Can China achieve a soft landing?

PositionA SYMPOSIUM OF VIEWS

China's official policy community seems desperate to curtail runaway investment even as it seeks to encourage the middle class to consume. Interest rate increases have been difficult to implement. Currency appreciation, occurring at only a modest pace, appears to offer little help in slowing the economy. Some have suggested that as an alternative, the official community is starting to encourage hikes in exports prices as a kind of backdoor means of slowing things. Of course, no one can completely predict the future state of the global economy, but what are the chances China successfully achieves a soft landing over the next year or two?

TADASHI NAKAMAE

President, Nakamae International Economic Research

Having followed the Asian model of over-investment and under-consumption established by Japan in the 1960s, the Chinese economy inevitably faces a hard landing.

Investment in steel factories, for example, increases demand for steel, leading to further investment in steel factories. As a result of such self-perpetuating investment-led growth, fixed capital formation is 38 percent of China's GDP compared with household consumption at 35 percent. The rapid expansion of supply capacity relative to the domestic market has made China overly dependent on exports. The Chinese economy now looks particularly vulnerable to any fall in external demand stemming from weakness in the U.S. housing market.

Even without such an external shock, the profitability of Chinese industries is already declining fast, for two reasons. First, oversupply has undermined capital efficiency. Second, wage inflation has begun to emerge, especially due to the short supply of skilled Chinese workers. This cost pressure is causing multinational producers to switch new investment from China to cheaper destinations, and causing both multinational and domestic producers to raise the prices of the goods they produce in China.

The renminbi is thus being revalued, in real terms: even with the exchange rate remaining more or less unchanged, cheap imports from China are becoming a thing of the past. From the global perspective, the inflationary impact on commodity prices of China's growth has hitherto been balanced against the dual benefits of supply of cheap goods and downward pressure on wages. But now these benefits to developed economies are fast disappearing--a shift that will stimulate protectionist argument.

As wage inflation eats further into already deteriorating return on capital, China's capital investment bubble must sooner or later burst. Capital investment and economic growth will then both go into reverse, chasing each other downwards in a vicious spiral.

As a basis for judging when China has reached this point, the usual indicators of economic downturn--GDP and unemployment statistics, and so forth--will not be reliable.

The figures to watch are changes in China's foreign exchange reserves. In the five years to 2005, these grew by $653 billion from $166 billion to $819 billion. During the same period China's accumulated current account surplus was $328 billion. Foreign direct investment into China accounted for most of the remaining $325 billion increase in reserves. According to official statistics, about half of this direct investment flowed in from Hong Kong, the Bahamas, and other tax havens. If the inference is valid that the nature of such investment is largely speculative, then China appears to be very vulnerable to capital flight. The beginning of the hard landing--regardless of what rosy picture official statistics are still painting at that time--is likely to coincide with the beginning of capital flight.

In sum, after years of over-investment and under-consumption, China is bound to suffer a fate similar to that of Japan: a hard landing followed by years of structural adjustment. Nobody can predict exactly when the hard landing will come, and what hardships it will bring. But the chances of China establishing in the next year or two the conditions for sustainable economic growth, and thereby averting an eventual hard landing, are non-existent. If China enjoys another couple of soft years, it will simply mean that the economy has yet to land.

My rating of the chance of China achieving a soft landing, on the scale of one to ten, is one.

JEFFREY A. FRANKEL

James W. Harpel Professor, Kennedy School of Government, Harvard University

Odds that if China revalued the currency within the next year or two it would substantially resolve global imbalances (e.g., halve the U.S. current account deficit): 0 percent.

Odds that China will undergo a nominal appreciation of the yuan sufficient to make a modest contribution to equilibrate excess demand domestically, by shifting production from traded to non-traded goods: 30 percent.

Odds that China will undergo a real appreciation of the yuan sufficient to make a modest contribution to equilibrate excess demand domestically: 45 percent.

Odds that China's growth will continue strong for the time being, with a small increase in flexibility in the currency having little effect and with questions of sustainability remaining: 60 percent.

Odds that we will continue to debate whether China will have a soft landing: 75 percent.

Odds that there will eventually be some serious bumps along the way before the Chinese miracle is complete, such as a banking crisis or real estate crash: 90 percent.

FRIEDRICH WU

Adjunct Associate Professor of International Political Economy, Institute of Defense & Strategic Studies, Nanyang Technological University, and former Director of Economics at Singapore's Ministry of Trade and Industry

Even though there was a deceleration in the expansion of industrial output and fixed asset investment in the latest month of July, one month s figures do not make a trend. We will have to wait for a few more months' numbers on fixed asset investment, industrial output, bank loans, money supply, and construction activity, as well as property transactions and prices, before we can draw any meaningful conclusion on whether the administrative and market-based measures implemented by Beijing earlier are taking effect. To look for excess capacity, one has to see inventory and sales figures, and company profits, which all have a time lag.

The key question is whether the leaders in Beijing would have the political resolve to rein in provincial and municipal government officials who are enamored with extravagant construction projects that help drive the investment frenzy. The recent humiliating penalty (to write a public self-criticism paper) for the governor of Inner Mongolia and his deputies for embarking on an unauthorized investment binge in coal-fired power plants sets a good example. But there are still many more defying regional "economic tsars" that Beijing has to subdue. Some of us still have the misconception that the Chinese Communist Party is a powerful monolith. But actually its rule is rather fragmented, especially after three decades of opening to the outside world and increasing economic decentralization.

The central government's rope-tightening act would also pit the People's Bank of China against powerful state-owned commercial banks which hitherto have provided almost free-flowing credits for many investment projects of dubious value. In particular, credit managers of the local branches of these banks either are under a lot of pressure from local officials and businessmen to lend, or are lending to the latter willingly in exchange for unspecified benefits. Graft is still rife at the sub-national levels.

While the outcome cannot yet be known, failure to avert an economic "hard landing" this round would have widespread ramifications not only within China but also beyond its borders, as China's economic linkages with the rest of the world have multiplied and deepened since the last "near hard landing" episode in the 1990s. Not only would...

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