The international community, and particularly policy makers in the United States, put great expectations on the contribution that China can make to global economic recovery by rebalancing its economy through promoting consumption growth.

The Chinese authorities broadly accept this priority and have put in place a number of policy measures that aim to achieve it.

Piecing together a complete picture of Chinese consumption by drawing on both official and unofficial data reveals some interesting detail about how far China is along the way to boosting domestic consumption.

China’s consumption share of GDP was probably underestimated by an average of 3.1 percentage points during the past decade, as it declined steadily from 64 per cent in 2000 to 50 per cent in 2008, in line with official statistics, but recovered afterwards to 54 per cent in 2010.

These figures could mean that China’s long-awaited economic rebalancing has already begun, especially if the sharp decline in the country’s trade surplus from 7.5 per cent of GDP in 2007 to 2.1 per cent in 2011 is taken into account. If these changes continue, the Chinese economy may transition from an economic ‘miracle’ toward more normal development, as growth slows, inflation rises, industrial upgrading accelerates and economic cycles become more dramatic.

Boosting China’s domestic consumption has been a key government policy in trying to rebalance the economy. But according to official statistics, the consumption share of GDP declined persistently from 62 per cent in 2000 to 47 per cent in 2010, highlighting a serious policy failure.

Even more surprising is the widening gap between retail sales growth and total consumption growth in recent years. The fact that consumption-related retail sales grew increasingly faster than total consumption indicates the relative weakness of components of consumption unrelated to retail sales. This weakness is mainly in China’s services sector. But this is at odds with common sense, as normally the income elasticity of demand for service goods is much higher than that for other consumer goods.

The Chinese National Bureau of Statistics derives consumption data from household survey data. If household income was significantly underreported, as various studies have suggested, then it is quite possible that household consumption was also grossly underestimated, and likewise for consumption growth rates in general.

A re-estimation of China’s consumption share of GDP, taking into account these distortions, suggests that China’s consumption share of GDP actually declined from 64 per cent (with official statistics recording only 62 per cent) in 2000 to 50 per cent (officially 48.4 per cent) in 2008, but then recovered to 54 per cent (officially 47 per cent) in 2010.

What could have driven the improvement?

There is a strong argument that both China’s ‘growth miracle’ and its economic imbalances during the country’s reform period are attributable to widespread distortions in factor markets. These distortions generally repress factor costs and, therefore, are like subsidies to producers, investors and exporters. At the same time, they also tax households. This explains both the increasing dominance of investment and exports in Chinese growth and weakening consumption during the past decade. This implies that the key to rebalancing China’s economy lies in further liberalising its factor markets and removing cost distortions.

Anecdotal evidence suggests that the climate for increased consumption has started to improve in recent years. This seems to have been mainly triggered by changes in factor costs and returns, but more importantly, the changes are by and large natural market responses, instead of deliberate policy adjustments. The government certainly took steps to reform pricing mechanisms for factor markets, most clearly in energy prices and exchange rates. But a rapid growth in wages and the increased role of market-based interest rates were still the most significant changes.

While the People’s Bank of China has not taken concrete steps to liberalise interest rates, those that are market-based have started to play an increasingly important role in China’s financial intermediation. Changes in both labour and capital markets are also positively impacting on consumption in at least two ways. First, they increase household income, while also reducing ‘subsidies’ to Chinese enterprises. And second, rising wages and interest income advantage low-income households, and should help improve income distribution.

This analysis has encountered both disbelief and scepticism.

Some critics have argued that retail sales are a poor proxy for consumer demand, since China’s figures must incorporate wholesale business, and government and business procurement. But Chinese retail sales figures do not include wholesale business, and the analysis does not use retail sales as a proxy for consumption.

Others object to the analysis because China’s undervalued currency, relatively low wage growth and repressed interest rates show little sign of reversal — and these are crucial factors in repressing household income growth.

But with a decreasing trade surplus, declining foreign exchange reserves and even occasional expectations of a currency depreciation, estimates of the renminbi’s undervaluation have been significantly re-evaluated downwards. Wages have in fact grown rapidly, and while regulated interest rates did not change much, the proportion of financial intermediation subject to market-based interest rates has risen sharply. These are exactly the types of changes that are driving a rebalancing of the Chinese economy and recovery of consumption.

Reports of China’s declining consumption share are exaggerated, and the official statistics are partly to blame. Rather, the opposite appears to be true, with China’s consumption share already starting to expand.

Yiping Huang is Professor of Economics at Peking University and Professor at the China Economy Program, the Australian National University. He is also Chief Economist for Asia at Barclays Bank, Hong Kong and co-authored the report The Great Wave of Consumption Upgrading (January, 2012).

1. Rebalancing China’s economic structure
2. Sustaining economic growth in China
3. Malaysia’s New Economic Model as a rebalancing strategy

China’s economic developments in 2011 closely resembled those of 2008: over-heating at the beginning of the year; moderating due to policy tightening around mid-year; and decelerating as a result of external recession before year’s end.

But 2012 will probably not be a replay of 2009, as neither a hard landing nor a sharp rebound look likely this year. GDP growth may slow from 9.1 per cent in 2011 to 8.1 per cent in 2012 — with softer external demand and weaker residential investment — and inflation could ease from 5.5 per cent to 3.2 per cent. Consumption will probably play a greater role in the coming year, and both monetary and fiscal policy should be modestly expansionary. Key risks for China include deeper recession of the world economy and a disorderly correction of the housing market.

Currently, China is suffering from a range of economic difficulties, which have fuelled fears of a hard landing. For instance, the number of small and medium enterprises (SMEs) declaring bankruptcy is growing rapidly, with several high-profile cases widely reported in the media. The flow of funds into private lending has been disrupted in certain areas. House prices declined for a third month in November, with potentially significant implications for investment growth and asset quality. Local government investment vehicles, with total liabilities of at least 10.7 trillion yuan (US$1.7 trillion), find it difficult to repay loans when they are due. And the recent expansion of shadow banking transactions may also cause risks for the financial system.

