china in the global crisis-2009

8/8/2019 China in the Global Crisis-2009

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ESTUDOS E PESQUISAS N 290

China in the Global Crisis:Recovery and Continued Reform?

Albert Keidel *

XXI Frum Nacional - Na Crise Global, o Novo Papel Mundialdos BRICs (BRIMCs?) e as Oportunidades do Brasil

(Crise como Oportunidade, Atravs do Plano de Ao)18 a 21 de maio de 2009

* Former senior economist in the World Bank's Beijing office, former China desk officer and acting director in the U.S.Treasury Department's Office of East Asian Nations, and former senior associate at the Carnegie Endowment forInternational Peace. He teaches a graduate course on China's economy in Georgetown University's Public PolicyInstitute.

Verso Preliminar Texto sujeito revises pelo(s) autor(es).

Copyright 2009 - INAE - Instituto Nacional de Altos Estudos. Todos os direitos reservados. Permitida a cpia desde que citada afonte. All rights reserved. Copy permitted since source cited.

INAE - Instituto Nacional de Altos Estudos - Rua Sete de Setembro, 71 - 8 andar - Rio de Janeiro - 20050-005 - Tel.: (21) 2507-7212 -Fax: (21) 2232-1667 - E-mail: [email protected] - web: http://forumnacional.org.br


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China in the Global Crisis: Recovery and Continued Reform?

Albert Keidel1

May 2009

XXI National Forum

Rio de Janeiro, Brazil

Introduction and Summary

After 30 years of rapid domestic-investment-led growth, China's economy and its leadership

institutions face a severe test in the 2008-09 global financial and economic crisis. In many

important dimensions, the combination of China's economic institutions and leadership strategies

should be just what is needed to manage this emergency swiftly and decisively. But it is still tooearly to know whether they can handle a sudden decline in China's large trade surplus--a decline

that may still be in China's economic future this year and next.

For the longer term, however, the real test will be whether the crisis will slow or accelerate

China's economic reforms and the pace of sustainable growth. Many of the Chinese steps taken

to stimulate domestic demand make heavy use of China's well-refined planning and policy-

lending mechanisms. While these have had a useful place in China's first 30 years of reform and

global opening, China's maturing economic and social needs will require that reforms continue to

expand in many more-market-oriented directions.

The global crisis could either suppress the pace of China's next-phase reforms, or provide a boostof funding and structural innovation to speed them along. So far, the signs are promising. At

issue is China's particular brand of economic leadership and whether China can continue on a

growth path that promises to surpass U.S. total GDP in roughly twenty years.

China's Place in Global Imbalances and Causes of the Crisis

An important question in considering solutions to and policy implications from the current global

crisis is this: what ultimately caused the crisis? With special regard to China, how much of the

crisis was due to conditions set in place by China and other developing countries who ran large

trade surpluses after the 1997-98 Asian financial crisis?

A body of recent analysis asserts that China's large current account surplus and high international

savings rate forced large capital inflows on the United States. These inflows, the argument

continues, lowered interest rates and enabled the large-scale expansion of mortgage lending and

other consumer credit in the United States that set up conditions for the crisis in the first place

1 Albert Keidel is a former senior economist in the World Bank's Beijing office, former China desk officer andacting director in the U.S. Treasury Department's Office of East Asian Nations, and former senior associate at theCarnegie Endowment for International Peace. He teaches a graduate course on China's economy in GeorgetownUniversity's Public Policy Institute. He is grateful to the Instituto Nacional de Altos Estudos for the opportunity toparticipate in Brazil's XXI National Forum.


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(Dunaway 2009, Pettis 2009, Wolf 2009). One phrase sums up the argument: "[China's] manipu-

lation is arguably the most important cause of the financial crisis. Starting around the middle of

this decade, China's cheap currency led it to run a massive trade surplus. The earnings from thatsurplus poured into the United States. The result was the mortgage bubble." (Mallaby 2009)

Figure 1. Global Current Account Imbalances

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-5

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-3

-2

-1

0

1

2

3

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

United StatesChina

Oil Exporters

Southern & Peripheral Europe

Northern (non-oil) Europe

Non-mainland-China East AsiaRest of the World

Current Account Balance as Percent of U.S. GDP

United

States

China

Rest of the World

(Latin America,

South Asia,

Africa,

&c.)

% Oil Exporters

Southern &

Peripheral

Europe

Northern

EuropeNon-mainland-China East Asia

Sources: Keidel 2009, from IMF World Economic Outlook interactive data base; with author's calculations.Note: Northern Europe: Switzerland, Sweden, Netherlands, Germany, Finland, Denmark, Belgium, Austria.Southern & Peripheral Europe: Ukraine, UK, Turkey, Spain, Portugal, Poland, Latvia, Italy, Hungary, Greece, Georgia,France, Estonia, Czech Republic, Bulgaria, Bosnia & Herzegovina, Belarus, Armenia, Albania.Non-mainland-China East Asia: Vietnam, Thailand, Taiwan Province, Singapore, Malaysia, Korea, Japan, Hong Kong SAR.Oil Exporters: Venezuela, United Arab Emirates, Saudi Arabia, Qatar, Russia, Oman, Norway, Nigeria, Kuwait, Iran,Canada, Azerbaijan, Angola, Algeria

This argument draws on an identity in international economics, in two versions, that says:

(1) Current Account Surplus = Foreign Savings, and

(2) Current Account Deficit = Foreign Borrowing.

