Walking A Fine Line: China’s Macro Adjustment

Once again, Beijing is walking a fine line between fire and ice – between over-heating and over-cooling its economy. This balancing act deeply worries U.S. financial sectors as well as other Asian entities (such as Japan, South Korea, Singapore, and Taiwan), whose economic performance is highly dependent on exports to China’s expanding markets. But Chinese policymakers have walked this fine line before, under similarly intense external pressure. Recall that the Chinese economy waded through the 1997 Asian financial crisis, the internet burst in 2000 and the SARS epidemic in 2003, largely unscathed. And, Beijing has a safety net – the de facto dollar peg has performed well as a nominal policy anchor, providing much needed stability to China’s financial system and economy for near a decade. More importantly, Beijing is determined to stay on the right track by using a raft of timely and preemptive macro-adjustment measures, which have been announced and swiftly implemented since August 2003.

The National Bureau of Statistics of China released a new batch of economic statistics for the first half of 2004 in mid-July. Although China’s macro-adjustments are still evolving, after three quarters of policy tightening, nearly every economic indicator points to a deceleration of activities, and it appears that a soft-landing of the Chinese economy is the most likely scenario. Though there is no scientific definition of a soft-landing, it generally refers to 8 – 9% GDP growth [1], under 4% yearly consumer price index reading, 12 – 15% year-on-year growth of industrial production and fixed-asset investment, and around 20% year-on-year growth of imports and exports.

Several factors support the claim that Beijing can successfully engineer a soft-landing. First and foremost, the fourth generation leadership barely has any other choices but to get the economy right. Without a stable economy, China’s leadership risks the loss of political credibility. That said, this government’s past record speaks for its capacity to ride different economic cycles. Secondly, the intention of Beijing’s economic policy really is to correct structural imbalances – i.e., to rein in excessive investments in certain sectors while boosting lukewarm domestic consumption – so as to prolong the economic growth cycle at a more sustainable level, say around 8% annual GDP growth. The policy cocktail is basically a mix of macro initiatives (tightening monetary policy and phasing out of proactive fiscal policy) and administrative measures at the micro level (shutting down an illegally developed steel mill in Jiangsu province). Probably more emphasis has been placed on the administrative aspect at this initial stage, though Westerners have been largely skeptical about the effectiveness of such measures. While this concern is valid, the blended strategy appears to be very much in line with the mixed character of the Chinese economy in terms of ownership, regional imbalances and urban-rural disparity. Furthermore, administrative measures are a necessary evil to deal with the inherent tensions between the central and local governments. The final factor in support of the claim that Beijing can engineer a soft-landing comes from the June statistics, which prove that macro-adjustments have taken hold, although the mission is far from complete.

While coal, oil and electricity shortages and transportation bottlenecks still pose a serious problem to the Chinese economy, it is also worth noting that newly extended short-term loans dropped sharply in both May and June. Moreover, the slowdown in auto sales due to restrictions on auto loans has lead to the deceleration of consumption in June. Policymakers in Beijing are taking note of this “collateral damage” from administrative controls. For the first time since February, the Chinese central bank, in late June, started to scale back from its weekly bill issuance. This process, whereby the central bank issues bills to commercial banks to take back base money supply temporarily, has been a primary policy tool since last April. It has been used to sterilize money base as a byproduct of the rapid build-up of foreign exchange reserves under the de facto dollar peg currency regime, thus allowing more liquidity in the money market. Early this month, the State Council (Cabinet) actually held a television conference attended by the central bank, the China Banking Regulation Commission (CBRC), the Ministry of Finance and the Labor Ministry, to promote measures aimed at diverting more small-volume guaranteed loans to small-scale enterprises to help with the reemployment of laid-off urban workers. As a result, the rhetoric of both the central bank and CBRC has toned down a bit in terms of curbing lending.