But these factors are unlikely lead to a hard landing of the Chinese economy for at least three reasons. First, the changes have mainly been caused by policy adjustments, such as macro-policy tightening and housing restrictions. Some changes, such as the correction of property prices, may be necessary in order to facilitate healthy development in the future. If the situation deteriorates sharply, the government should be able to reverse the policies quickly. Second, these problems have not yet developed into systemic macro risks. Despite an increasing incidence of bankruptcy, for instance, the SME sector as a whole is still growing steadily. Also, the widely reported collapse of private lending activities remain isolated, concentrated largely in Wenzhou city of Zhejiang and Eerduosi city of Inner Mongolia.

And third, balance sheets are still quite healthy for households, banks and the government — which should underwrite resilience even if the economic situation deteriorates. Total household borrowing is below 18 per cent of GDP, less than the value of households’ annual savings. If property prices decline modestly, households will not be forced to deleverage. And given the banks’ average non-performing loan ratio is at 2 per cent and the reserve requirement ratio (RRR) is at 21 per cent, some deterioration of credit quality is unlikely to make the banks dysfunctional in the near future. Finally, public debts are only 17 per cent of GDP in China. If all contingent liabilities are included, they could amount to nearly 70 per cent of GDP. But the government still has room to use fiscal resources to contain domestic risks and support economic growth.

So based on current trends, 2012 should see a soft landing in China. Affected by a sluggish external economic environment, export and import growth will likely halve to 9.8 per cent and 12.8 per cent, respectively. Reduction in net exports could reduce GDP by 0.4 percentage points. Of the three key components of fixed-asset investment, manufacturing investment is relatively more resilient and infrastructure is more or less a function of government policy. Uncertainty surrounds residential investment, which is likely to slow significantly in the coming year, following sharp adjustment in both property prices and transaction volumes. Despite this, residential investment should continue to grow in 2012 — albeit at a slower pace — due to large development projects, ongoing construction and the expansion of public housing.

Domestic consumption will be key to maintaining the economy, although the pace of its expansion should also moderate. In recent years, retail sales have consistently outperformed GDP. But the GDP-by-expenditure data continuously show declining consumption, due to reporting errors in household survey data, such as the under-reporting of income and household spending. Estimates combining information from both GDP by expenditure and retail sales suggest a turning point in 2007, after which consumption’s share of GDP actually picked up steadily. This is consistent with improvements in the social welfare system and a rapid growth of wage income in recent years.

The authorities have become vigilant against downside risks, evidenced by the recent adjustment of the reserve requirement ratio. But policy makers are concerned about a premature and aggressive easing of policies, given what might be considered ‘overstimulation’ three years ago. Four more cuts to the RRR and a slight increase in fiscal deficit can also be expected throughout 2012. The purpose of RRR adjustment is to stabilise liquidity conditions, instead of stimulating growth, given the steady slowing of China’s money supply. Although a cut to the policy interest rate is not predicted, the chance of rate cuts could rise significantly if the global economy falls into deeper recession or the correction of the housing market becomes disorderly.

Yiping Huang is Professor of Economics at Peking University and Professor at the China Economy Program, the Australian National University. He is also Chief Economist for Asia at Barclays Bank, Hong Kong.

This is part of a special feature: 2011 in review and the year ahead.

1. Will Asia step up to the global challenges of 2012?
2. Russia and APEC 2012: imaginary engagement?
3. Asia, Europe and regional cooperation in 2012

The current international economic system is defined by three key features.

First, the United States is a dominant leader in designing and enforcing the international economic rules.

Second, the US dollar is the cornerstone of the international monetary system. Third, three international organisations — the International Monetary Fund (IMF), World Bank (WB) and World Trade Organisation (WTO) — are responsible for maintaining order in the international economy.

For more than half a century this system facilitated steady growth of the global economy. But recently there are growing calls for reform. Two important events have strengthened these demands. The first is the ascendancy of emerging market economies, with calls for some emerging economies to move to the centre stage of international economic decision-making. The second is the subprime crisis in the US, which raised serious questions about the future international roles of the US and its dollar.

China is likely to play an important part in the transformation of the international economic system. It is already the second-largest economy in the world according to market-based GDP measures and may overtake the US as early as 2013 according to the purchasing power parity-based GDP measures. China’s international economic influences have grown exponentially, especially in international markets for labour-intensive manufactured goods, raw materials and commodities and foreign exchange.

Given the significant role it is likely to play in the process, a key question for reforming the international economic system is: what does China want?

First, China wants reform, not revolution, of the international economic system. It recognises that the world has become a multi-polar system, with a number of large economies possessing significant influence on the world economy. China shares many of the economic values of these nations, including those that relate to free trade and investment, and is keenly interested in working with the other major countries in building a ‘harmonious world’. While some existing rules are in urgent need of reform, China wants to improve the existing international economic system, not abandon it.

China sees the G20 as the best compromise between representativeness and efficiency for dealing with international economic issues and is interested in making it a permanent institution. The Sino–US partnership will remain a cornerstone for China’s international economic relations, but China is not ready to formalise the institutional arrangement of a Group of Two (G2) for global economic affairs. China promotes collaboration among the BRICs countries (Brazil, Russia, India and China) but regards the association more as a platform for formulating policy positions among key emerging market economies, not as a parallel organisation alongside the G20.

China is in favour of any restructuring initiatives that give more influence to emerging market economies within international organisations such as the IMF and the World Bank. While these organisations have made important contributions to China’s economic reforms, their governance and rules should be reformed to better reflect the new reality of the world economy. IMF reforms, for instance, should allocate more voting shares to developing countries, give up the practice of appointing Europeans to its managing directorship, abandon the US veto power and set policies more appropriate for emerging market economies.

China supports reforms of the international monetary system but sees avoiding the sudden collapse of the US dollar as critical. The transition of the global reserve system is likely to be a long-term process. China, the US and the other major economies of the world should work together to ensure a smooth transition of the role of the dollar, which is critical for providing a stable global economic environment. China also wishes to internationalise the renminbi (RMB), which could eventually become part of a multi-reserve system.

If China wants to see other countries cooperate in making these desires a reality, it will have to acknowledge and follow through on its own responsibilities. For example, as the world’s second largest economy, China needs to abandon its small-country mentality. Economic decisions by any large countries should take into account the possible effects on, and reactions of, other countries.

China must also promote further liberalisation of its own economy and move closer to a market economy, including reforms of its exchange rate regime, capital account controls and distortions in other factor markets. At the same time, China should also promote private sector development and contain the influence of the state sector, especially in international economic areas. This is critical for supporting an open and efficient international economic system.