These two equations say nothing about causality, but it is fashionable to assume a causal

sequence such that savings behavior drives current-account balances or that the savings and


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spending patterns in one country cause and reinforce those in another. A popular argument then

asserts that China's high rates of national saving have been a direct cause of global imbalances

and by extension the global financial crisis that these balances induced.In resolving such issues for the recent past, especially for the case of global savings imbalances

and their responsibility for causing the global crisis, a quick look at the world-wide pattern of

current-account balances makes it difficult to assign responsibility to China. A large U.S. current

account deficit reappeared in the 1990s, following the decline of an earlier large deficit in the

1980s associated with the U.S. savings and loan crisis. After a pause for the 2001 U.S. recession,

the U.S. current account deficit surged in 2002-06 (Figure 1).

Two different causal sequences have been posed for the U.S. deficit and subsequent world crisis.

According to the first, enormous trade surpluses in some countries, especially China, forced their

foreign savings on the U.S., lowered interest rates and enticed consumers and government intounwise lending habits. According to the second, rapid expansion of U.S. domestic liquidity from

a poorly regulated and over-leveraged financial sector fueled U.S. consumer spending on a scale

that forced surpluses to appear in other countries (Keidel 2009, Wolf 2009). A possible corollary

to the second explanation is that overheated consumer demand in the U.S. transmitted

inflationary pressures to exporting countries, requiring them eventually to fight inflation in ways

that weakened import demand, strengthening if not causing trade surpluses. In China's case, a

surplus emerged not because export growth accelerated in 2005 but because import growth

slowed (Keidel 2008a, 2008b, 2009). The most obvious import decline was for machinery.

A review of the evidence indicates that the second explanation is more plausible (Keidel 2009).

If nothing else, the timing gap between the U.S. deficit and China's surplus argues against China

being the driving motor of this crisis. The first appearance of a large U.S. deficit after the Asian

financial crisis was in 1998-2000. Unlike the rest of East Asia, China's current account was

nearly balanced until 2005. By 2005, U.S. subprime mortgages were already entering default,

many years after excessive borrowing had already surged in the United States (Keidel 2009).

Export-led growth and a world without imbalances

Several components embedded in this debate, however, deserve quick mention because they are

relevant for discussions later in the paper. First, did China's three decades of economic success

rely on export-led growth? Second, what would a world without current-account imbalances looklike?

It is easy to assume that China's growth pattern has followed the export-led example of other

earlier East Asian industrializers like Japan and South Korea. Close analysis of China's growth

pattern, however, shows that shifts in domestic investment, not exports, explain fluctuations in

China's GDP growth pattern. In the 1990s and up to 2005, China's GDP growth pattern, unlike

those of Germany, Japan and the rest of East Asia, correlated negatively with that in the United

States (Keidel 2008). In other words, when U.S. GDP growth surged, China's growth weakened

because of domestic policies, and when the U.S. economy weakened, China surged (Keidel


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2008). Other recent work reaches similar conclusions and adds that the major impact of trade on

China's growth is in productivity gains from technology imports, not export demand (He &

Zhang 2008).With this background, a dramatic reduction in China's trade surplus during the crisis may be

better seen not as a shift in growth paradigm but rather a return to China's growth configuration

before the recent period of large international imbalances.

The second question can be summarized in terms of whether a world with appropriate current

account balances would see rich countries with surpluses or with deficits. One view is that rich

countries should run surpluses and lend funds to poorer developing countries (Bernanke 2005).

But from the developing country perspective, this would mean continuing deficits, indebtedness

and foreign asset ownership. It would mean little if any chance to accumulate the foreign

exchange reserves a developing country would need to relax regulation of its capital account.The alternative is for rich developed countries to run modest deficits, relying on the reserve-

currency status of their growing indebtedness. This issue is controversial. One former European

Finance Minister told me that the G20 determined in 2005 that rich-country deficits were

ultimately preferable, but the G20 had to tone down the related statement that year because of

one member's objections. Its public statement, he said, only called for a reduction in global

imbalances. Developed countries like Germany and Japan appear especially reluctant to follow

this model.

For China going forward, this controversy over an appropriate pattern of global current-account

balances helps establish a strategic international financial framework. China obviously needs toadjust its trade surplus dramatically downward, but to what point? To a sustained deficit? It will

likely be many decades before China's size and maturity will be able to support the Renminbi

(RMB) as one of the world's reserve currencies.

China Enters the Crisis -- Three Separate Trends and Initial Policy Paths

In the thirty years between 1978 and 2008, China's economy went through numerous fast and

slow economic growth cycles while overall maintaining average annual growth averaging close

to 10 percent a year. Every single up and down swing in this period was triggered by shifts in

domestic policy and in particular domestically funded investment fluctuations (Keidel 2008).

China's rural land-tenure reforms of the 1980s and its market-oriented enterprise, banking, home-

ownership and foreign trade reforms in the 1990s bequeathed to the 21st

century an economy

with much higher productivity and a burgeoning global interconnectedness.

By 2008 China had already had a challenging decade. With growth finally recovering from its

late 1990s slump, China in the spring of 2003 faced the SARS pandemic, which threatened to

shut down its whole economy and which consequently triggered a sizeable government stimulus

program. Inflation in 2004-05 brought China's first wave of credit tightening, followed by

another anti-inflation effort in late 2007. With its investment rate at over 40 percent of GDP and


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an ICOR (the rate of new capital needed per increase in GDP) more efficient than that of less

capital-intensive India, China's output increased fast and with it so did real household

consumption -- especially in rural areas.But with the continued increases in China's trade surplus on top of already robust domestic

demand, China's economy after 2005 exhibited signs of overheating. Rising wages accompanied

government attempts to suppress inflation and manage strong demand for consumer durables on

top of a real estate boom in 2006-07. Real GDP growth in 2007 was 13 percent, as food prices

jumped 12 percent.

