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Downturn May be a Blessing for China

Straits Times 30 July 2012

WITH the United States and Europe still mired in crisis, China’s economic landscape presents an increasingly dreary picture.


Responding to the global outlook, China’s central bank the People’s Bank of China has reduced the reserve requirement ratio, cut interest rates, injected short-term liquidity through reserve repurchases, and allowed the yuan to depreciate to help exporters maintain competitiveness.

On the fiscal side, policymakers also sped up the approval and budget allocation process for infrastructure investments, and introduced demand-side incentives to boost domestic consumption of China-made products.


Despite these efforts, policymakers have been quick to point out that China will continue to adopt prudent monetary policies and rule out another 2009-style stimulus package.


Three years on, even though the outlook looks daunting in the short term, the Chinese economy is in much better shape to cope with any eventuality.


The economy is still on track to expand 8.2 per cent this year, according to a Reuters poll. Given the government’s willingness to support growth at all costs, a hard landing – which some interpret as 6.5 per cent growth – is still possible but highly unlikely.


What China faces is not a cyclical downturn caused by domestic weaknesses that can be ridden out through counter-cyclical macroeconomic measures while the downturn runs its course. The global market continues to be plagued by structural imbalances and financial deleveraging in the West, both of which will take years to correct. Aggressive monetary and fiscal measures may lift China in the short run but the effects will soon run out, leaving its economy in even greater imbalance.


Chinese policymakers are more concerned with inflation and structural imbalances, while the West battles deflationary pressures and stubbornly high unemployment.


The usual practice of aggressively cutting both the reserve requirement ratio to improve liquidity and interest rates to stimulate investment may not be in the best interests for China.


If economic conditions do not substantially worsen with the current bout of monetary easing kicking in by the second half of the year, relatively high interest rates can be maintained or even raised instead of being lowered further. Keeping interest rates relatively high has several advantages.


The higher cost of funds discourages investments of low return. Rising interest rates also help to restrain inflationary pressures which are expected to pick up by the fourth quarter. Finally, banks have more room to raise deposit rates to alleviate their problem of slowing deposit growth.


In short, even though Chinese policymakers are likely to introduce more measures responding to softening growth in the short term, those hoping for another 2009-style stimulus package are likely to be disappointed.


One central government spending measure worth bumping up is the public housing programme. Beijing can help share more of the construction and land costs, almost 85 per cent of which is borne by local governments.


More public housing investment will help boost consumption, pull along growth in many housing-related industries, speed up the pace of urbanisation, create many jobs for the growing urban population, and ease price pressures in the private property market.


More pertinently for the new incoming party leadership, it will earn the government immense goodwill and further fortify the party’s legitimacy to rule.


The problem for China is not overinvestment but misinvestment – the inefficient allocation of capital results in money going to the connected rather than the needy.


The slowdown may be a welcome respite for Chinese policymakers who have been trying hard for some time now to curb rampant speculation, reduce excess industrial capacity and rein in misinvestments so that money can be redirected for better use.


The economy’s structural imbalance is probably a greater and thornier issue than the slowdown for policymakers.


It is relatively easier for China to fight economic deceleration than to overcome deeply entrenched vested interests of local governments, state-owned enterprises and political cronies. Despite introducing the New 36 Clauses privatisation policy in 2010, for example, progress has been painfully slow because of those vested interests.


China’s lopsided financial system is an urgent problem that needs addressing. It is still dominated by state banks making large easy profits because of outmoded policies made when the banks were weak and needed protection. The inefficiency in capital allocation leads to the emergence of a shadow banking system and an underground one in recent years.


Within this shadow banking system, local governments acquire off-balance sheet financing through funding vehicles for their infrastructure investments.


Much of the 2009 stimulus money went disproportionately to state-owned enterprises and local governments, while small and medium-size enterprises (SMEs) were left to scour for high interest- bearing loans from the underground banking system.


The underground banking system totalled 3 trillion yuan (S$587 billion) to 4 trillion yuan across the country.


The formal banking system is today laden with 10.7 trillion yuan of potentially unserviceable debt, while the underground one faces mounting risks of bad loans made to SMEs.


Until the financial system has more depth and breadth and becomes more market driven, any use of it to drive the economy will likely lead to more imbalances.


This greatly curtails the effectiveness of counter-cyclical macroeconomic tools and limits policymakers’ ability to manage the economy, especially in times of crisis.


Market observers say Chinese policymakers are behind the curve in tackling the slowdown and are calling for another big-bang stimulus package. They hope a strong and speedy recovery can again help pull the regional and global economies out of the doldrums.


So far, Chinese policymakers have rightly resisted those calls. Unlike the panic of 2009, the crisis- seasoned policymakers exude quiet confidence this time round. Unless the European debt crisis deepens, dragging the global economy with it, the Chinese government should stay on course to rebalance and restructure its economy, using just the right doses of policy action to prevent a hard landing.


The current downturn may be a blessing in disguise for China, allowing its economy to emerge not just bigger but also healthier and stronger.

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