Finally, it is time for China to learn to work with the US and other G20 members to provide public goods services for the world economy. In line with China and the other emerging economies asking for more rights, they should also share more of the responsibility in maintaining a stable global economic environment, enforcing the international economic rules and assisting countries temporarily struck by adverse economic shocks.

Yiping Huang is Professor of Economics, Peking University, and in the China Economy Program, The Australian National University. He is currently Chief Economist for Asia for Barclays Bank, based in Hong Kong.

This article appeared in the most recent edition of the East Asia Forum Quarterly, ‘Asia’s global impact‘.

1. An Asian response to international financial reforms
2. China’s economic reforms pushed by civil society
3. China: what long-term policies and reforms are needed to sustain growth?

A year ago, I made five predictions for the Chinese economy in 2010 in an article prepared for this Forum: 1) the renminbi will probably begin to appreciate against the dollar; 2) job market pressures may rise again even as the economy recovers; 3) housing prices would probably begin to weaken; 4) structural imbalances were likely to deteriorate further; and 5) the government would likely introduce another stimulus package.

Now that the year 2010 has retreated into the rear vision mirror, we can confirm that predictions (1), (3) and (4) actually occurred, but prediction (2) didn’t materialize. The government did not announce a new stimulus package in 2010, but in mid-year the State Council and the PBOC re-confirmed the need to continue expansionary monetary policy, reversing its earlier decision to return to a neutral policy stance. So I might get some marks for prediction 5).

Predictions 3) and 5) were based on the expectation that the stimulus package would run out of steam before the end of the year. If the private sector could not step in to fill the gap, then either the job market would weaken or the government would be forced to stimulate growth again. What actually happened was that exports picked up much faster and private sector spending was stronger than I expected.

What caught international investors’ attention at the beginning of the year was, of course, the call by a number of prominent investors and economists that the China bubble would burst. Jim Chanos, founder of the New York-based Kynikos Associates, predicted a slump after excessive property investments in China. Kenneth Rogoff, a Harvard Professor and former Chief Economist of the IMF, predicted that a debt-fueled boom in China could trigger a regional recession within a decade. Later, James Rickards, former General Counsel of hedge fund Long-Term Capital Management warned that China was in the midst of ‘the greatest bubble in history‘. He argued that PBOC’s balance sheet resembled that of a hedge fund buying dollars and short-selling renminbi.

Chanos, Rogoff and Rikards were certainly right to warn against rapid growth of both liabilities and bubbles. These risks could potentially lead to disastrous consequences, which were already evidenced by the experience of Japan in 1989, East Asia in 1997 and the U.S. in 2007. But were investors to translate such warnings into investment strategies for 2010, they would have lost lots of money.

The fundamental difference between China in 2010 and Japan in 1989 or the U.S. in 2007 lies in the balance sheet position. Before the meltdown in Japan after 1989 and in the U.S. after 2007 the balance sheets for the government, companies, banks and households were already in very bad shape – they all had very high leverage ratios or debt burdens. It only needed a modest change in either policies or prices, or both, to trigger a major meltdown.

China’s current circumstances are very different. China bears worry about fiscal sustainability, especially given the reckless spending habits af local governments. This is cause of concern, not a an immediate trigger of crisis. Even if we count unfunded pension funds, local government borrowing and potential non-performing loans, total public liability is still only around 50 per cent of GDP. Over the past years, fiscal deficits widened to about 2 per cent of GDP. But fiscal revenues have been growing by around 20 per cent per annum for more than 15 years. Although the growth rate slowed to 9 per cent in 2009, it rebounded to 21 per cent in 2010.

Given the massive credit expansion over the past two years, the quality of banking assets is likely to deteriorate going forward. Yet, a banking crisis remains highly unlikely in the conceivable future. This is because the average non-performing loan ratios of the Chinese banks are still relatively low, at below 5 per cent in most banks. More importantly, the government is likely to assume responsibilities for new non-performing loans in the coming year. One scenario is for the government to transfer non-performing assets to asset management companies, as it did in 1999. The corporate balance sheet is also quite healthy. During the last ten years, corporate income as a share of national income increased steadily. Despite the adverse effects of the financial crisis, growth of industrial profits accelerated throughout 2010 and reached over 20 per cent during the second half of the year.

The property bubble is the most important evidence supporting the case of the China bears. Property markets have obviously shown signs of a bubble, judged by usual indicators such as the price/income ratio, rental yields and the vacancy ratio. But normally, collapse of housing bubbles is triggered by either sudden slowing of income growth or the dramatic tightening of monetary policy. These can happen faster if households have already become overly leveraged. But this is not yet the case in China. Mortgage loans account for about 12 per cent of total outstanding loans. This is equivalent to 24 per cent of GDP, only a little over household income in one year.

All these factors suggest that, while the risks may be on the rise in China, a collapse or bursting of the bubble or crisis are unlikely in the near future. And the fundamental factors supporting macroeconomic and market stability are continued strong economic growth and very healthy balance sheets for the government, companies, banks and households. The risks for the Chinese economy in 2011 are unlikely to come from the liability side.

Liquidity, however, has become a bigger challenge for the Chinese policymakers and investors. The Fed’s QE II is already asserting pressures on China, through a sudden jump in inflows of ‘hot money’. Whatever the Fed’s motivation, QE II is likely to continue in 2011 and is likely to further complicate China’s economic situation.

China’s own monetary policy direction is even more complicated. From the end of 2008, PBOC maintained very loose monetary policy, as evidenced by RMB9.6 trillion in new loans in 2009 and possibly RMB7.8 trillion in 2010. PBOC will probably set the new loan target at RMB7.2 trillion in 2011, lower than the actual numbers in the previous two years but still 50 per cent more than PBOC’s original target for 2009. Credit expansion was useful in supporting growth. The downside is that loose monetary policy created inflationary pressure. In 2009, we saw waves of price increases first in the stock market and then in the housing market. Entering 2010, the government tried hard to crack down on property prices. Economists are generally skeptical about effectiveness of those restrictionary measures. But at least housing prices stopped going up.