This was the setting for China's engagement with the global financial crisis of 2008-09.

Interestingly, worsening unemployment, slowing industrial output and weakening consumer

demand reflected three separate developments, two of which were entirely domestic. We can

appreciate the character of China's 2008-09 crisis only by following developments in all threearenas.

The first arena was a central government program begun as early as the first half of 2007 to close

small inefficient and heavily polluting export-oriented plants in southern China. The second was

what appears to have been an overly harsh suppression of the real estate market as part of credit

tightening measures to control inflation in late 2007. The third, as demand in the United States,

Europe and Japan collapsed, was the extraordinary decline in both exports and imports starting in

the fourth quarter of 2008, a decline that curiously left China's trade surplus virtually unchanged

in early 2009. It is a decline that apparently has not yet run its full course.

Closings and layoffs in a pilot "upgrade" to southern China's manufacturing sector

In late 2008, the governor of China's southern Guangdong (Canton) Province made a speech to

his senior government advisory group that was apparently pulled from mainland news media in

December 2008 almost as fast as it had appeared (Zhai 2009). His speech and mainland media

coverage described how China's central government, as early as the first half of 2007 -- and as

the initial roll-out of a nationwide plan -- had put limits on the number of small and medium-

sized export enterprises that could operate in the province. It also reduced tax rebates for exports.

The governor complained that these upgrading policies were going too fast and had caused the

closure of too many firms and the loss of too many jobs. He said he had objected directly to

Premier Wen Jiabao.

The same source quoted government statistics showing that 14,000 plants, or 15% of all plants in

Guangdong, had been closed by the first three quarters of 2008 -- well before the full force of the

global crisis hit China. Even in late 2008, upgrading, restructuring and plant closing were still

high on the Guangdong government's list of priority programs (Zhai 2009).

Indeed, in the very depths of the global crisis impact in late December 2008, China's cabinet (its

State Council) formally passed its "Program Plan for Reform and Development of the Pearl

River Delta," which it also called its plan for the "Scientific Development Pilot Reform Area"

(Xinhua 2008b).


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Chinese media describe this reform of the major industrial area of southern China as a pilot

program for a coming national reform movement to upgrade industry according to China's new

strategic concept of "Scientific Development." Scientific Development is China President HuJintao's strategy to go beyond merely seeking rapid growth to also emphasize a wide range of

national goals important for development sustainability, especially pollution control, reductions

in inequality and poverty, improvements in healthcare and education, and greater sophistication

in economic output.

Interviews with Hong Kong government officials early in 2009 confirmed that Hong Kong has

been cooperating for several years with the Guangdong government to close or relocate small,

inefficient and heavily polluting export-oriented factories, many of which were owned by Hong

Kong businessmen. Beijing's plan for the region announced in December explicitly emphasizes

close coordination with Hong Kong and Macao in preparing and implementing the program. In

addition to restructuring and "upgrading" manufacturing's sophistication, the plan calls for major

investments in airports, ports, expressways, railroads and shipping container handling centers.

Such a large and ambitious program of pro-active restructuring, with its intentional plant closings

and layoffs, raises questions about how much of China's apparent difficulties during the crisis are

actually the consequences not of the crisis but instead of premeditated consolidation and

upgrading. In this case, the international crisis may actually be doing a service to mainland

leaders' reform ambitions, because without the crisis to blame for these changes, they would be

politically much more difficult to implement.

As the crisis response in China continues to unfold, it is worth remembering that what might

look like agile steps to take advantage of a stimulus windfall for furthering needed reforms could

instead be the crisis-facilitated implementation of plant closing and layoff programs that had

been in preparation and even early implementation long before the crisis appeared.

A government-induced and prolonged real estate slump in 2007-08

The second major dimension of China's experience in the global financial and economic crisis is

its own domestic real estate market collapse in 2008 as the result of inflation-fighting tight

money policies introduced in late 2007.

China had already tightened credit and slowed investment growth to fight inflation in 2004-05,

after the anti-SARS stimulus package proved more than was needed for growth to recover. but

inflation reappeared in 2007, mainly as the result of sudden food price increases, and by the

second half of the year the central bank greatly strengthened its efforts to cool off the economy.

The shift in monetary stance was formally confirmed at China's annual government economic

policy conference in December 2007 as a shift to a "tightening stance." The tightening appears to

have already been under way for some time, however (Figure 3).

Several factors contributed to what in hindsight looks like an excessively aggressive and

prolonged inflation-fighting program. For one thing, the inflation situation appeared more

serious than it was because of severe snow storms in January and February of 2008 and their


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temporary impact on the prices of energy, food and other consumer goods. The "headline"

inflation data in China are year-on-year measures, which reflect all the price changes over the

previous 12 months, rather than only more recent trends.In China's case, the year 2008 carried with it a heavy overhang of shock price jumps which did

not continue but which were carried along in the year-on-year monthly data policy makers saw

most frequently (Figure 2). Secondly, China's statistical measures showed the rapidly changing

real estate situation only with a delay, so the credit-tightening policies continued for longer than

was necessary--indeed, carried on so long that they caused a serious slump in the domestic real

estate market.

