China’s economy slow going

Attendees at this year’s sold out Cayman Business Outlook heard that China’s economy will grow slower due to the desperately needed rebalancing of its economy and the US has to overcome a “chronic disability to govern”, according to key note speakers.

The one-day conference at the Ritz-Carlton typically provides Cayman with a global perspective and this year the focus of the event was the changing global economy and China’s increasing economic weight in the world.

Fidelity Group Chairman Anwer Sunderji offered some contrasting statistics comparing Chinese and US development. While China was the largest exporter of goods and the largest net creditor to the world, the US was hampered by a government debt burden that might reach $15 trillion this year. High levels of unemployment and the “relative impoverishment” of the US after the financial crisis would raise the question, how the US will cope with this new story of “downward mobility”, Sunderji said.

Dealing with China’s imbalances

However, in contrast to what is often reported, China did not well through the crisis either, said Michael Pettis, professor at Beijing University. “It was disastrous,” he said.

Pettis noted a growing recognition in China that the country needs to rebalance its economy, away from an overreliance on its trade surplus.

While optimists in China say that the incoming new leadership is concerned about domestic imbalances, recognises the problem and will rebalance the economy, they also admit that the adjustment will be difficult, Pettis said.

Pessimists on the other hand say it is probably too late and believe that the new leadership will have to establish itself first in internal power struggles during the first two years, before a re-balancing of the economy can be tackled.

Highlighting China’s trade surplus, he explained that China’s trade imbalances have to be met by corresponding imbalances in other economies, such as the US and some European states, which run trade deficits. A re-balancing of the Chinese economy and lowering of the trade surplus would thus resolve imbalances in the rest of the world as well. At the same time, European trade deficit countries would have no other option than to cut their deficits and the US has also shown some commitment to do so, he said.

But the options available to China to rebalance its economy all have their own drawbacks.

The most important imbalance in China is a record low share of domestic consumption of GDP, which in 2010 reached 36 per cent, compared to 70 per cent in the US and other developed countries.

Pettis explained that of the three sources of domestic economic growth, consumption, domestic investment and trade surplus, China’s GDP is relying too much on its trade surplus and high investment rates. This is a problem because the trade surplus will ultimately lead to trade tensions, he said.

At the same time investment rates that are too high are problematic, because they will result in the misallocation of investments, which, experts agree, has been going on for at least the past two to three years, Pettis said.

Throughout history comparable periods of rapid growth, undervalued currencies and low consumption were followed by a lost decade, he said, giving Japan as the prime example.

Pettis also believes Chinese consumption is low, because it followed the Japanese growth model.

In Japan the tax structure and hidden taxes led to a high savings rate in three ways.

Firstly, an undervalued exchange rate reduced the value of household income by effectively increasing the cost of imports. This effect is virtually the same as a tax on imports.

Secondly, the gap between wage growth and productivity growth increased, as wages rose more slowly than productivity. This benefitted employers and producers and limited household spending.

Thirdly, in a financial system where savings are largely bank deposits and corporations are funded mainly by loans, the control of interest rates can become a hidden tax, Pettis said. Low interest rates in fact benefit corporate borrowers, but become a tax on net savers such as households.

The rebalancing of the Chinese economy will therefore require a rise in the share of household income, but each of the options available to China’s political leaders has its own drawbacks, which make the adjustment difficult.

Raising the value of the currency will slow down growth and stifle the economy, if done too quickly.

Raising wages will threaten the competitiveness of Chinese companies, which are “addicted to low wages”, Pettis said.

And raising interest rates will increase government debt. Chinese government debt rates are much higher than the often reported 20 per cent, Pettis said, who estimates that they are more in the region of 70 per cent, if not higher. As the Central Bank has to buy foreign currencies from the export sector, a rise in interest rates will result in the Central Bank getting negative carry, meaning that it pays a higher interest on domestic liabilities than it receives on foreign currency assets.