Then prices of beans, garlic, apples, cotton, sugar and other commodities started to skyrocket one after another. Government officials were extremely busy running around inspecting inventories and punishing speculators. Surprisingly, the government was very reluctant to take aggressive monetary policy measures. With abundant liquidity and negative real deposit rates, waves of price increases continued to rotate around different products. By the end of 2010, the growth in the consumer price index (CPI) was already above 5 per cent year-on-year or above 12 per cent month-on-month annualized.

There were probably two reasons for the government’s reluctance to tighten monetary policies. One, it is still more worried about growth than inflation. And, two, it is somehow convinced that recent price increases were a reflection of structural adjustment, not overall inflation. The problem, that argument suggested, did not require monetary policy action.

So how will the Chinese economy do in 2011? There shouldn’t be much uncertainty about GDP growth reaching 8.5 to 9.5 percent. Export growth should remain solid. Whether or not the trade surplus will widen rapidly again depends on China’s import policy. Any widening of China’s external account imbalance, or lack of progress in rebalancing, could lead to significant international pressure on Chinese exchange rate policy.

Unless the PBOC changes its current policy approach, inflationary pressure is likely to rise further, at least during the first half of the year. The CPI may reach a cyclical high of 10 per cent, but rapid acceleration of inflation should eventually change the policymakers’ stance, since they are also worried about the political consequences of high inflation. We may see high inflation during the first half of the year and then aggressive policy tightening in the second half of the year, including rate hikes, currency appreciation and tightening liquidity. Those measures should exert some downward pressures on inflation, asset prices and economic growth.

One big uncertainty surrounds the trend in housing prices. In 2010, the government adopted two rounds of tightening policies in April and October. As a result, housing prices did not go up. But they probably did not go down, either. There will be a strong tendency towards increasing housing prices as soon as the government shows any sign of loosening its controls. The government has already confirmed that it will continue to crack down on housing prices in 2011. Some experts predict significant decline of housing prices. The analysis here suggests otherwise. A more likely outcome is continued stabilisation, not collapse, of housing prices in 2011.

Yiping Huang is professor of economics at the China Center for Economic Research at Peking University and in the Crawford School of Economics and Government in the ANU.

This is part of a special feature: 2010 in review and the year ahead.

1. Chinese economic risks
2. China needs to adjust its monetary policy now
3. Social security and housing the poor in China

On 21 November, Sunday, China’s State Council issued a new policy document (the Sixteen Articles)  aimed at stabilising prices. It is encouraging the policy authorities are starting to take price increases seriously.

But reading the document is like entering a time machine, and being transported right back to the 1980s. If the policy document were issued in the 1980s, then there would probably have been one article specifically capping the prices by the government. At that time, the prices of many products, including food products, were directly controlled by the state. But even with those direct controls, there was no way even the that the government could contain inflationary pressures. The consumer price index (CPI) rose above 10 per cent in both 1985 and 1988.

Among all the sixteen articles of the 21 November edict, two appear to be the most important. The seventh article focuses on providing temporary price subsidies and the eight article proposes a linkage mechanism between social security payments and increases prices. After all, the poor are often hurt most seriously by inflation as their income grows more slowly that other incomes and food accounts for a high proportion of their total spending. It is critical to provide some assistance to the poor when the inflation rate is running high. From a long-term perspective, government policy should shift from supporting growth to supporting social security in order to ensure political stability.

The most striking feature of the entire document is absence of the term ‘monetary policy’. Monetary policy wasn’t mentioned even once.

Why?

One possible reason is that some prominent Chinese economists argue that the current high rise in the CPI reflects structural adjustment of prices, not overall inflation. If that’s the case, then we don’t need to apply monetary policy tools. But if general prices are rising at a fast pace, then it’s hard to argue that China is not experiencing an inflation. Inflation is a monetary phenomenon. In 1988, 1994 and 2007, there were also then economists who argued that the rise in the CPI was the result of structural price adjustment. Without seriously tightening monetary policies, inflation got out of hand in every one of those years.

Indeed, the policy measures suggested by Sixteen Articles are not only micro in nature, but also central planning in style. They call for better management of farms for the production of winter grain and oils. They require the railway department to arrange cotton transportation properly in Xinjiang. They order the state power grid not to cut off power supply to fertilizer factories and to close down illegally built corn processing factories. This is really going back in time. Is this really the second decade of the 21st century after thirty years of market-oriented reform?

PBOC (the Central Bank) seems like a lonely voice. Last Saturday, it raised reserve requirement again. But even that will probably not be enough. Why have food prices increased? There are surely factors in the production and transportation system that influence the pattern of price increases. But if prices are rising across board, then it is not a micro issue but a macro problem. Why have prices of agricultural products skyrocketed one after another? It is because we have too much money chasing not enough goods. And the real deposit rate is significantly negative. In other words, the monetary policy environment is encouraging everybody to speculate. If you don’t speculate, you definitely lose money. Speculation, of course, does not guarantee profits. And the government is busy cracking down on speculators. Every time the government does so, more speculators appear.

During the sixty years of China’s People’s Republic, we have learned well enough that administrative measures will not be effective in controlling inflation. On university campuses this is plain for all to see where the government often forbids university canteens to raise food prices. The prices do not change. But the portions become smaller and smaller.

Unfortunately the government is going back to the future again.

Yiping Huang is Professor of Economics at CCER in Peking University and in the Crawford School at the ANU.

1. China’s atavistic economic policy strategies
2. Indonesia’s inflation outlook
3. India: Controlling inflation without hurting growth

One of the policy issues at the top of the agenda at the recently concluded G20 summit was global rebalancing.  Achieving strong, balanced and sustained growth was identified by the G20 leaders as a key policy objective.

While G20 officials agreed to allow greater roles for market forces in exchange rate formulation, they also emphasised the need for structural reforms in order to resolve global imbalances. The G20 leaders must be commended for not taking the wrong policy path. The agreements reached by the G20 finance ministers’ and central bank governors reduced the risk of a global currency war.

But the possibility of a currency war has not yet been completely averted. Opinion leaders in the West continue to contemplate various options for the US to wage a currency war with China. These include a new version of the Plaza Accord that would focus on exchange rate and fiscal policies in major surplus and deficit countries; punitive import tariffs; restrictions on access to the US Treasury market by countries with surpluses; countervailing intervention by the US; and the Fed flooding the world with dollar liquidity.