Figure 2. Chinese Consumer Inflation by Two Measures, 2007-2009

-2-101234 % Month-on-Month SA*

2007 2008 2009

Total CPI

* Seasonally adjusted

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-2

0

2

4

6

8

10

Jan

Mar

May

Jul

Sep

Nov

Jan

Mar

May

Jul

Sep

Nov

Jan

Mar

% Year-on-Year

2007 2008 2009

Total CPI

Sources: China National Bureau of Statistics, Monthly Statistical Bulletin, 2006-2009, various issues, and author'scalculations.

The timing of the slump in China's domestic real estate funding can be seen in Figure 3. The best

measure of this dramatic downturn would be month-on-month measures adjusted for regular

seasonal effects, but these data they are too unstable and of too short duration as a data series to

be useful. Instead, the growth rates are calculated year-over-year, which obscures exactly when

the slowdown began, making it look later than it was. But even in these data it is clear that the

sharp decline in funding pre-dated the financial crisis' eruption in September 2008. What seems

important to note is that even these year-on-year data are better than officially published statistics,

which only show year-on-year change for year-to-date funding levels, statistics that change more

and more slowly as the year proceeds and heavily obscure new trends.


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Figure 3. China Real Estate funding Slump, 2007-2009

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25

50

75

20071-2 3 4 5 6 7 8 9

10

11

12

20081-2 3 4 5 6 7 8 9

10

11

12

20091-2

Total Funding Bank Loans & FDI Other, including mortgages

Other, including Mortgages

Bank Loans & FDI

China Real Estate Funding% increase (y-o-y)


The slump in real estate spending and hence in real estate construction and sales had a profound

effect on China's domestic economy beginning in early 2008. Most importantly, a real estate

pricing bubble had formed by late 2007, fueled by the excessive funding in the third-quarter of

2007 (Figure 3). The credit tightening burst this bubble, and real estate and consumer durable

prices began to fall and continued to fall. With prices falling, buyers increasingly stayed on the

sidelines, waiting for a better price. Inventories of construction materials and steel, as well as

finished goods, began to accumulate. In April 2009, a senior researcher in a Beijing government

think tank told the author that many government analysts now think this domestic slump is the

cause of China's greatest economic difficulties today.

This slump in domestic demand follows a thirty-year pattern of major economic fluctuations in

China triggered by domestic investment policy shifts, not foreign trade (Keidel 2008). In the past,

it has taken Chinese leaders a period of time to be satisfied that their inflation-fighting measures

had worked. But the third component in China's current crisis condition, the collapse in global

trade, has completely overridden any lingering concerns.

The global crisis' foreign trade impact on China

The impact of the global crisis on China's economy is mainly through its effect on trade, both

because of the sharp decline in world trade volumes and commodity prices, and because of


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difficulties acquiring trade credits as global finance froze up in the fourth quarter of 2008. Until

that time, China's export growth had been gradually decelerating from its growth surge earlier in

the decade, following its 2001 accession to the World Trade Organization (WTO). Trends inFigure 4 confirm that China's surplus only began to appear at the end of 2004, just when Chinese

customs statistics (NBS 2006) show weakened import demand for machinery and transportation

equipment corresponding to China's first domestic anti-inflation credit tightening and investment

slowdown of the decade.

Figure 4. China Trade Growth and Balances, 2002-2009 (3-month moving averages)

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0

20

40

60

80100

120

-40

-30

-20

-10

0

10

20

30

4050

60

2002

2003

2004

2005

2006

2007

2008

Exportgrowth(Leftscale) Importgrowth(Leftscale) TradeBalance(RightScale)

BillionUS$%increase(yoy)3monthaverage


The clearest point from Figure 4's longer-term 3-month rolling average perspective, however, is

that China's exports and imports both grew extremely rapidly for most of this decade, only

gradually decelerating from 35 percent growth in 2003-04 to under 25 percent in the first half of

2008. The most important explanation for this rapid growth is the re-routing of exports from

other Asian economies through China -- exports that had initially been shipped directly to theUnited States and Europe. For example, total exports from East Asia to the United States barely

changed at all through much of the 2000s; exports to the United States actually declined from a

number of East Asian economies as they sent their semi-finished products and key components

to China for inexpensive assembly, packaging and shipment to North America. The buildup of

this kind of trade pattern also helps explain the pattern of export and import deterioration once

the global crisis hit China in full force.


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Individual monthly data for more recent years (Figure 5) show that export growth first dropped

sharply in November 2008, well after the initial impacts of the southern coast restructuring began

and also clearly after China's real estate slump became serious.

The curious aspect of China's export growth collapse is that through the first quarter of 2009

import growth rates fell even faster than export growth, so that China maintained a trade surplus

-- indeed, it maintained positive growth in its trade surplus through February. As we will see

later in the paper, this trade surplus in the first quarter barely declined at all. The major

explanation for this most likely is that the decline in U.S. and European import demand has been

more difficult for those other East Asian economies who have assembly operations in China than

it has been for China's value-added contributions and its solely domestically sourced exports.

This point is made most clearly in Figure 5's data for November and December 2008. It appearslikely that while China was finishing and shipping exports to fill pre-crisis orders, new orders for

post-crisis processing and assembly had weakened dramatically, immediately reducing demand

for imported parts and materials. As a result, China's trade surplus in November and December

increased rapidly. A clearer understanding of this relationship awaits more detailed analysis of

trends in customs statistics. How this relationship will play out in the longer term is not at all

clear.

