China’s macroeconomic policy dilemmas

Like many with strong opinions, I sometimes criticize (politely, I hope) press coverage of topics that I follow closely. 

For example, I have long thought that coverage of China’s consumption boom should be qualified by noting that exports and investment continue to grow faster than consumption.    As a result, consumption is still trending down as a share of China’s GDP.  That helps to explain how savings growth has been able to outpaces investment growth.   China’s current account surplus is rising, not falling.  

But more often than naught, I am impressed by how well the financial press covers difficult topics.    For example, Andrew Batson’s reporting of China’s very strong first quarter GDP in Friday’s Wall Street Journal hit all the right notes.    Batson's reporting combined reactions to China's GDP data from some of the best Anglophone China watchers around – Jon Anderson, Nick Lardy, Louis Kuijs – with the reaction of key Chinese policy makers.

Li Xiaochao – the spokesperson for China’s National Bureau of Statistics – seemed to indicate that China intends to continue to take a series of small steps to try to slow its growth without changing too much.

“One very important lesson we have learned is not to make excessively large policy adjustments but rather to take small micro-steps and fine-tune them.   The aim is to avoid a hard landing of the economy.”

China has avoided a hard landing.   But it also hasn’t really started on any approach path that will lead to a landing of any kind – hard or soft.  Its economy is gaining altitude. 

Consequently, a key question that arises from Batson's reporting -- and Li Xiaochao's statement -- is whether a new set of small steps will work better than the small steps that have been tried so far.   A tiny appreciation against the dollar, for example, won’t work if the dollar continues to slide against other currencies.

If China’s goal is to avoid too big of a boom now in order to limit the risk of a big bust later, its existing policy approach hasn’t worked.   Stephen Roach made this point quite clearly last Friday.

It’s been about three years since the current tightening campaign began.  Yet China’s GDP growth has accelerated steadily over that period, from 9.5% in 2004 to 9.9% in 2005, 10.7% in 2006, and now to 11.1% in 1Q07. 

Roach expects – based on his conversations with key Chinese policy makers – that China will take more decisive actions to cool its economy.   The credibility of China’s leadership is one the line.   He expects China to use administrative controls to clamp down on investment.

Clamping down on investment has worked in the past.  Think back to early 2004.   But it has consequences.   It is a step away from relying more on markets and less on central planning to govern China’s economy.    Restraining domestic demand growth (by curbing investment) rather than restraining export growth (by allowing the RMB to appreciate) also has tended to increase, not decrease, China’s current account surplus.   

I suspect that a new round of administrative tightening – perhaps accompanied by a removal of tax preferences for exports but not accompanied by sufficient RMB appreciation against the dollar to offset the dollar’s slide v other currencies – will deliver more of the same.

Another China watcher -- Eswar Prasad -- implicitly recommends a different policy course.   Call it less NDRC, more PboC.  Or less central planning and more central banking. 

Prasad argues that China needs to rely more on the traditional tools of macroeconomic management, like interest rates.    In order to do so, China needs to let its exchange rate move.    Otherwise, higher Chinese rates will just suck more money into China, thwarting the desired tightening (India is discovering this now).    China needs higher rates than in the US to curb investment growth -- and to make it attractive for firms to put their profits on deposit in the banks rather than plough them back into anything that offers a nominal return of 2-3%.   But higher rates will pull in more money (or would, but for controls) and work against China’s ongoing efforts to encourage private capital outflows unless there is a meaningful chance the RMB will fall.

Prasad thinks China’s authorities want financial modernization more than exchange rate flexibility, and consequently recommends framing external demands for more flexibility as a necessary part of financial modernization.   Without the ability to raise interest rates in a meaningful way, China will be forced to rely more and more on administrative controls.    After all, the banks are very liquid and have plenty of funds to lend out.   And interest rates are too low to curb demand for borrowing. 

Prasad’s position has long appealed to me.   But I am losing conviction.  I suspect China probably missed the window when it could have gained a degree of monetary autonomy with a modest revaluation and a bit more RMB “flexibility.”  

By waiting, China let pressures build.   China’s current account surplus is on track to reach $350b, if not more, this year.    To bring about balance in the absence of government intervention, China needs to let the RMB appreciate enough so that import growth rises and export growth slows enough to bring the surplus down.  OR it needs to let the RMB rise to the point where there are strong expectations that it will fall.  That would induce $350b of private capital to flow out of China in a world where Chinese rates are higher – not lower – than they are today.  

To gain monetary flexibility, China now needs – I suspect – a rather large revaluation.   One large enough to end strong expectations of further appreciation.   One large enough to induce private capital outflows even with higher Chinese interest rates.   I don’t think China’s authorities are willing to let that happen. 

That implies that administrative controls will remain the main policy tools available to China’s authorities.   But changes in prices controlled by the government can also play a role.  The RMB/ dollar is certainly one such price.

I consequently hope that China relies a bit more on RMB appreciation to slow export growth and a bit less on administrative controls to curb domestic investment this time around.