None of these options would be effective in addressing the root cause of the global imbalances. Some are even impossible to implement. Even if the US is able to exclude China from accessing the primary Treasury bonds markets, it doesn’t have the means to restrict China from buying Treasury bills in the secondary market. Given that China is already the largest holder of Treasury debt, banning China from the market could mean significantly higher costs of capital. Countervailing intervention is even more difficult. Since China still maintains capital account controls, it would be extremely difficult for the US to source renminbi in international currency markets.

A trade war is possible, for example, through the import tariffs suggested by the Congress. But such measures would have to pass scrutiny by the World Trade Organization. Import tariffs would certainly reduce Chinese exports to the US. But, whether China continues to export to the US or the gap is filled by exports from other low-income countries, such import tariffs would lead to higher prices of basic consumer goods and probably higher inflation in the US. Given the differences in comparative advantage between China and the US, it is doubtful that the lost jobs would go to the US.

A new version of the Plaza Accord would not work, either. The essence of the Plaza Accord was currency appreciation and expansionary fiscal policies in surplus countries and currency depreciation and contradictory fiscal policies in deficit countries. Such an approach, however, could lead to excessive currency adjustments, which would create significant adjustment difficulties. More importantly, the Plaza Accord certainly did not root out the causes of global imbalances.

The US can certainly flood the world with massive dollar liquidity by running its printing presses. In the current environment, this serves at least three purposes. One, increases in liquidity may be able to reduce the premiums on risky assets and, therefore, effectively lower the cost of capital. Two, eventual inflation could help to reduce the burden of US public debt, which is currently more than 90 percent of GDP; and, finally, massive dollar liquidity would push down the dollar exchange rates against all other world currencies.

Since the US is the issuer of the global reserve currency, it can print the greenbacks as much as it wants. But doing so generates negative impacts on the rest of the world. The most likely outcome is super-bubbles in emerging market economies. Despite massive liquidities in the US, it is not creating inflation expectations or asset bubbles at the moment. Instead, since its interest rate is low and its value is falling, the dollar is the best currency for carry trade. Investors borrow in the US but buy assets overseas. Emerging market economies including China look like attractive places to invest.

But we have seen similar situations before. In the early 1990s when the US maintained loose monetary policy conditions, investors poured liquidity into East Asia and helped to create big bubbles. After the Fed began to tighten monetary policy from 1996, capital flows reversed and the East Asian asset bubbles burst. Therefore, the most likely victim of the Fed’s second round of quantitative easing (QE2) is probably not the US itself but the emerging market economies.

Global imbalance problems are caused by a range of factors, including exchange rate misalignment and domestic market distortions. Therefore, it is better to adopt more comprehensive policy approaches to deal with the problems. Currency is important, but certainly we should not expect the depreciation of the dollar to be sufficient to eliminate the US current account deficits.

The same is true for China. During the past 30 years China has adopted an asymmetric market liberalisation approach. While product markets are almost completely liberalised, factor markets remain heavily distorted. These distortions lower the costs of production, subsidise producers, exporters, and investors and are behind China’s structural imbalance problems. Therefore, completion of factor market liberalisation should be a critical part of the reform program necessary to rebalance the Chinese economy.

But the exchange rate also has to move more quickly. Increasing exchange rate flexibility is consistent with China’s announced policy goals. China has to do our part by introducing a more flexible exchange rate and reducing the current account surplus. Steady but faster appreciation of the renminbi could also be part of the effort to prevent China from becoming the victim of the Fed quantitative easing policy.

When the dollar liquidity flows outside the US, China will be one of the favorite destinations because of its strong growth, high interest rates and expectations of currency appreciation. If it doesn’t adjust our current policy, China could be the next big bubble.

In order to avoid that unhappy outcome, the central bank should let the currency rise steadily. That might attract more hot money inflows, but it is better than a one-step adjustment. The central bank also needs to raise interest rates more swiftly. Again, it might encourage more capital inflows because of the wider interest rate differential between China and the rest of the world, but if rate hikes introduce caps on asset prices, then the net impact on hot money is unclear.

Finally, the authorities need to consider temporary measures to control capital accounts. An exchange rate adjustment will take some time and tighter controls of capital flows may provide a better environment for that adjustment.

More importantly, capital account controls can help stop US dollar liquidity at the border. But of course, such controls should be temporary and for the adjustment period only. Once a large part of the adjustment is done, we should abolish those controls and re-accelerate capital account liberalisation.

Yiping Huang is professor in the Chinese Center for Economic Research at Peking University and in the China Economy Program at the ANU.

This article was originally published on the 19^th of November in China Daily.

1. What to do about China’s currency
2. Using the G20 to avoid currency war
3. Avoiding a US-China currency war: Need for rational calculation

Today, the National Statistics Bureau released October’s batch of economic data. Almost all indicators for economic activity, including fixed asset investment, industrial production and even retail sales, slowed in October (as measured by year-on-year growth rates). The whole country’s attention, however, was firmly fixed on inflation data. CPI was up by 4.4 per cent year-on-year in October, compared with 3.6 per cent in September and the consensus forecast of 4.0 per cent.

This was the highest level reached in 25 months. Food prices, in particular, increased by more than 10 per cent.

This increase in the inflation rate is more alarming if looked at from the perspective of a month-on-month reading, which accelerated to 0.7 per cent in October from 0.6 per cent in August and September. This implies that the annual inflation rate is already running at above 8 per cent, and is perhaps why a senior policymaker admitted several days ago that CPI in 2010 would likely exceed 3 per cent, the official target. And the October increases may not be the end of the current inflation cycle given tighter food market conditions, accelerating wage growth and very loose liquidity conditions.

As to the level of growth, it is true that growth is moderating, evidenced by both monthly economic data released today and quarterly GDP growth data (down from 10.3 per cent in the second quarter to 9.6 per cent in the third quarter and possibly around 9 per cent in the fourth quarter). But most economists agree that the current growth slowdown is likely to be limited. The market generally expects GDP growth to stay at the 8.5-9.5 per cent range in 2010.

The term ‘marginal stagflation’ has been suggested by a government official during internal discussion. It refers to the situation when growth is decelerating but inflation is accelerating. This combination certainly complicates economic policymaking: should the central bank tighten or ease monetary policy? Fortunately, the People’s Bank of China (PBOC) already provided an answer to this question last night by hiking the reserve requirement ratio by 0.5 percentage points.

