(This interview was published in DNA edition dated November 30, 2009.)
China’s economic growth model, which served it well for 30 years, is due for a structural overhaul because of changes that wrack China and the world, according to Dragonomics Research and Advisory managing director Arthur Kroeber. In an interview to DNA Money’s Venky Vembu in Hong Kong, the Beijing-based erstwhile journalist surveys the economic landscape. Excerpts:
When China’s GDP grew 8.9% in the third quarter, your research said, “the structure of growth stinks.” Growth is expected to be 10% this quarter. How does that smell?
In the first three quarters of 2009, about 95% of growth came from investments. That’s far higher than is the case even during a cyclical investment boom in China, and is not sustainable. For the whole year, we’re looking at 8% growth this year, and maybe 8-8.5% next year. I’m sceptical about claims that China can somehow grow 9-10-11%. I don’t think that’s possible.
8% growth is sustainable, but over the next few years China has to move from 8% growth that’s coming 95% from investments, to 8% that’s balanced between investment and consumption. Current policy measures have succeeded in stabilising economic growth, but have not addressed structural problems in the economy.
If distorted investment-led growth is a problem, why did Chinese policymakers go for it?
In the fourth quarter of 2008, as far as we can tell, quarter-on-quarter GDP growth was about zero. China faced a severe demand shock, and leaders responded with a stimulus, almost of all of which pointed to investments. It’s a perfectly legitimate thing to do – as a short term measure. But it needs to be followed up with more medium- and long-term measures to change the structure of the economy.
What kind of structural reforms are needed, and is it happening?
There are three major areas where structural reforms are needed: (a) financial system (b) fiscal system and (c) services markets.
In the financial system, there have actually been a lot of reforms, and I feel they will proceed at a rapid pace. But nothing has been done on the fiscal front. It presents a political problem, and I don’t expect anything to be done at least until the next government takes over in 2012. As for service sector deregulation, we’ve seen a lot of lip service, but nothing concrete.
On balance, there are reasons to be cautiously optimistic that they will eventually get these things right, but there are also reasons to be concerned.
What kind of fiscal sector reforms are needed?
First, there needs to be a lot more government spending on social services; in fairness, they’ve started doing that: we’ve seen increased government spending in education, healthcare and pensions. But more broadly the fiscal structure needs to be change so local governments have fewer incentives to overinvest.
Did the 4 trillion yuan stimulus do its job or did it feed the structural imbalances?
The 4 trillion number is kind of fictional. What we’ve seen is a significant increase in government fiscal spending, but more importantly, a large increase in bank lending, and borrowing by local governments via the bond market. The actual amount of increased spending this year is considerably more than 4 trillion yuan. The stimulus was meant to get a lot of construction projects started, and it seems to have done that – initially in infrastructure and subsequently in the property sector.
What about concerns that bank lending was misdirected into stocks and proprety markets?
That issue is overstated. Most of that money went into physical projects or is sitting around waiting to be deployed in physical projects. Yes, there is extra money in the property market, and you are likely seeing signs of asset price inflation. If prices rise further, you could have a social equity problem, with a large number of people priced out of the market.
When the stimulus effect runs out, if we don’t see global growth return, will China need a second stimulus?
The problem is the opposite: what China wants is not a second stimulus, but to get a sense of how quickly it needs to withdraw the current stimulus. Right now, we have inflationary pressures, particularly in the property market. If you had the same level of monetary expansion next year as you had this year, it will affect the consumer price inflation as well.
Why does China need to change its growth structure, which has worked well for 30 years?
China is heading towards two turning points, both of which indicate that a change of economic structure is necessary. First, over 30 years, the dependency ratio (the ratio of people of non-working age per 100 people of working age) fell from about 80 in the early 1970s to under 40 today. But it will now start to rise as the population ages.
Second, for the past 20 years, average export growth was about 20% (in US dollar terms); since 2001, when China entered WTO, until 2008, the average export growth was 27%. This year it will be minus 10. In the coming years, it will be of the order of 5-10% – much lower than in the past. The productivity growth and the technological transfer that come from rapid export growth will be reduced.
Two of the significant contributors to Chinese growth will, going forward, contribute a lot less than they did in the past. The challenge for economic policymakers in China is to address this problem. Demographic transition can be addressed by investing more in human capital: educate people better so that even though there are fewer workers, they become more productive and can work more years. And to counterbalance export growth slowdown, domestic demand needs to be more, with higher emphasis on generating efficiency in the domestic economy. Capital productivity is a big part of this.
Does ‘capital productivity’ mean fewer investments?
China invests in infrastructure and heavy industrial capacity, which are good things, but offer low fianancial returns, particularly when done by state-owned enterprises (SOEs). This needs to be shifted so that there is less investment by SOEs, and more by private enterprise, which invests more opportunistically, on whatever works. That’s a gradual process, over time. But for this, the private sector must have industries it can invest in, which is well served by opening up the service sector.