The just-released trade data for April 2009 show a likely pattern -- export growth has weakened

further while the import decline has abated. The result is a roughly 20-percent drop in China's

Figure 5. China Monthly* Trade Growth and Balances, 2007-2009

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60

80

100

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-30

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-10

0

10

20

30

40

50

2007

2008

2009

Exportgrowth(Leftscale) Importgrowth(Leftscale) TradeBalance(RightScale)

BillionUS$%increase(yoy)

* Note: Because Chinese New Year shifts regularly between January and February, year-on-year growth calculations for these twomonths are unusable; here, each January and February statistic is the average of both months' levels.

Sources: China National Bureau of Statistics, Monthly Statistical Bulletin, 2006-2009, various issues, and author's calculations.


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trade surplus--a potentially important component in GDP growth for the second quarter and the

rest of 2009-10.

The critical conclusion to draw from China's trade patterns in the global crisis to-date is that it istoo early to know what the ultimate impact of world-wide trade contraction will be on China. So

far, of the three major Chinese crisis components, the trade dimension appears to have been the

most benign. The April decline in China's trade surplus indicate this state may not last much

longer.

China's Stimulus Program and Initial Signs of its Effectiveness

The speed and ferocity of the global financial crisis appear to have taken Chinese leadership, like

virtually everybody else, by surprise. China's monetary authorities had only just begun a cautious

relaxation of its tight monetary stance as headline inflation data for August 2008 were announced

in early September. The balance between inflation worries and real estate market difficulties

appeared to be uppermost in their minds.

Table 1. China's 10-Point Stimulus Program of November 2008

Program Name GDP% Description1. Housing 1.3 Affordable low-rent housing, rural housing, nomad

settlement, slum clearance2. Rural infrastructure 1.2 Roads, power grids, methane use, potable water, North-South

water diversion, reservoirs, irrigation, poverty relief3. Transportation 5.0 Passenger rail, coal rail routes, trunk railways, airports, urban

power grids

4. Health and education 0.5 Grass-roots medical system, junior high school construction,special education and cultural facilities

5. Environment andenergy

0.7 Pollution protection, sewage and garbage treatment,forestation, energy conservation

6. Industry 1.2 Innovation, restructuring, high-tech industry and services7. Disaster rebuilding 3.3 Speeding up Sichuan earthquake zone reconstruction8. Household incomes n/a Minimum grain price, social safety net subsidies including

pensions, farm subsidies9. Taxes 0.4 VAT reform extension, technological upgrading

10. Finance n/a Remove commercial loan quotas, priority bank credit forpriority projects, for rural areas, small enterprises, technical

innovation, and M&A industrial rationalization.13.7

Note: GDP shares are based on the reported 2008 GDP level (NBS 2009a). Sources: Descriptions and Taxes figure from Xinhua2008a; other stimulus data (in RMB yuan) from World Bank 2009.

Once the global crisis situation became clear, however, China in November responded swiftly

with the largest (as a share of GDP) officially announced fiscal stimulus package in the world. It

followed up with extensions and adjustments to the stimulus and in December launched a

powerful monetary expansion. By the end of the first quarter 2009, the impact of this stimulus


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was still unclear, but GDP growth was still positive using year-on-year calculations and by some

quarter-to-quarter growth estimates. But to maintain even these lower first-quarter growth rates,

China's domestic demand growth would have to accelerate significantly if its trade surplus isgoing to decline as much as seems likely.

China's initial stimulus program

China's stimulus program, announced in November 2008, received a great deal of attention

because of its scale -- 12-to-14 percent of GDP, depending on which year's GDP one uses to

calculate the shares. The stimulus is to extend over a two-year period.

Figure 6. China Quarterly GDP Growth

0

2

4

6

8

10

12

14

Annual Quarterly(yoy)200820062004200220001998

GDP Growth, Percent y-o-y 13%

9%

13.8%

7.0%

6.1%

Sources: China National Bureau of Statistics Monthly Bulletins, various issues and NBS 2009b, with author calculations.

The total figure is somewhat misleading for several reasons. First, a portion of the spending is for

projects already in the five-year plan; the stimulus program merely advances the dates of their

implementation. Second, Beijing announced that only one-third of the total amount would be

fiscal spending -- that is, coming from government budgets. The rest would rely heavily on

domestic bank lending. Virtually all of China's major banks are state-owned or state-controlled.

Hence, the tenth item in Table 1, labeled "Finance," is really a financing methodology point

rather than an expenditure category; it reportedly accounts for two-thirds of all expected stimulus


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financing. Third, not all of the 10 points have monetary figures formally associated with them.

For example, it is not clear what the spending scale will be for increasing household incomes.

In addition to this initial stimulus announcement, government has on several occasionsannounced supplemental stimulus programs and adjustments to the original program. The actual

plan for China's stimulus program therefore seems to be flexible and responsive to changing

conditions. Chinese officials have repeatedly emphasized that they are ready to do more if it

becomes necessary.

Stimulus implementation, the economy's response and potential prospects

The single clearest indication of the scale of China's stimulus implementation has been the scale

of China's credit expansion from December 2008 through March 2009. In the first quarter of

2009, new bank credit was equivalent to 15 percent of GDP -- an enormous sum. Such a large

program of new bank lending emphasizes not only how much the stimulus plan is more than

budgetary outlays, but also how China's economic policy making apparatus blurs the distinction

between fiscal and monetary policies.

First-quarter statistics give some indication of how the economy is responding to initial stages of

the stimulus. It is of course difficult to know the impact of the stimulus without a reliable

counter-historical indication of what might have happened without it. Under global crisis

conditions, a trend line from the past is no longer a plausible counter-historical indicator.