The state-owned enterprise sector “is a value destroyer”, Pettis noted. SOE debt levels are high and the sector is barely profitable. Virtually all of the SOE’s 1 per cent profit margins can be explained by the borrowing advantages that state-owned enterprises enjoy and the household sector is paying for that, he said.

Pettis believes the new leadership will bring the trade surplus down, but it will take China 8 to 10 years to slowly make the necessary adjustments. Initially the trade surplus will continue to grow before it decreases.

However, because China had waited too long and the adjustments will be difficult, Pettis expects a rapid decline in growth rates, much lower than the anticipated 5 to 7 per cent.

The reduction of the trade surplus itself is not as negative for the world economy as often feared, he said, because China’s trade surplus decline will add some growth to the global economy.

US at a political crossroads

The US meanwhile finds itself at a similar political crossroads, said FT columnist and The Atlantic editor Clive Crook. He characterised the situation in the US as a “chronic disability to govern” combined with economic problems.

While he acknowledged Sunderji’s assessment of a “relative economic decline” of developed countries, he argued that this was just another term for “global economic convergence”, indicative of rising living standards in the developing world and staggering growth rates in countries like China and India.

He did not think the idea that developing countries catching up was “depressing”, as the important aspect of “relative economic decline” was the word “relative”.

Small prosperous European countries, he said, are examples for successful economies despite their relatively small weight in the global economy. A country’s goal should not be to become the largest economy in the world, but to improve the living standards of the population.

The US is facing the problem that the general rule that the US economy typically was able to rebound sharply from a deep recession no longer applies, he said.

Crook’s explanation for the slow and “jobless” recovery of the US economy based on three points.

He argued that the bursting of the real estate bubble means that consumers have to come to terms with the fact that their approach to household finance has been flawed. This has a profound effect on US consumers and resulted in a savings rate that moved from -2 to 6, a “colossal number” for the US.

Weak regulation is another reason for the sluggish recovery, according to Crook. There are concerns over the effect of Dodd Frank, a regulatory reform of “2,000 pages of loose ends”, he said, comparing it to Sarbanes Oxley, a response to accounting scandals, which was “ill-considered” and “ill-measured”.

China’s capital surpluses, which largely found a home in the US and fuelled the housing crisis were the third factor mentioned by Crook. While he believes that the Federal Reserve had done what it could with quantitative easing and low interest rates, he said that if the capital markets turn against the US dollar, “we could be in for a second round of house price declines”.

Crook noted that the Federal Reserve Chairman Ben Bernanke “showed boldness and ingenuity” through unconventional measures such as quantitative easing, the buying of distressed debt and dozens of programmes designed to stimulate the economy.

These measures have worked, he said. Even though the recovery has been “disappointing”, it “could have been a lot worse”.

In the short term the former Economist editor advocates low taxes and a loose fiscal stance that would allow debt to stand for one year. He believes the capital markets would let the US get away with it, if this was combined with a long term commitment to lowering debt. But he also warned that if the first US states went bankrupt, the shock to the financial system would affect federal debt as well. The debt ceiling, he predicted, will be breached in April or May of this year and could lead to a government shut-down.

While the de-leveraging is going to continue, there remains an acute uncertainty politically.

Crook argued that political decisions, in particular Barack Obama’s ability to be the champion of political compromises, and the next budget would largely determine the path the US is going to take for the rest of the Obama presidency. He noted in particular US income tax reform as one example for such a compromise across party lines.

A global society at risk

A similar ability to make compromises and act collectively is also needed on the global level, said Edward Kolodziej, research professor, emeritus, and director of the Center for Global Studies at the University of Illinois.

He outlined that dealing with increasing global interconnectedness requires that we recognise that there is now a global society and that this society is at risk. The threats to the global society, which due to its differences and divisions is not a community, can only be tackled if the world’s states and peoples assign priorities to addressing systemic risks, he said.

Kolodziej emphasised that “there are no superpowers”. “The US did not have its preferences abroad right for a long time” and “China will not be any different”, he said.

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Michael Pettis, a professor at Beijing University, discussed China’s future growth. – Photo: Michael Klein

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