With the first U.S. Fed rate hike of 25 basis points out of the way, some pressure has been lifted from the Chinese central bank to raise rates. But, as Beijing’s blended macro strategy shifts gear to rely more on macro policy adjustments, rather than austere administrative measures at the micro level, questions about when China will follow suit with an interest rate hike are set to intensify. China’s capital controls and distinct economic cycle allow its monetary policy to be more independent of the U.S. than it should be, in theory, given the de facto dollar peg. Moreover, the start of a tightening cycle in the U.S. actually gives the Chinese central bank more room for discretion on interest rate policy, because higher U.S. interest rates should help decrease speculative capital flows into China (which have contributed to a rapid expansion of the monetary base, thus excessive credit growth, capital investment and rising inflation). It follows, then, that the faster the Fed raises interest rates, the less pressure there will be on the Chinese central bank to raise rates.

Furthermore, the consensus view of Chinese central government agencies is not conducive to an imminent interest rate hike. The National Development and Reform Commission and the Chinese central bank, the two heavyweights behind macro policy, apparently agree that there is no urgency to raise interest rates in the immediate near term. Moreover, the National Bureau of Statistics holds the position that overall contractive macro policy (i.e., a rate hike) is unnecessary and improper. Clearly, policymakers currently do not feel compelled to raise interest rates in near term. The next quarterly meeting of China’s Monetary Policy Committee probably will take place in September — a likely time for a decision on interest rates. A hike is not inevitable in 2004, should the third quarter economic statistics further decelerate and the central bank succeeds in tempering the inflation expectations of the public.

Beijing policymakers have their hands full with these macro-adjustments concerns, therefore bold steps on currency regime reform are unlikely to materialize this year. That said, as the U.S. Treasury department acknowledged, China has taken cautious yet concrete steps toward the goal of introducing more flexibility to the currency system. The latest move was a Memorandum of Understanding (MOU) signed between the Chinese central bank and the Chicago Mercantile Exchange to help develop China’s currency derivative markets, which was already touted by the Bush Administration as an achievement leading to the U.S. general election. Revamping the rudimentary financial architecture is a top priority and banking reform is the most important precondition of currency reform. Before China achieves certain milestones in banking reform, say, successful global listings of the Chinese Construction Bank and the Bank of China, currency stability will continue to be the dominant theme. Moreover, the more volatility in the Chinese macro economy and global financial markets, the longer the de facto dollar peg will stay to provide much needed stability – remember that “stability” is the magic word in China!

There are some positive developments on the horizon. Speculative capital inflows have probably waned considerably since March, because of dimmed prospects on the revaluation of Chinese currency and anticipation of interest rates normalization process in the U.S. A cooling off of speculative inflows betting on a Chinese currency revaluation long has been a precondition for Chinese policymakers to move forward on currency reform. Slower speculative capital inflows, then, could help pave the way for further reforms to China’s foreign exchange regime. We may see a moderate widening of the narrowly traded currency band, perhaps 1% on each side, late this year or early next year; while pegging a basket of currencies is probably only likely in medium term. China really is taking a much broader, more comprehensive and sequenced approach on currency reform issue, guided only by its own priorities and following only its own timetable.

While the economic developments in the first half of 2004 are generally encouraging, questions still remain for the better governance of the Chinese economy. How should the Chinese government exit gradually from heavy reliance on administrative measures and really let the macro policies do the macro adjustment job? How should it reform its land and credit management systems to be more market-oriented? And how should it reform its investment and financing system in such a way as to fundamentally root out new rounds of investment bubbles? In the words of a Chinese saying by “crossing the river by grabbing stones” – and probably that is the only answer at the juncture.

Notes

1. As a reference point, Chinese economy grew 9.1% last year according to official statistics, but private sector estimated the real growth at 11 – 14%. The National Bureau of Statistics adjusted the GDP growth of the first half of 2003 up to 8.8% from 8.2% early this week, and the final GDP growth data for 2003 has yet to come.