In terms of GDP growth, at first glance (Figure 6), China's record of 6.1 percent first-quarter

year-on-year GDP growth appears to be a significant accomplishment. Most major economies in

the world are recording negative growth. It is of course a dramatic slowing from the peak

quarterly growth record of 13.8 percent less than two years earlier. One nagging question is

whether year-on-year growth calculations are reliable under these circumstances. The influence

of a better growth record earlier in 2008 still gives a boost to this first-quarter y-o-y growth rate.

Unfortunately, the seasonality of China's

quarter-on-quarter (q-o-q) growth has been

changing rapidly over the last decade, so it,

too is not fully reliable. The most likely

estimates for seasonally adjusted q-o-q GDP

growth in the fourth quarter of 2008 and the

first quarter of this year are 2.1 percent and

3.7 percent, respectively. Much lower than

the y-o-y figure of 6.1percent, but still

positive.

The worrying part of China's first-quarter results is more serious than measurement uncertainties,

however. China's GDP growth was only 6.1 percent even though its net exports barely declined

at all. In other words, China's GDP demand suffered no meaningful negative consequences from

Table 2. GDP Expenditure Growth, 2009 Q-1

Contribution Growth(Percentage Rates

Points) (Percent)

Consumption 4.3 7.2

Investment 2.0 6.7Net Trade -0.2 -2.0Total 6.1 6.1Source: Xinhua 2009, with author calculations.


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its export decline because imports fell so much faster, yet its domestic demand still weakened

significantly.

One version of China's first-quarter growth appears in Table 2, based on data from the first-quarter's data-release press conference. Change in China's trade surplus only contributed a

negative 0.2 percentage points of growth to China's GDP output difficulties. If China had been

seriously affected by the global trade contraction, net trade's negative impact would have been

much stronger, and its GDP growth would have been much lower.

The lack of any significant negative

trade impact raises the question of why

China's manufacturing output growth,

at only 5.3 percent, was so weak in the

first quarter (Table 3). For the timebeing, the burden of sustaining China's

growth seems to be borne by the

services (tertiary) sector. Just such a

shift is however one of China's

medium-term restructuring goals, so

China's initial response to the crisis is not completely out of sync with longer-term desirable

development directions.

The overall picture for China in 2009, then is one of greater vulnerability to the likely path of

global recession than its headline growth statistics would indicate.

China doesn't publish full-blown expenditure GDP data on a quarterly basis, but very rough

estimates indicate that if China's trade surplus (its net exports) of goods and services declined by

only a third in 2009, domestic demand would have to grow at 11 percent for the whole year in

order for annual GDP to come close to the government's target of 8 percent. With the slow start

early in the year for such an ambitious possibility, the stimulus burden is to generate mid-teens

double digit domestic demand growth in the second half of 2009. Such a result would imply a

dramatic growth acceleration.

Just-released April 2009 manufacturing output growth rates underscore the uncertainty of

China's recovery this year -- as well as the fickleness of such short-term indicators. Figure 7presents both year-on-year (y-o-y) and seasonally adjusted month-on-month (m-o-m SA) data on

Chinese manufacturing growth through April. By both indicators, growth deteriorated rather than

accelerating, as one might expect in a strong recovery.

In yet another dimension, one indicator of a successful domestic demand turnaround would be a

clear end to what has looked like price deflation in recent months and possibly some mild

increases in prices across the board. The most recent data on consumer price inflation, for April,

give positive indications -- but only after correcting for the weaknesses of year-on-year (y-o-y)

measures. We can see in Figure 2 that April 2009 y-o-y CPI price data are different from month-

Table 3. Quarterly GDP by Sector (% y-o-y)

GDP Primary Secondary Tertiary

2008 Qtr-1 10.6 2.8 11.5 10.9

Qtr-2 10.2 4.0 11.1 10.5

Qtr-3 9.0 5.7 9.2 10.1

Qtr-4 7.0 7.4 6.2 7.4

2009 Qtr-1 6.1 3.5 5.3 7.4Source: NBS 2009b, and National Bureau of Statistics monthly bulletins,

various issues, with author calculations.


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on-month seasonally adjusted (m-o-m SA) CPI indicators. The "headline" y-o-y figure reads as a

price drop of 1.5 percent and looks like a deterioration from March's CPI y-o-y decline of

1.2 percent. This negative 1.5 percent statistic might lead policy makers to think that morestimulus is needed to fight deflation.

But the m-o-m SA result for April CPI inflations is not negative; it is a positive 0.1 percent

change from March price levels, which when compounded for a whole year would yield a

+1.1 percent CPI increase. The difference with the m-o-m price decline result is due to price

changes a year earlier, when the m-o-m SA series shows there was a brief surge in CPI prices.

Compared to this surge a year earlier, April 2009 is lower, but not compared to March 2009.

Figure 7. China Monthly Manufacturing Growth, 2007-09

-5

0

5

10

15

20

1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4

Month-on-month, Seasonally Adjusted, not annualized Year-on-year

% increase in industrial value added (y-o-y, m-o-m SA)

2007 2008 2009

m-o-m SA, not annualized

y-o-y

Sources: China National Bureau of Statistics Monthly Bulletins, various issues and the China National Bureau of Statistics

seb site, www.stats.gov.cn, with author calculations.

One month's positive inflation results are not enough to guarantee that China's domestic stimulus

is working. The important lesson is to be careful about relying too heavily on y-o-y rates of

change.

Furthermore, if inflation does reappear quickly because of China's strong stimulus, what should

be the government's response? During a global recession, when China has a large trade surplus, a

little inflation could be a good thing. General inflation would induce an effective real revaluation

of China's currency on top of what might be recovered domestic demand for imports.