Clearly, then, inflation is the number one risk, at least for now. Because of the widespread labor-shortage problem, wages are currently growing at 20 per cent. New loans amounted to RMB 587.7 billion in October alone, and total new loans in 2010 are likely to exceed the RMB 7.5 trillion target set by the central bank. This follows a record of new loans at RMB 9.6 trillion in 2009. Although PBOC hiked the base deposit rate by around 25 basis points three weeks ago, today’s CPI data made the real interest rates even more negative. Wherever possible, money is chasing goods and assets madly. Prices of sugar, cotton, beans, apple and garlic are skyrocketing one after the other.

The Fed’s QE II (second phase of quantitative easing) may further complicate China’s inflation picture. To be fair, given the current condition of the US economy, there is nothing wrong with the Fed supplying a lot of money. In fact, quantitative easing has already had some positive impact on the US economy, by allowing for financial intermediation and pushing long-term bond yields. But it has produced two problems for the rest of the world. The first is that unfortunately the greenback that the Fed is printing is a global reserve currency. And the second is that, with a sluggish economy, close-to-zero interest rates, and expected depreciation, the US dollar is the best currency for carry-trade. So ironically, by adding massive liquidity to the global economy, the US may produce an asset bubble outside its borders. It is most likely that such a bubble would occur in the area of global commodities and/or affect emerging market economies.

There is nothing China can do to change the Fed’s decision. But China should try its very best to avoid becoming the victim of loose US monetary policy. My own reading from the latest policy changes is that the authorities have probably concluded that preventing the creation of a new bubble in China is of utmost importance. Since the beginning of the year, the government has already implemented two rounds of tightening policies for the housing market.

But the key policy changes have, and will continue to, take place in monetary policy, in the forms of currency appreciation, rate hikes and temporary capital account controls. The need for currency appreciation is well understood by now, although resistance remains strong. A stronger currency is necessary to avert a currency war and to rebalance the Chinese economy (internally and externally).

PBOC introduced the first rate hike on October 19. This was an important departure from its previous position of holding the interest rate unchanged when the currency is under pressure to appreciate. This previous position was motivated by a fear of attracting more hot money inflows. But this rate hike is critical in order to combat inflation and prevent asset bubbles. It is true that higher interest rate might attract capital inflows. But caps on asset prices, and other measures discussed below, should actually discourage hot money flows.

Finally, it is possible that the authorities may also adopt some temporary measures to control short-term capital flows. Such measures may fall into two areas; cracking down on hot money inflows (through current account channels) and restricting short-term capital flows (by imposing a reserve requirement or a Tobin tax). Some measures may be necessary in order to provide a stable market environment for gradual exchange rate adjustment and to deal with likely spillovers from the Fed’s QE II.

These restrictions are likely to be temporary since the government is determined to accelerate capital account liberalization over time.

Yiping Huang is professor of economics at the China Center for Economic Research at Peking University and in the Crawford School of Economics and Government in the ANU.

1. US-China economic imbalance: Alternatives to appreciating the Chinese yuan
2. The turning period in Chinese development
3. China needs to adjust its monetary policy now

On September 29, the US House of Representatives passed the bill to punish China for its undervalued currency. For the bill to become actual policy, it requires endorsement by the Senate and approval by the president. So, with mid-term elections due for the House and the Senate on November 2, the currency tension between China and the US might ease somewhat temporarily.

Treasury Secretary Tim Geithner indicated during a Ways and Means Committee hearing before the House of Representatives that he would use the upcoming G20 Summit in Seoul to pressure China to accelerate pace of renminbi appreciation. There are some obvious benefits of using a multilateral framework such as G20 Summit for resolving a currency dispute. But a ‘Plaza Accord II’, if that’s what Geithner had in mind, might be a dangerous way to go.

Agenda for the Seoul Summit

Many government officials from G20 members have been busy for the past months defining a proper agenda for the G20 Summit in November. This is critical because otherwise the gathering would be a waste of the leaders’ precious time. More importantly, the relevance of G20 as an institution depends on its ability to solve global problems. Since inception of the G20 Summit, its legitimacy has frequently been questioned.

To be fair, the G20 already has a long list of items proposed for discussion among leaders in Seoul in November. Many are a direct extension of the efforts fighting the global financial crisis. They include creation of a policy framework supporting strong, sustained and balanced growth around the world, restructuring of the financial regulatory framework and reform of the International Monetary Fund (its voting power and governance structure).

For sure the leaders would again have to discuss the issue of exit from expansionary fiscal and monetary policies. The Toronto Summit actually had an agreement on this but its implementation was complicated by worsening of the sovereign debt crisis in Europe and risks of a double-dip recession in the world economy. Continuation of excessively loose monetary and fiscal policies, however, could be poisonous for future growth.

Other issues proposed for discussion by experts and policymakers are the Doha Round of WTO Trade Negotiation, anti-corruption, climate change and marine environment protection. These are all important subjects. The Doha Round, in particular, could play a vital role in containing trade protectionism and ensuring an open and free trade system. The difficulty, however, is that the leaders might not be able to deliver concrete results in the short term.

As the host of the Seoul Summit, the Korean government has also added two items to the agenda: global financial safety net and development. But it isn’t clear yet if Korea intends to build a financial safety net completely independently of the reform efforts for the financial regulatory system and the IMF. Certainly, development of low-income countries is important both politically and economically. But what can G20 leaders deliver on all this in Seoul?

Rebalancing of the global economy

One area where the G20 can play an important role is global rebalancing. From its beginning in Washington in late 2008, the G20 Summit repeatedly stressed the importance of rebalancing as a way of both reducing financial risks and supporting sustainable growth. So far, however, we have seen very limited action from respective governments. This is understandable since global leaders have been busy containing financial and economic risks.

There is a wrong-headed perception among some experts and officials that the global imbalance problem is fundamentally a problem between the US and China. If that is the case, then the task of rebalancing should be left to these two countries and the G20 would have little to contribute. This is not consistent with the facts. True, China accounts for a large part of the global surplus. But similarly, Japan, other East Asian economies and oil exporters also contribute significantly to the overall surplus.

