BackNarrowing economic options for China
China's progress has been due to its economic pragmatism. Some of it may have to rub off on its foreign policy too
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A good friend sent me the text of an interview of Roderick MacFarquhar, a China scholar, conducted by Ashutosh Varshney. The interview loudly proclaimed that China would not make concessions to win India’s friendship. The world, with few exceptions, has little understanding of the range, nature and magnitude of the economic troubles unfolding in China.
There are reasons why China might not oblige either the China scholar or the interviewer. China might be a touch keener to do things differently this time. This column will focus mainly on the economic logic due to space constraints though there are other reasons, doubtless. The cyclical slowdown in the Chinese economy and the structural headwinds that raise big question marks over long-term growth revival mean that China would be prudent to look for sources of growth diversification.
Consensus forecasts now put China’s growth rate in the coming years in the range of 6.5-7.5%. The subtext is that China’s real growth rate slows down gently from around 8-9% to around 6-7%. The soft-landing case rests on the belief that as China’s nominal gross domestic product (GDP) growth slows down, the gap between the nominal GDP growth rate and the level of interest rates in the country narrows. China’s lending rates have been far below nominal GDP growth rates, creating an incentive for excess investment and overcapacity. As the nominal GDP growth rate slows, this “free lunch" provided for borrowers disappears and hence it would reduce the incentive for borrowing and investment. Thus, the economy would be or is already on its way to a rebalancing away from investment and towards consumption. This thesis is elaborated by Michael Pettis, a long-standing China watcher, in a recent essay titled, What does a “good" China adjustment look like?
The problems with this thesis are several. It is one thing for the incentive to borrow to invest to be reduced and it is another thing for savers to be compensated with positive real returns on their deposits. Nominal deposit rates remain very low. Of course, real deposit rates may turn positive because of declining inflation rates or even outright deflation. China’s inflation rates measured by both its consumer price index and the GDP deflator have declined sharply in the last two years. But that would be cold comfort for China’s households. A deflating economy will crimp savings options and will not generate jobs, especially if past bad investments come home to roost and fresh investments are hard to come by with the elimination of the underpricing of capital relative to nominal GDP growth.
One suggested solution for the unemployment risk is to liquidate state assets and for the government to fund employment. It is not clear how this would work in practice. Which sectors would do the actual hiring? The other mechanism that the author proposes to kickstart consumption is a large initial wealth transfer from rich households to the poorer ones. This would allegedly drive growth in services sectors. Will Chinese elites acquiesce without protest in a large-scale wealth transfer? A recent survey by Barclays Wealth showed that nearly half of the Chinese elites surveyed do not rule out emigrating out of China in the next four to five years. The number for India was 5%.
At the same time, the government is also expected or urged to assume the bad debt of local governments and state-owned enterprises and to pay off the debt through privatization and higher taxes!
Is there a real Chinese private sector, except in pockets, with capacity to manage and run large enterprises? Even if there is, what is the cost of capital it would face with financial repression ending and with the debt burden of the sovereign itself having gone up, prompting a likely credit rating downgrade? Will higher taxes go down well with households and will they not come in the way of a rebalancing towards consumption?
Further, if the state had to do massive transfer payments, assume bad debts, privatize and sell state assets, the Communist party would become a pale shadow of its former self and its control over the economy would be so considerably reduced as to render it almost irrelevant. Is that politically feasible? Further, even if China’s household consumption remained steady in the face of falling GDP growth, will China really accept 3-4% real GDP growth and will it leave China’s international standing unaffected? One of the reasons the Japanese prime minister pursued a strategy of boosting his country’s nominal GDP growth rate is that low or no growth had battered his country’s international image. China would be even less ready than Japan to accept low rates of economic growth, even as it faces a worse housing and credit bust than Japan did two decades ago with dire consequences for its banking sector.
China’s progress in the last three decades has been largely due to its economic pragmatism. Some of it may have to rub off on its foreign policy too, especially towards India.
V. Anantha Nageswaran is co-founder of Aavishkaar Venture Fund and Takshashila Institution.
Comments are welcome at baretalk@livemint.com. To read V. Anantha Nageswaran’s previous columns, go to www.livemint.com/baretalk
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