China: No Longer the Villain

While concerns about Spain and, to a lesser extent, Italy have again taken center-stage, a number of experts and market participants are almost as worried and skeptical about China as they are about the eurozone. external pageThe China bears have been predicting a crashcall_made within the next one to two years for the last several years. As China’s growth is unbalanced, there is no shortage of concerns:

• A real estate bubble.
• Excess credit and investment which can turn into rising non-performing loans.
• Large liabilities in the shadow banking system, notably financing vehicles for the local government.

To this, you can add social stability and a political system that baffles outside observers.

Despite this, the IMF does not seem to be overly worried about China. Four points of good news stand out:

First, the Fund forecasts an average GDP growth of 8.6% between 2012 and 2016.

This is down from a previous forecast of 9.4%, but 8.6% is certainly not a ‘hard landing’. In fact it is not even a soft landing – at 8.6% China would still be flying high. A China crash external pagedoes not even figurecall_made in the list of the Fund’s main risks to the outlook, which are external pagelimitedcall_made to the eurozone crisis and a geopolitical shock to oil prices.

Second, the Fund expects that sustained strong Chinese growth will no longer come at the expense of global economic stability, through the global imbalances.

Last September, the IMF projected China’s current account surplus to widen significantly in the coming years, to over 7% of GDP. Now, it expects it will rise to a much more moderate 4%.

Third, the IMF has re-assessed the extent to which China’s growth had already shifted to domestic rather than external demand.

In September, the IMF expected a external page2011 current account surpluscall_made of over 5% of GDP; it turned out to be less than 3%. Discussing how China’s current account surplus narrowed from over 10% of GDP in 2007 to less than 3% in 2011, the IMF estimates that most of the correction has been driven by stronger domestic demand (investment), an appreciation of the renminbi (nearly 15% in real trade-weighted terms), and a worsening of China’s terms of trade, as its exports have become cheaper and its imports more expensive (the price you pay for being so large as to move world prices). Here, lower growth in advanced economies seems to have played a relatively minor role.

Of course, within domestic demand the imbalance of investment over private consumption has external pagegotten worsecall_made.

Fourth, China widened (slightly) the renminbi’s trading band just in advance of the release of the new IMF forecasts.

China is no longer the main culprit, its current account balance is back within normal bounds, and it becomes harder to argue that its currency is grossly and artificially undervalued.

Good news for the global economy

If this China scenario plays out, it will be very good news for the global economy, as both the pace and the re-balancing of China’s economy will help support global growth. Indeed, the IMF projects an average global GDP growth of 4.3% over 2012-17, higher than the 4% average of the pre-crisis decade (1998-2007). The extent to which China’s growth is export-driven or domestic demand-driven is only one side of the picture. In a recent Vox column, external pageDi Giovanni et al. (2012)call_made discuss the implications of China’s sectoral patterns of growth for global welfare.

The IMF base case for China is much more likely than the bear case, in my view. China’s leaders prize social stability, and know that to preserve it they need robust economic growth. They realize that the current growth model is unsustainable, and their strategy shows a remarkably lucid understanding of the challenges and the most likely solutions, as reflected in the external pagereportcall_made issued jointly with the World Bank a couple of months ago. This sort of clear, comprehensive strategy might not be enough, but it is a lot better than what EU and US policymakers have got us used to. Not all Chinese politicians agree on the need for further reforms. There will be fierce resistance from vested interests and, even with the best intentions, the reform challenges are formidable. There will be accidents along the way. But China has huge foreign exchange reserves, relatively low debt levels (even including local governments), and healthy private-sector balance sheets.

Most importantly, the transformation of the economy that has already taken place is starting to create a set of pro-reform vested interests. Liberalization has started to acquire a momentum of its own as a larger number of consumers get a taste of better living standards and private companies develop. Further liberalization will be partly from within – it is not fully dependent on policy efforts.

Conclusions

It is extremely hard to understand China. Its sheer size implies that its economic transformation is by definition an unprecedented experiment. Statistics are relatively poor. And since the stakes are so high, it is hard not to let emotions get in the way of a rational assessment. If China fails, especially if it fails soon, the global economy could plunge back into recession. If China succeeds, it will upset the existing balance of economic power.

So we need to remain humble, keep watching, and keep thinking. But its track record to date – 10% annual growth on average for the last 40 years – suggests we should not be too quick in dismissing its chances.