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Consequently, China's trade surplus could shrink faster in 2010 than would otherwise be the case,

not because of export weakness but because of import strength.

In a recession-ridden world prone to trade protectionism if unemployment worsens significantly,a continued sharp reduction in China's trade surplus might help weaken arguments of

protectionism advocates worldwide. Avoiding full-blown global protectionism is one of the

world community's major objectives, as emphasized by both G20 meetings. China's swift

recovery if coupled with inflationary tendencies could have unintended extra beneficial

consequences.

Summing up China's current situation.

The above analysis has presented a number of the curious complexities in China's current

experience with the global financial and economic crisis. China's economic system appears to

give it an advantage in coping with the crisis. In important ways, however, the full force of the

international crisis, especially its trade dimension, does not seem to have hit China yet. Its

domestic stimulus appears large, robust and flexible, promising a quick turnaround in domestic

demand. The best summary might be to twist the old adage, "It's not a question of whether but of

when, " into "It's not a question of when, but how bad." The scale of China's domestic stimulus

ensures a strong, perhaps overheated, recovery in the next 12 months. At issue is just how low

GDP growth will fall under the influence of shrinking world trade.

Looking beyond current crisis circumstances and prospects for medium-term recovery, the most

interesting question of all is whether the crisis can steer China's economic policy institutions,

with their systemic leadership capabilities, in even more useful directions as China continues to

shake off poverty and modernize.

Policy Tools and Reforms going Forward -- Economic "Leadership"?

The following section of this paper is a quick survey of just a few selected Chinese policy

methods and their outlook. It is intended to suggest discussion during the Forum sessions and on

the sidelines. The treatment here is therefore brief and evocative.

The policy tools China has applied to crisis management are the same tools it has refined and

reformed as the basis for its 30 years of rapid economic growth since introduction of major

market systems in 1978. How will the crisis affect China's economic reforms and the nature of

these pre-crisis economic institutions? Additionally, what ideas or suggestions do these policy

methods have for the global discussion under way about international regulatory institutions and

new standards for strengthening development efforts in modernizing economics?

In a sense, China's whole package of economic methods amounts to a systemic leadership

capability -- the ability to conceive and implement medium- and longer-term programs that face

short-term opposition because of the inconvenience if not discomfort they bring to significant

interest groups. The advantages of such a system are many -- if the leadership authority has an

accurate sense of the job that needs doing to spur sustained modernization.


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The disadvantage of a strong economic leadership capacity is its potential abuse by those

exercising so much authority. Virtually all developing countries experience corruption, cronyism,

suppression of information, and violation of civil liberties and basic human rights--including thebasic rights of women. It is important to consider the degree to which successful economic

leadership in any country must come at the expense of certain civil liberties and privileges. How

severe is this tradeoff, and what institutional adjustments might shift the whole tradeoff in a

benign direction?

This is a question that faces not only countries like China and India both before and after the

global crisis. The same question faces the global financial and commercial community as it

decides how much leadership authority to give international regulatory bodies, hopefully to the

benefit of long-term global development, over the objections of individual countries and other

compromised groups whose shorter-term interests might be jeopardized.

In China's case, an important question is whether the crisis has forced China to revert to a cruder

more authoritarian mode of its economic leadership formula. After recovery from the crisis, will

China's long-term program to increase the sophistication of its economic governance mechanism

have lost ground? Or will the crisis have sped up its progress? Indications are that both

influences may be operating, with a good chance that the crisis is speeding reform overall.

Public investments and financial system evolution

Since the crisis began, China's combination of sophisticated investment planning capabilities,

symbolized by its planning commission, and strong government-directed bank lending facilities,

represented most clearly in its State Development Bank, has allowed China in a very few monthsto push through enormous increases in stimulus spending for a range of "shovel-ready" projects.

This is the same "quasi-fiscal" capacity that for 30 years enabled China's remarkable success in

expanding the physical infrastructure needed to support its increasingly market-based growth.

A major concern is that, because of the crisis, what had been an increasingly market-oriented

funding system for public investments will revert to clumsier "force-fed" government-induced

bank lending for all sorts of projects, national and local. A related concern is that the effort to

push so much commercial lending into the economy will result in large numbers of unproductive

and unprofitable investments, ultimately resulting in a rapid increase in non-performing bank

assets.

The future of China's repressed financial system and its large-scale policy-based lending activity

is indeed one of the most interesting issues in China's economic future. The author has heard

foreign experts warning the Chinese that if they don't change their system, they will end up like

Japan! The Chinese response was, "That would be great!" China has roughly US$3,000 per

capita GDP while Japan over US$40,000.

The more fundamental issue, however, is how and to what degree are developed-country

financial institutions and standards poorly suited for developing countries, and with what should

those institutions and standards be replaced in poor countries attempting to generate rapid


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balanced growth? Both China's experience and current crisis conditions encourage a more useful

treatment of this topic.

Currency and capital account issues

Foreign exchange markets, exchange-rate regimes and capital account management questions

arise naturally when comparing China's experience with the current situation in most of the rest

of the world. China has had a closely disciplined capital account, for both portfolio investments

and FDI. It has managed its exchange rate through market interventions that have kept it

relatively stable with reference to a basket of currencies of major trading partners, despite

enormous international pressure to carry out dramatic nominal appreciation of the RMB.