The global imbalance is a global issue. Resolution of it is better effected through multilateral frameworks. It certainly helps reduce risks of direct confrontation between the worlds’ two largest economies. The multilateral approach is also more likely to root out the core problem. For instance, even if China is forced to eliminate its current account surplus, the global imbalances may continue if other surplus countries do not do the same. The US might simply shift its borrowing from China to others.

But how should G20 deal with global rebalancing? The approach hinted at by Geithner through forced appreciation of renminbi is likely to be dangerous and unproductive. It might amount to a ‘Plaza Accord II’ as proposed by Bill Clines of the Peterson Institute of International Economics. In essence, a ‘Plaza Accord II’ would require currency appreciation and fiscal expansion in surplus countries but currency depreciation and fiscal contraction in deficit countries.

But ‘Plaza Accord II’ will probably be as ineffective as the original Plaza Accord which did not eliminate the global imbalances. For instance, the US current account surplus as share of GDP was 1.7 per cent in the 1980s, stayed at 1.6 per cent in the 1990s but surged to 4.7 per cent in the early 2000s. Princeton historian Harold James put it more bluntly: ‘The lesson of the past clearly indicates that a more sophisticated approach is required rather than exerting massive pressure for exchange rate adjustment and looser monetary and fiscal policy.’

‘Plaza Accord II’ is likely to be dangerous because it might force excessive on-off currency adjustment in surplus countries like China. Given the current state of the economy and the financial sector, drastic currency movements are likely to cause real difficulties. And any downturn of the Chinese economy today could risk growth and recovery from recession in many countries around the world, most notably East Asian economies and commodity exporters.

Coordinating structural reform

A better approach would be for G20 to focus on structural reform in key countries in which imbalance is a problem. And currency adjustment should be an important part of the, but not the entire, policy solution.

The G20 could play a role since it is able to look at experience in different countries. It can also coordinate the timing of the structural reforms in respective countries, since the reduction of a surplus in one country inevitably leads to, or has to be accommodated by, the reduction of a deficit in another country.

Take the example of China. The large Chinese current account surplus was derives mainly from distortions in factor markets, which repress costs of production and artificially improve the competitiveness of China’s manufacturing exports. Exchange rate misalignment is only a part of the picture of distortions. Elimination of the current account surplus requires liberalisation of the factor markets. Relying exclusively on currency adjustment to correct external imbalances would requires an out-sized appreciation, and that would be difficult for China to accommodate at this stage, both politically and economically.

Likewise, the exceedingly low savings rate in the US before the subprime crisis was caused by a number of factors. Simply depreciating the US dollar by a significant margin is unlikely to lift the savings rate materially. Such currency moves threaten to destabilise the economy and financial markets.

For the G20 to play a positive role in global rebalancing, it would have to depart from the earlier approach of the G7 focusing only on exchange rate and fiscal policy. Instead it should make efforts to encourage and coordinate more broad-based structural reforms in both surplus and deficit countries, consistent with what was agreed by G20 leaders in September 2009 in Pittsburgh, namely:

G20 members with sustained, significant external deficits pledge to undertake policies to support private savings and undertake fiscal consolidation while maintaining open markets and strengthening export sectors.

G20 members with sustained, significant external surpluses pledge to strengthen domestic sources of growth. According to national circumstances this could include increasing investment, reducing financial markets distortions, boosting productivity in service sectors, improving social safety nets, and lifting constraints on demand growth.

Rebalancing already happening

The good news is that global rebalancing is already happening. Both the current account deficit in the US and the surplus in China as shares of GDP have shrunk by half from their respective peaks before the crisis. Obviously, part of these adjustments must be cyclical, given global economic recession. But the bulk of the decline in global imbalances from 2007 to 2009 was a result of countries rebalancing export and import growth, and that is more likely to be sustainable.

Again, taking China as an example, recent adjustment of its external imbalance was, at least to some extent, a result of changes in domestic factor markets. Factor costs have been on the rise despite the global financial crisis. This is most evident in labour and resource markets due to changes in both policies and demand-supply conditions. During the past year, the government has begun to reduce price distortions for most resource products in order to improve economic efficiency. The upcoming labour shortage is already pushing up wages by close to 20 per cent a year.

PBOC deputy governor Hu Xiaolian recently argued that adjustment of fFactor prices are an important way in changing the renminbi’s real effective exchange rate. Such price adjustments are bound to have important impact on China’s trade composition. Rising wages, for instance, not only directly benefits consumption but also forces labour-using industries to move inland, another important positive factor for promoting domestic demand.

These are the policy issues that G20 leaders should focus on, with flexible exchange rate regime as a part of the broad structural reform package. The G20 can help identify some best practices, defining target ranges, setting time frames and laying out some types of disciplinary mechanisms (such as taxes on excessive surpluses and deficits). But it is better to leave decisions on choices of policy instruments and the pace of implementation to national governments.

Yiping Huang is professor of economics at the China Center for Economic Research at Peking University and in the Crawford School of Economics and Government in the ANU.

This is an article from the most recent edition of the East Asia Forum Quarterly: ‘Asia and the G20’.

1. Way through on global recovery
2. Global re-balancing: the G20 can learn from the misguided Plaza Accord
3. Japan: Will the DPJ weather the global rebalancing?

On October 19, PBOC announced a series of rate hikes. Although economists have been arguing for monetary tightening for months, this move was a surprise to many in the market.

This policy adjustment tells us several things: (1) monetary policymakers see greater inflation risks than the headline CPI inflation data; (2) the government is probably trying to avoid the Japan mistake: loosening domestic monetary policy in order to reduce pressure for currency appreciation; (3) therefore currency appreciation is likely to continue, if not accelerate; and (4) the authorities might adopt certain measures to control the capital account temporarily in order to discourage ‘hot money’ inflows.

China’s headline CPI rose to 3.5 per cent year-on-year in August, up two-tenth of a percentage point from the previous month. And disaggregated data reveal that inflation is mainly about food prices. This is the reason why some officials argue that monetary tightening was neither needed nor effective. However, during the thirty years’ reform period, almost every major inflation problem (in 1988, 1993 and 2007) was initially caused by food inflation. So the monetary policymakers would not treat food inflation lightly.

