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21 Jun 2013

Chinese model runs out of road

Stephen King

by Stephen King

HSBC Group Chief Economist

Chinese model runs out of road

Beijing has had to search for alternative sources of rapid economic expansion

Before the onset of the global financial crisis, China could be relied upon to export its way out of trouble. Year after year, its exports grew at an annual rate well in excess of 20 per cent. As its current account surplus rose, its economy expanded with a swagger that became the envy of the world. Now, however, China’s export growth has faded, its current account surplus has almost disappeared and Beijing has had to search for alternative sources of rapid economic expansion.

For a while, Beijing thought it had the answer: if exports weren’t expanding quite so quickly, the infrastructure tap could be turned on

For a while, Beijing thought it had the answer: if exports weren’t expanding quite so quickly, the infrastructure tap could be turned on, helped along by easy credit. It was the ultimate Keynesian stimulus. No one could object to infrastructure investment because, compared with the industrialised world, China’s infrastructure was still in its infancy.

Beijing’s subway system, for example, is tiny compared with the London Underground or the Paris Metro. Yet, even as infrastructure spending increased and social credit expanded, the Chinese economy was unable to regain the buoyancy of old. While the mid-2012 dip could conveniently be blamed on the eurozone crisis, the renewed weakness in the first few months of 2013 could not be so easily brushed off.

With its feet now firmly under the desk, Beijing’s new administration has had a re-think. As Premier Li Keqiang stated last month: “To achieve this year’s economic targets, the room to rely on stimulus policies or government direct investment is not big – we must rely on market mechanisms...We must revitalise private investment and spending through deregulation and other reforms.”

It's easy to see why Beijing might be concerned with the old “pump-priming” model. Alongside excessive credit growth, it has become increasingly clear that the marginal return on capital has been declining rapidly. Put another way, more pump-priming has led to slower growth and bigger financial imbalances.

The focus now is on supply side reforms designed to strengthen the economy’s foundations. As ever, there will be near-term costs. Interest-rate liberalisation is a perfectly sensible move but is likely to increase the cost of funding in the short term. Reducing government administrative spending may lead ultimately to a more efficient allocation of resources but will, in the short term, dampen demand. Introducing market pricing for a range of utilities – water, electricity – may take Chinese companies and consumers into the real world but may also squeeze real incomes. And, in a bid to encourage more in the way of private investment, the iron grip of the state-owned enterprises will have to be eased: that means more competition but, inevitably, a great deal of resistance too.

Two implications stem from this. First, Beijing is willing to tolerate a lower growth rate in the short term than might have been the case earlier in the financial crisis. Supply side reforms may dampen growth near-term but, by reducing dependency on potentially wasteful pump-priming, they may also reduce some of the “fat-tail” downside risks that China might otherwise have to contend with. Second, following a period of weak data, there is no longer the guarantee of a Pavlovian knee-jerk pump-priming response. The message is clear: Beijing is increasingly concerned about the quality, not the quantity, of growth.

Yet there are limits. A growth rate sustainably below 7 per cent would probably lead to big job losses for migrant workers, as occurred in 2009. So despite the emphasis on supply side reform, Beijing may still need to provide a safety net should economic growth slow to a crawl. With a fiscal surplus in the first five months of the year and, if necessary, room to cut interest rates, pump-priming measures could still be dusted off. Given its new emphasis on the supply side, however, Beijing will prefer to keep its powder dry unless it really has to act.

HSBC’s new forecasts, courtesy of Qu Hongbin, Chief Economist for Greater China, suggest economic growth of 7.4 per cent both this year and next (down from 8.2 per cent and 8.4 per cent, respectively). While still impressive, these gains are much lower than the double-digit increases regularly seen before the onset of the financial crisis. China, however, is being realistic: it is not immune from developments elsewhere in the world and, like other countries, doesn’t possess a stimulus “magic wand” to return easily to the growth rates of old.

The implications for the rest of the world are discomforting. Supply side reforms should safeguard China’s future but, for other countries, the bigger concern is likely to be the near-term loss of Chinese demand momentum. The most obviously vulnerable are China’s near neighbours. The bigger challenge, however, may be for those commodity producing countries that previously lived off a heady cocktail of strong Chinese pump-priming and, thanks to the Fed, easy credit conditions. For them, 2013 is turning out to be a challenging year.

This article was originally published in The Financial Times on 21 June 2013.

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