Thursday, April 8, 2010

China’s face-off with an over-stimulated economy

China’s 4 trillion RMB stimulus package is unprecedented in term of scale and probably consequence, too. While agressively putting the country’s GDP back on track, its long-term impact on the economy could be ugly.

A double-digit GDP growth, strong rebounds in exports, retail sales, and business sentiment – China’s 4 trillion RMB stimulus package is more successful than ever in stimulating its already fast expanding economy, if not too successful. While the western world starts to grapple with the repercussion of its own monetary stimulus, China’s looming reality of dealing with its over-stimulated economy present a gloomy challenge. The government’s recent measure of curbing bank lending is undoubtedly encouraging but deserves the fair criticism of lacking decisiveness and resolution.

Wasteful infrastructure projects

With more than 35% of stimulus budget spent on roads, railway and power plants, China’s persistent economic emphasis on infrastructure investment sounds more bewildering than astonishing to any outsiders. In China, there is a well-known old saying that goes ‘To build the road is the first step towards building up your wealth’. It implies that infrastructure is the key to economic development, a concept into which everyone in China buys without doubts. This explains why hard infrastructure projects are always the priority of the central government’s policy – road and railways are listed as priority in China’s current Five Year Plan.

Source: Xin Hua News

Physical infrastructure projects are also an all-time local favourite. In China, the infrastructure projects are largely decided at provincial or city government level. By one estimate, 90% of all fixed-asset investment (FAI) in China is locally-driven. It is an option that local party leaders find most comfortable with since it requires little change from habits acquired from decades of managing an economy powered by investment. More importantly, infrastructure spending contributes directly to GDP numbers by creating both aggregate demand and production capacity. It naturally enhances the promotion prospects for local officials whose performance is measured by economic growth. After all, Bao Ba (i.e. ensuring GDP growth) of 8% is the motto of almost every government official in China. Likewise, infrastructure investment is the most direct way to stimulate the local economy and provide jobs – an easy populist strategy to win the ordinary people’s support. Last but not least, FAI and related projects generate proportionally more tax income for the local government due to the peculiarities of the tax system in China and the revenue split between the central and local governments.

Economists’ concerns about such wasteful investment are exemplified by China expert Patrick Chovanec’s comment in his recent blog post China’s Wasteful Stimulus:

All over the country, every province has at least one mega project. It’s one thing to build one mega project over a 10-year plan. It’s another thing to build this 10-year project in two years and do many of them all over the country. How much capacity expansion can the economy digest at one time?”

China’s real Q-o-Q fixed asset investment (FAI) growth (Source: National Bureau of Statistics)

A direr consequence: asset bubble

In matters of policy in a vast country like China, the devil is always in the execution. The huge stimulus measures rolled out in response to the worldwide financial crisis were meant to cushion external shock and support business activity. However, a large chunk of the money was wrongfully diverted to speculation in the real estate market, which has helped to fuel a property bubble. It is implicitly acknowledged in China that almost every government agency or ministry sits on a big balance sheet of land or property investment. Likewise, there are also suggestions that a big chunk of business loans to large State-Owned Enterprises (SOEs) made its way into investment in land and real estate development. All of these help explain China’s spiralling property price in the face of global economic meltdown. In my view, China’s high household savings rate is more due to high housing prices than to the lack of a social security net. It discourages household consumption and further tilted China into a dangerous imbalance in economic structure.

Falling behind the curve in tightening policy

In China, the People’s Bank of China (PBOC) implements monetary policy as instructed by the State Council. The priority for policy decisions in principle is prices and the business cycle while stock and land prices should be secondary considerations. However, in reality, the policy always tends to focus on economic growth.

As the impact of the global financial crisis dies down, virtually every central bank is likely to tighten monetary policy over the next two years. The early movers—Israel, Norway and Australia—all had relatively mild recessions whereas countries like the US, which was the centre of the financial crisis, are likely to tighten policy much later.

In this respect, China is looking perilously out of step. China had by far the most aggressive response to the crisis, with one of the biggest fiscal stimulus packages in the world as a share of GDP and the most aggressive push on bank lending. In addition, China tied its currency to the country with the loosest monetary policy. Yet the Chinese government’s obsession with GDP performance makes it over-anxious about stifling economic growth by tightening up the monetary policy too quickly.

But as we all know, if China does not fight back against its over-stimulated economy right now, the damage to its economy will only be much worse.

Written by Evelyn Zhang

Taken from:’s-face-off-with-an-over-stimulated-economy/