The current momentum of inflation is already pretty serious. CPI rose by 0.6 per cent month-on-month in August, which can be translated into annualised rate of 7.2 per cent. This certainly is way above the central bank’s target. More importantly, the headline number is probably grossly underestimated due to under-represented service prices in the basket. Some economists put down a more realistic CPI reading at 5-6 per cent currently, compared with the official number of 3.5 per cent. The Ministry of Commerce collects market prices for agricultural food every week. These numbers confirm that food prices already rose during the past three month at annualised rate of above 30 per cent!

But that’s not all. Two more factors shadow outlook of China’s inflation picture. First, although loan growth is slowing, the total new loans will still exceed 7.5 trillion yuan, PBOC’s annual target.. This is about 50 per cent more than in a normal year. With negative real deposit rates, liquidity holders desperately look for opportunities to invest. They first pushed up stock prices and then housing prices. When these prices stabilised, they shifted their focuses on certain types of commodities, such as beans, garlic, cotton and sugar. As long as liquidity is abundant, some prices will rise rapidly.

Second, wages are rising by at a pace of 20 per cent a year. Economists and government officials still dispute the notion that China is rapidly approaching the Lewis turning point. But every business person in China agrees that it is happening: it is increasingly difficult to find additional workers and labor costs are skyrocketing. Increases in wages are actually a positive development for China today. It has already led to improvement in consumption and therefore should be good for rebalancing of the economy. But inevitably, it will be inflationary.

The rate hike on October 19 is not only an effort to combat potential inflation, it is also an important departure from the typical Japanese approach of fighting currency appreciation. In the months following implementation of the Plaza Accord, Japan lowered interest rates and increased money supply. The reason? To reduce pressure for appreciation and mitigate impacts of appreciation. That approach, however, caused an even more devastating consequence: an abnormal bubble, which eventually collapsed in 1989.

Some policymakers had a similar mindset in the early days: we could not hike the rate because it would exacerbate currency pressure. But they have been worrying about an asset bubble since the beginning of the year. The government already implemented a number of tightening measures toward the housing markets. Those measures, unfortunately, did not have much impact since they did not address the root cause of the bubble risk: liquidity. The rate hike on October is unlikely to lead to a collapse of the housing prices, which have potential to go up further in the coming years given healthy balance sheets for the households and banks. But the latest change in the mindset of government officials may be able to help China avoid major asset bubbles like those experienced by Japan in the late 1980s and by the US during the early years of this century.

There is a worry that the rate hike might lead to more inflows of ‘hot money’. This is probably true, given that all major central banks and those in Asia are in a pause mood, if not loosening mood. But if the rate hike adds downward pressure on asset prices, it may at the same time discourage hot money inflows. The net impact is not clear. But ‘hot money’ is not something the government can completely eliminate.

In the near term, it is probably safe for the government to allow the currency to continue to appreciate. With risks of a double-dip receding, the policymakers are probably more confident about the growth outlook. There is also a possibility that they may tighten controls over certain types of capital inflows in order to reduce ‘hot money’ flows. These, however, should be viewed as temporarily responses to volatile market conditions. The long-term trend of capital account liberalisation remains on track.

Yiping Huang is professor of economics at the China Center for Economic Research at Peking University and in the Crawford School of Economics and Government in the ANU.

1. Is China entering a period of ‘marginal stagflation’?
2. China’s exchange rate policy dilemma
3. China needs to adjust its monetary policy now

Weaker data on consumption, income, employment, as well as forward-looking indicators in the US and the deceleration of GDP and production in China have triggered renewed fears about a double dip recession. In fact, the recent slowing of economic activity is the natural result of changes in policy and the economic environment. The slowing of economic activity is likely to be temporary. But beyond the very near term the world economy, especially the US and China, will transition to a new state of slower growth and higher inflation.

Three factors contributed to the recent slowing of economic activity. First, the speed of recovery between October and March in both the US and China was abnormal and unsustainable. Second, the sovereign debt crisis in Europe, while having limited direct impact on economic activity in the US and China, seriously affected confidence in these countries. Third, both the Fed and the People’s Bank of China (the PBOC) engaged in withdrew a portion of monetary stimulus at the beginning of this year.

Still, at least for now, a double dip scenario still looks highly unlikely due to four important factors supporting growth. First, financial conditions in both the US and China remain favourable, and, both the Fed and PBOC recently reiterated their intention to maintain loose monetary policy. Second, domestic demand appears steady around the world. Third, the inventory cycle is not yet over and may still add to growth performance in the coming quarters. And, finally, the balance sheets of households and corporate entities already improved significantly, evidenced by deleveraging in the US.

Of course, there are still serious risks facing the world economy. One such factor is the housing market in both the US and China, including home prices, available credits and housing demand. If housing markets turn down sharply, this could seriously dampen economic activity.

Beyond the next several quarters the world economy may experience a historical transition toward slower growth and higher inflation.

One consequence of the global financial crisis is a sharp deterioration of fiscal conditions worldwide. In the early 1980s, only about five per cent of countries had fiscal deficits greater than ten per cent of GDP. This proportion dropped to zero in the 1990s and early this century. But it is now above 45 per cent. In the US, for instance, the debt/GDP ratio is already above 90 per cent. Historically, a high debt burden would produce a significant decline in GDP growth and a corresponding increase in inflation rates (a common rule of thumb is that when the debt ratio is above 90 per cent, GDP growth falls by four percentage points while CPI rises by six percentage points, compared to a baseline debt ratio below 30 per cent). If history repeats, we are likely to see much slower growth and higher inflation in the US.

In China, the government has been focusing on structural adjustment in order to sustain rapid growth. But most policy efforts failed to cure the problem of debt to GDP. In fact, the imbalance problems have worsened sharply during the past seven years. Now there is no way for China to delay its structural reforms. A key adjustment, which is already occurring, is the liberalisation of factor markets, which will probably push up production costs, raise inflation rates and weaken economic activity on the margins. Such adjustment is necessary. China’s growth may shift to a lower gear but it should certainly become more sustainable.

We should expect the possibility of a new world economy with slower growth and higher inflation. The shape of this world economy will have significant impacts on consumers, businessmen and policymakers.

Yiping Huang is professor of economics at the China Center for Economic Research at Peking University and the Crawford School, ANU.

1. China’s coming era of slower growth: Are western economies prepared?
2. India’s war against inflation victimises growth
3. India: Controlling inflation without hurting growth