The hottest topic in China’s economy this week is a new working paper by that monetarist doyen Barry Eichengreen (along with Donghyun Park of the ADB and Kwanho Shin of KU) over at NBER.
Using international data starting in 1957, we construct a sample of cases where fast-growing economies slow down. The evidence suggests that rapidly growing economies slow down significantly, in the sense that the growth rate downshifts by at least 2 percentage points, when their per capita incomes reach around $17,000 US in year-2005 constant international prices, a level that China should achieve by or soon after 2015. Among our more provocative findings is that growth slowdowns are more likely in countries that maintain undervalued real exchange rates.
China bears are eating this up, as they rightly should. But some cold water is in order.
Eichengreen’s prediction of a 70% chance of a China slowdown medium-term sounds important only because it includes a number. Everybody knows a slowdown is a matter of when and how much, not if. A drop of 2% would mean growth rates in the 7-8% range after 2015 – which is almost exactly what the government officially targets.
The term “middle income trap” is thrown around with abandon, reviving nightmares of 1970s Latin American, and to a lesser extent, some Southeast Asian countries like Malaysia. But if 7% growth rate is a “trap,” it’s one the US and Europe would be happy to fall in to.
I think the problem is instead the real risk that China’s economy is a bit like the Russian empire: If it’s not growing, its shrinking. Any meaningful (2%+) slowdown becomes a collapse because so much growth stems from fixed-asset investment predicated on continued blistering growth in all sorts of sectors to even stay above water.
It ties into Eichengreen’s finding that countries which maintain undervalued exchange rates slow down more rapidly. The authors speculate that enhanced price competitiveness dulls incentives to increase productivity via innovation, or maybe because it exacerbates economic imbalances.
I think it’s almost certainly the latter. Like the Latin America’s Import Substitution Industrialization (ISI) scheme, suppressing the real exchange rate is essentially a means of transferring wealth from consumers to the corporate (specifically industrial-export) sector. But eventually it accrues diminishing marginal returns, and when the sector peaks it’s not at all easy to readjust to a more balanced service-based, consumer-led economy.
So in that sense an undervalued exchange rate doesn’t in itself impact any correction. Instead it’s a symptom of a dangerous economic approach that fuels high growth but tends to dramatically peter out after economies hit a certain development stage.