But the numbers on the producer side are still strong.” He continues: “A lot of the drop in corporate profitability has been cost-related. It has been a difficult year for a lot of producers.”

Overcapacity Threatens Profits
Producers’ difficulties are not limited to inflation, Hess goes on to explain. “The other side of it is that the manufacturing economy has expanded so quickly for so long that there is a lot of capacity there. Exports are slowing, so the thought is that much of this output could find its way back into the domestic economy,” he says. “For this reason, prices for non-food items—consumer goods like clothing and footwear—have actually been falling.”

With rising costs and less pricing power, businesses in China are already beginning to suffer—by Chinese standards, at least. According to the state-run Xinhua News Agency, corporate profitability is on the slide, with China’s listed companies reporting average income growth of about 16% year on year in the first half of the year. Corporate profits of China’s listed companies grew 70% in the first half of 2007.

The difficulties producers face point to another central element in China’s great balancing act: maintaining a sustainable level of economic growth. China has tightened monetary policy to fight inflation and over-investment. But now, as the rate of global economic expansion continues to slow, the tight monetary policy could limit economic growth in China. Policymakers are treading a fine line as they try to find an appropriate balance between limiting over-investment and inflation on the one side and maintaining stable economic growth on the other.

Again, though, China is dealing with a high-class problem. Its economy grew by an astounding 11.9% in 2007, and while it has slowed in the first half of this year, year-on-year GDP growth is still over 10%. Significant challenges lie beneath these big growth numbers, however, and Chinese policymakers are carefully devising strategies to make sure that if growth continues to slow, it slows moderately, without any drastic swings that could upset the country’s social balance.

The considerations in devising this strategy are many. Foreign demand for Chinese products could weaken significantly if economic growth in the country’s primary export markets continues to slow. The appreciation of the Chinese yuan, a trend that is almost certain to continue, makes exporters’ products more expensive in these markets. If exports slow, policymakers must look to domestic demand to pick up the slack, but while domestic demand has been strong in recent years, most of this demand is fueled by new investment. If the global market experiences a prolonged downturn, China cannot rely on investment alone to prop up domestic demand.

“There are three pumps to the Chinese economy: domestic consumption, fixed asset investment and exports,” explains Michael Pettis, professor of finance at Peking University. “If the export pump weakens, then fixed asset investment will also weaken eventually. Investment cannot really be the engine of growth if exports are slowing, because the increased production needs the export markets.”

If investment slows, which is eminently possible, China must rely more heavily on consumption to counteract any lessening of demand overseas. Recent data does, in fact, show some encouraging signs of a pickup in domestic consumption. Most notably, the country’s retail sales have risen steadily in recent months, hitting a nine-year-high growth rate in July of 23.3%. But this pickup in growth may be difficult to sustain. “Domestic consumption shot up recently, but the jury’s still out as to why,” Pettis continues. “It could have been an Olympics effect, with people spending money on new televisions, athletic clothes and travel to Beijing. This may explain the big jump. We have to see what happens over the next few months.”

Deutsche Bank senior economist Syetarn Hansakul warns that the strong retail momentum may not last. “We expected retail sales to be strong, to have positive growth, but not to the tune of 20-odd percent. That surprised us.” She adds: “But if the US downturn is prolonged, this will not be sustained. When the export business is slowing down, that will eventually translate into the consumer psyche.”

Government May Take Up the Slack
If this happens, however, Hansakul believes that the government will step in with its own investment plans. “If household consumption starts to slacken, then we can look to the state to turn up the volume on infrastructure spending,” she predicts.

Global Insight’s Hess agrees that government spending can spur economic growth if needed. “If exports slow,” he explains, “there are tools the government can use to prop up demand. The government has already been spending a lot of money on education and basic services, and there’s still a lot of room for that.” He expects government spending to pick up later this year and next.

Greater infrastructure and social services investment would help China on several fronts. First, the investment will stimulate the economy. China’s 10.4% growth is still the fastest of any of the world’s largest economies. But to absorb the growing labor force, the country needs this strong growth or the risks of unemployment-related social tensions will rise. On a similar note, improvement in social services and public facilities will also help diffuse potential social tensions. Finally, improved education and infrastructure will solidify economic foundations for future growth.

The government will also implement policies to strengthen its small and medium-size enterprises (SMEs), Hess believes. These companies tend to be labor-intensive and concentrated in areas the government would like to develop, especially the service sector, he points out. Most of China’s SMEs have also suffered from recent monetary policy tightening, with capital constraints severely limiting growth.

The government is already taking steps to promote SME growth. China’s ministry of finance on September 11 announced plans to invest 3.51 billion yuan ($511 million) this year to support SME development. The government will offer lower tax rates for SMEs, open up new avenues for raising capital and encourage government entities to purchase products and services from SMEs, according to the ministry’s statement.

China’s central bank will also introduce a pilot program allowing some SMEs to raise money through corporate bond issuance, domestic media have reported. Only a handful of SMEs will participate initially, but the program could eventually expand in scope, increasing opportunities for China’s SMEs to realize their economic potential.

As China’s economic miracle continues into its post-Olympics period and the country celebrates 30 years of increasing openness and reform, the country’s leaders face some complicated challenges. The balance of economic forces— internal and external, private and public, pro-growth and anti-inflation—will be difficult to maintain. But China’s leaders, like its athletes, have shown adroit skill and unparalleled balance, and its leaders, like its athletes, may yet impress the world with their results.

China pegs the value of its currency, the yuan, to a basket of currencies. Few people know the exact formula used, but most people agree that the yuan is undervalued. For this, among other reasons, more money comes into the country than leaves it. Each time a bank exchanges Chinese yuan for foreign currency, the Chinese government adds foreign currency to its ballooning foreign exchange reserves.

And “ballooning” is no overstatement. These foreign reserves stood at $346 billion in June 2003. By June this year China’s foreign exchange reserves had grown to $1.8 trillion. For most of those past five years the increase in foreign exchange reserves stemmed from China’s popularity as a source of foreign investment and its famously high trade surplus. But that is changing, according to research published recently by Peking University professor Michael Pettis and economic analyst Logan Wright of Stone & McCarthy Research Associates. Pettis and Logan point out that in 2005 and 2006 the trade surplus, foreign direct investment and interest on reserves accounted for 80% to 90% of foreign exchange reserve growth. In 2007 the three elements dropped to 70% of the total new accumulation. From January through May of this year, however, Pettis and Logan estimate that it dropped to 39% of the total foreign exchange reserve growth.

The source of the other 61% is unclear, but most signs point to speculative capital inflows, also called hot money. Hot money flows into China when speculators bet on the continuing appreciation of the Chinese yuan. This money, as Pettis and Logan point out, is de-stabilizing for the economy. During strong growth periods it tends to flow in and supply money for investment. But when the economic cycle turns downward, hot money quickly exits the economy. In this way, hot money magnifies the ups and downs of the economic cycle.

Policymakers recognize the problem, but their options are limited. Some domestic media have reported that the government will more closely examine uses of foreign investment. Such efforts may slow capital inflows, but hot money will probably continue to flow into the country as long as the yuan is artificially undervalued.

Unfortunately, hot money also complicates further currency appreciation. Faster appreciation will reward speculators. Slower appreciation will prolong imbalances. In either case, hot money will continue to cause headaches for China’s policymakers.

Thomas Clouse