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Monday, April 16, 2012

Middle Kingdom's anti-gravity act

Special to The Japan Times

HONG KONG — It's officially OK now to recognize that China urgently needs economic reforms. Premier Wen Jiabao said so. So did Vice Premier Li Keqiang, who is likely to take over from Wen when the Communist Party can sort out its power squabbles.

Every other economist has taken up the cause. Christine Lagarde, the managing director of the International Monetary Fund, noted in Beijing last month that "Re-engineering of the growth model is being advocated at the highest levels of government, and this is highly desirable."

The buzzwords are "rebalancing the economy". A quick glance at the structure of China's economy shows the problem. Consumption has fallen to 35 percent of gross domestic product, almost unprecedentedly low by world standards. India, Japan, Taiwan and Thailand have consumption of 55 to 60 percent of GDP and the U.S. has 65 to 70 percent. China's fixed investment is 46 percent of GDP, between 10 and 20 percent higher than Japan and South Korea at similar stages of their economic development.

Officially the new course has been set and supertanker China is changing direction smoothly and capably under its Communist captains. Zhu Min, deputy managing director of the IMF, reiterated in Hong Kong that China's GDP depends too much on investment, which is "not sustainable", but he added confidently that "China's heading for a soft landing."

With the remarkable rapid shrinking of China's current account surplus, from 10.1 percent of GDP in 2007 to 5.1 percent in 2010 and to 2.7 percent last year, some Chinese economists have already declared victory. With rising wages and growing retail sales of consumer goods, there is little need to worry, according to the optimists.

Skeptics point out that rebalancing will not be so easy, and the domestic economy is still dangerously out of kilter. Adrian Mowat, J.P. Morgan Chase's chief Asian and emerging-market strategist, declared: "If you look at the Chinese data, you should stop debating about a hard landing. China is in a hard landing. Car sales are down, cement production is down, steel production is down, construction stocks are down. It's not a debate any more, it's a fact."

Satyajit Das, who has worked in financial markets for 30 years, declares that China's recovery from the global financial crisis was a result of "Botox economics." He claims that, "Using the advantages of a centrally controlled, command economy, Beijing boosted output through government spending and directed bank lending to maintain growth."

Since 2008, Das notes, almost all of China's growth has come from "government influenced expenditure." China's headline growth of 8 to 10 percent a year has been driven by new lending averaging between 30 and 40 percent of GDP. Up to 25 percent of these loans may prove to be nonperforming, amounting to losses of between 6 and 10 percent of GDP.

Professor Michael Pettis of Peking University makes an important point in his China Financial Markets newsletter, arguing that the promises of the Chinese leadership to bring changes are too often taken as fact: "Too many analysts overemphasize the intentions of the Chinese leadership when projecting China's future. If Beijing announces that it plans to accomplish a certain goal — raise the consumption share of GDP, or double the length of railroad track — analysts quickly incorporate that goal into their projections even when it isn't at all clear how Beijing will do it."

He adds that the same caution should be applied to the statements of political leaders everywhere, when they talk about debts.

Pettis has a very useful analysis of why China must rebalance its economy and, more important, how this can be accomplished. The key issue is that "China must stop transferring income from households to the state and must reverse those transfers. As Chinese household income and wealth become a greater share of the overall economy, so will Chinese consumption." Pettis lists Beijing's five options for change:

• Slowly reverse the transfers by gradually raising interest rates, the foreign exchange value of the currency and wages, or lower income and consumption taxes.

• Quickly reverse transfers the same way.

• Transfer wealth from the state sector to the private sector by privatizing assets and using the proceeds directly or indirectly to boost household wealth.

• Transfer wealth from the state sector to the private sector by absorbing private sector debt.

• Cut investment sharply, resulting in a collapse in growth, but mitigate the employment effect of this collapse by hiring unemployed workers for various make-work programs and paying their salaries out of state resources.

Each option has difficult ramifications. China faces economic, political and social difficulties given the underlying fact that rebalancing the economy ultimately means transferring resources from the all-powerful state sector, the state-owned enterprises, and well-connected Chinese who are living fabulously in the new China.

Pettis helpfully points out that even in a "bad case" scenario of zero GDP growth, if China had household income growing 3 to 4 percent and a similar contraction of the state sector, social unrest could be avoided. But it is unlikely that China's newly rich, any more than the rich Republicans in the U.S,. will happily accept any restrictions in their privileges — and remember that the rich are also the politically well-connected.

Das notes the immense differences in wealth in today's China. Sales of luxury items are growing rapidly, at 25 percent a year, in spite of heavy import taxes. For handbag maker Louis Vuitton, China is its biggest customer and has become the "Middle Blingdom" accounting for 15 percent of its global sales. (This is a portmanteau word punning China's traditional name.) China's share of the global luxury market is forecast to rise to 44 percent by 2020.

Not every Chinese has it so good. To buy a 100-square-meter apartment in central Beijing, costing 3 million renminbi ($450,000), a peasant farmer would have to have worked since the Tang Dynasty (ended A.D. 907. A blue-collar worker earning the average 1,500 renminbi a month salary would be luckier, only having to work since the Opium wars of the 19th century.

Pettis believes that China's growth could come down to 3 percent a year — and he has a bet with The Economist magazine that China's annual average growth for the rest of this decade will be 3.5 percent or less. He admits that he is an outlier, more pessimistic than the crowd. But he points to the collapse of other investment-driven miracles, in Brazil and in Japan. He quotes Rudi Dornbush: "The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought."

If China succeeds, it won't need to worry about empty boastful competitions about which is the biggest economy in the world: It will be a global economic power. But if China fails, it will be bad for the country and the world, not only economically, but politically and socially.

U.S. Republican candidates and others unhappy about the rise of China should not be complacent about Beijing's economic difficulties. After all, if Washington was worried about its own financial institutions being too big to fail, it should tremble about the global fallout from economic troubles in China, let alone the political and social repercussions.

Kevin Rafferty is editor in chief of PlainWords Media

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