Both the global financial crisis and the health of China's whole financial system invite an

investigation into ways China's experience can inform necessary adjustments in thinking aboutoptimal paths for financial sector development in poor and middle-income economies. How

might capital-account controls be more directly managed as a logical extension of domestic

financial regulatory systems? When is a current account imbalance the sign of a misaligned

currency rather than unbalanced forces of global demand? What is a suitable level of reserves for

a developing country; might it not be better measured as a share of domestic money supply and

potential capital flows rather than merely a facilitator of foreign trade? What should the new

standards be? Both the global crisis and China's experience invite reflection on these questions.

National savings-investment rates and growth of consumption

China has also been the center of a controversy about what a suitable rate of investment out ofGDP should be. When discussants at conferences and in associated research papers, media

opinion pages and blogs bring up this issue of what is the right balance between investment and

consumption in a developing economy, China is the most frequent reference.

China has enjoyed a investment rate (or savings rate, if you will) in GDP of over 40 percent, and

the concern is that by pushing fixed asset investment so much, this development strategy has

handicapped the growth of household consumption and ultimately of the basic source of national

demand needed to support sustained growth.

What is usually missing from the discussion is analysis of whether this investment is usedproductively or not and what China's very low levels of per-capita consumption in virtually all

categories says about the risk of overcapacity emerging anytime soon. A review of investment

efficiency is best summarized in the additional investment it takes to get additional GDP output

(the ICOR, or incremental capital-output ratio). Comparisons with India, a much less

industrialized and much less capital-intensive economy, shows that China's ICOR is as good as

India's, and for some periods better, despite its much higher rate of investment in GDP and its

more capital intensive economy (Keidel 2009b).


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The combination of China's low ICOR and high investment rate has resulted in decades of rapid

growth. The key point is that to the degree that the investment and consumption rates in GDP

have stabilized, as they have in China, both investment and consumption grow rapidly together.Real household consumption in China has grown at sustained rapid rates from the 1980s through

the most recent years for available data, averaging between 6 and 8 percent every year from 1985

to 2005, in all regions of China, according to one study (Keidel 2009c). The growth of

consumption has even accelerated in the years of high investment-savings rates since 2005.

Generating a high savings rate and using it efficiently for sustained growth is clearly one of the

major leadership requirements in a developing country. China provides an example of how this

has been done successfully so far, especially with its emphasis on an especially difficult

dimension, public infrastructure. China during the crisis, in the design of its stimulus program, is

clearly continuing this tradition. A big question is whether it can relax its grip on the structure ofnational investment to allow much broader private participation in its services sector, arguably

the most important dimension for its future expansion.

Labor force restructuring and reform

Economic leadership of the kind necessary for sustained development involves fending off

powerful interest groups whose particular demands do not serve the longer-term interests of the

country. China has faced this issue in numerous dimensions, but one deserves special recognition.

One of the best examples of an interest group China's leaders had to manage creatively but

sternly was its urban-registered labor force in the 1980s and 1990s. This labor force, more than20 percent of the total, had been heavily subsidized since the Maoist period, despite its low

productivity in over-staffed collectives and state-owned enterprises.

By using pro-rural administrative price reforms in the 1980s and a violence-plagued urban layoff

program in the 1990s, China pushed through a series of painful adjustments made politically

feasible because of an obvious major macroeconomic downturn beginning in 2007 and because

China's other pro-development institutions could also fund new urban job investments, could

administratively manage the pace of relative price changes, and could deploy a whole array of

social safety net subsidies and other compensations.

The basic task was to realign the productivity of a whole privileged class of citizens with itsliving standard expectations -- including some downward adjustment in those expectations for

significant subgroups of the class. Productivity rose through layoffs (50 million workers left

state-owned enterprise employment between 1996 an 2005) and liberalized regulations

encouraging small-scale enterprises and sole proprietorships.

In other words, China's economic leadership system did not allow the privileges of a subsidized

urban elite to block the major price, wage and employment reforms it saw as essential for

medium- and long-term national economic success. The guiding principle seems to have been to

create individual personal incentives encouraging productivity gains--like making education


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remunerative and encouraging small-scale entrepreneurial risk-taking. In this way, self-

motivated individual behavior promoted more rapid national growth.

These reforms are not finished. China still has legal distinctions nationwide between "urban"citizens and "rural" citizens". Pilot programs in major cities to eliminate these distinctions have

gone quite far but also run into serious challenges. The crisis, with strong reverse migration from

urban to rural areas for the time being, is a chance for China to continue these reforms. This on-

going process is important both for China after the crisis and for those wanting to learn from

China's experience.

Productivity-enhancing inequality

A widely mentioned aspect of China's modernization to-date is the increase in inequality it has

generated, both between regions and between and within urban and rural areas. As measured by

summary statistics like the Gini coefficient, increases in inequality have been substantial. But

summary statistics say nothing about the shape of different distributions and the contribution the

shape makes to creation of individual incentives for personal productivity and income gains.

China's growing inequality, especially between urban and rural areas, has to be considered in

conjunction with the investments China has generated in urban jobs, urban rural transport and

communication, basic education in rural areas, and increased flexibility in residency restrictions.

Together, they have made inequality an engine of personally motivated migration and job change

raising individual productivity and income.

As China responds to the global crisis, and as the Chinese stimulus program seeks to expandmore sophisticated and technically demanding employment opportunities, one of its many

challenges will be to make sure that inequality continues to develop in productivity-enhancing

ways. The stimulus program emphasis on affordable housing, middle-school education,

healthcare, and transport and communication all promise to work in that direction. The risk is

that a deep slump in output and employment growth from the collapse of world trade later this

year will create a large more permanently disenfranchised minority.

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