“Unsteady, imbalanced, uncoordinated and unsustainable” was how Premier Wen Jiabao described the Chinese economy in 2007. Wen’s comments have been widely quoted because they are so frank – some might say hyperbolic. China’s economy grew by a blistering 13.1% in 2007, and five years later it is still expanding by over 8% per year, surely a sign of rude health.
Not so, argues Nicholas Lardy, a senior fellow at the Peterson Institute for International Economics, a think tank based in Washington, DC. In his new book, “Sustaining China’s Economic Growth after the Global Financial Crisis,” Lardy writes that China needs to redress its economic imbalances immediately with drastic and wide-reaching reforms, or risk a serious slowdown.
China bears are a common species these days. Many are flash-in-the-pan doomsayers, but Lardy has produced sober-minded scholarship on the Chinese economy since the Maoist era. All the more disturbing, then, that he has sounded the alarm.
A place called vertigo
The book provides a sweeping overview of the current state and trajectory of the Chinese economy. In a nutshell, Lardy argues that China produces too many goods and invests too much in areas like infrastructure and property. This saps the strength of its services sector, which is smaller than it should be given China’s development, and crimps households, whose spending as a share of the overall economy is among the lowest of any country in the world.
How did China get to this point? Lardy blames a laundry list of short-sighted and market-distorting policies, including energy subsidies (which benefit electricity-hungry manufacturers), “financial repression” (in which savers are forced to accept too-low interest rates), and a weak social safety net (which makes a high savings rate necessary and suppresses consumption). Many of these imbalances cannot be cleanly separated, because ailments in one area of the economy quickly metastasize into other areas.
A prime example is the value of the renminbi, traditionally a flashpoint in China’s trade battles. That is because the State Council, China’s legislative body, charges the central bank with two conflicting goals: to keep the yuan undervalued to support export businesses, and to control the money supply to prevent runaway inflation.
To keep the renminbi undervalued, the People’s Bank of China prints money to purchase the foreign currency that flows into the country with China’s massive export industry. These foreign dollars, euros and so on are then recycled back out through massive foreign exchange reserves. Of course, printing that much money is apt to spark inflation, so the central bank ensures some currency is removed from circulation by requiring commercial banks to buy bonds and lock away large reserves.
Both methods drain money out of the economy, but at a price. The central bank must pay commercial banks interest on its bonds and reserves, and to avoid ballooning costs it sets rates absurdly low – often below the rate of inflation.
This effectively punts the cost onto commercial banks, which are paid miserly sums on funds that they might otherwise have lent to borrowers. To avoid bleeding banks dry from these low returns, the government fixes deposit rates across the country, guaranteeing commercial banks a fat profit on their other lending activities.
But someone eventually has to pay the “price” of an undervalued yuan. Ultimately it is Chinese households, who make up the bulk of bank savers and earn almost nothing on their deposits. Lardy identifies this punishment of savers as the main reason for the country’s shockingly low consumption as a share of GDP, China’s biggest economic imbalance.
Suppressing the renminbi has many other consequences, all of them unhealthy. Low interest rates encourage companies and local governments to go on borrowing binges and pile on debt, eventually leading to more non-performing loans. Commercial banks with fixed profits on every loan are incentivized to overlend. Foreign exchange reserves balloon as they soak up a flood of incoming foreign capital, money that is in turn poured into the US financial system.
The list of knock-on effects goes on, and an undervalued renminbi is only one policy distortion among many. On the whole, Lardy’s careful dissections suggest that relatively minor policy interventions have ignited chain reactions of perverse incentives and knocked China’s economy dangerously off-course.
Lardy argues that China will face a grim future if it does not address these economic imbalances. Exports will falter as demand from the US and Europe remains sluggish, and over-investment will eventually lead to diminishing returns and misallocation of capital. With consumption too weak to take up the slack, he argues, growth will inevitably slow – though he is careful never to say by how much, and distances himself from those predicting a “collapse” or “hard landing.” As the title suggests, Lardy plays it safe by focusing on how China must reform in order to sustain growth.
He identifies four main areas in need of reform. These include fiscal policy reform (such as cutting taxes and strengthening the social safety net), financial reform (allowing banks to compete on interest rates), exchange rate reform and price reform (removing subsidies for energy, water and land). Of these, Lardy hints that interest rate reform is the key driver to begin rebalancing.
However, for all Lardy’s mastery of the Chinese economy, his analysis of the politics of reform is underwhelming. He notes that today’s problems mostly began when economic reforms flagged around 2003-4, as China’s “fifth generation” of leaders consolidated its power. Because this generation lacks a dominant figure that can push through painful reforms, the pernicious influence of ill-defined “vested interests” goes unchecked, he writes.
This analysis barely scratches the surface. A better explanation might have explored the changing makeup of the Politburo and the rise of provincial party elites, who focus more on doling out goodies to their cronies back home than ideology of any stripe. The dynamics of such political patronage could explain apparent anomalies in the “vested interests” theory, such as why Beijing continues to push through painful property restrictions that directly impact the powerful real estate lobby. But this is a minor quibble in an otherwise excellent work.
“If we want everything to stay as it is, everything will have to change,” Giuseppe Tomasi di Lampedusa famously wrote about Sicily in his classic novel The Leopard. The same might be said of China’s economy today – sweeping economic reforms are not just desirable but unavoidable to maintain growth. And as Lardy cogently argues in this erudite and authoritative book, China’s time to make those reforms is running out.