How long will the transition take?
It’s a 10-year process. Initially, capital allocation will be better and efficiency of investments will improve. A social safety net will be built. After that’s gone on for several years, it should generate more household income. The share of private consumption in GDP fell sharply over the past decade. If good things happen, and are supported by demographic trends, it should be possible to increase private consumption growth over a decade.
Retail sales numbers in China are over the top. What’s with them?
China’s retail sales numbers sometimes make no sense. End 2008, when we knew quarterly GDP growth was zero, and some 20 million people were laid off from export industries, and wages were weakened substantially, retail sales accelerated! That’s unbelievable. Technically, they are not comparable with retail sales statistics elsewhere: they measure not just retail purchases but wholesale as well – not just household consumption but purchases by governments and businesses. So you need to look beyond retail sales numbers to get a sense of private consumption.
How does one account for the dissonance between 65% car sales growth and virtually flat fuel sales?
Throw those car sales growth numbers out of your head. A more accurate measure would be the increase in the total stock of passenger cars. For years now, the stock of passenger cars on the road has grown, on average, around 20-25% a year. Over the same period, apparent gasoline demand growth was about 9% a year. So there’s been a persistent discrepancy.
The likely explanations are (a) people are buying more smaller, fuel-efficient cars; second, they may be driving their cars less, and there’s anecdotal evidence of that. Most people in China are first-time car buyers who are drawn by the low sticker price but don’t calculate the operational cost. When they realise the operational cost implications, they drive a lot less.
You have to distinguish between infrastructure and property. The infrastructure that China builds is mostly economically productive; even if it doesn’t offer financial returns in the short run, it provides economic returns in the long run. China still has a huge infrastructure deficit, and needs to build next-generation infrastructure – high-speed rail networks, for instance. The alternative is, as in the US, to put everyone in cars – but there isn’t enough oil in the universe to keep them on the road. Even if there is waste in infrastructure, most of it is necessary and efficient.
In the property sector, there are some problems – but even there, there’s a difference between residential (80% of the property market) and commercial real estate. In terms of macroeconomy, the commercial real estate is such a small part.
If you travel in Chinese cities by night, you may see no lights on in many residential buildings. But these are apartments that were sold – and remain unoccupied. That’s because given the underdeveloped financial markets and inadequate social safety nets in China, property is a major investment vehicle. Second, there is no property tax, so the carrying costs are low; buyers can leave it empty for years, looking only for capital returns.
The peg of the renminbi to the US dollar is generating friction. How urgent is the need for RMB appreciation?
It’s a problem and the Chinese will be forced to do something by the second half of next year. Earlier, China was under pressure from the US, but now those frictions have been passed on to Europe, Brazil and elsewhere. It’s very difficult for China to say ‘It’s the evil Americans who are beating us.’
More substantively, the real exchange rate needs to appreciate. This can be done either by appreciating the nominal exchange rate – allowing the RMB to appreciate – or living with a slightly higher level of inflation. But China had a free lunch for many years until 2004-05 – when it ran a very high-growth economy, did not appreciate its exchange rate and did not have inflation. Perhaps some policymakers think the free lunch will continue forever. But by next year, they’ll have to do one of three things: settle for a lower growth; raise the exchange rate; or allow inflation to rise. Even Chinese policymakers who understand this may find all the options unpalatable. There’s a lack of consensus in the government about what to do and what the mechanisms for adjustment must be. But I think they’re going to be forced to act by next year.
Earlier this year, there was breathless talk of the RMB as a reserve currency. Can it happen?
The Chinese government never gave any indication that it had an interest in seeing the RMB as a reserve currency. But there was a lot of loose, ill-informed talk from others about that. There is a lack of understanding about what a reserve currency is. Right now, there are three reserve currencies: the US dollar, the euro and the yen. People failed to distinguish between a reserve currency in general – which is any currency that people are willing to hold some of their forex reserves in – and the principal reserve currency, the US dollar. There are two types of reserve currencies – primary and secondary – and the RMB is neither. What is requires for the RMB to get there is to get convertible, for China to have deep and liquid debt markets that people can park a part of their excess holdings in and get into and out of easily and quickly without affecting the price. China’s currency is not convertible; China doesn’t have debt markets that enable that to happen; and when you think of all the structural requirements needed to make the RMB convertible, it will take a minimum of 10 years – and probably more like 20 years.
You argue that there isn’t a realistic alternative to the dollar as a global reserve currency. In the event of a trade friction, cannot China drop the ‘dollar bomb’? Can they not afford to do it?
It’s not just that China cannot afford to it. It cannot do it. If they sell their dollar holdings, they have to buy something else. What will it be? No one has an answer.
There’s not enough JGB (Japanese government bonds), or euro securities – or iron ore mines – in the world to absorb anywhere near enough of China’s needs. There just isn’t enough. So, it’s not that they cannot afford to. It’s that they cannot. Impossible!