IMF, China And The Economic Elephant In The Room

Screenshot of IMF's Country Page for China

THERE IS SOMETHING other-worldly about the International Monetary Fund’s new report on its latest Article 4 Consultation with China: a rational analysis of structural economic reform amidst a maelstrom of tensions between Washington and Beijing.

The Fund’s report outlines the recent progress made by China in reducing financial sector fragilities and continuing to open up of the economy. It stresses the need for ‘staying the course on deleveraging and financial de-risking’ and for further progress in addressing distortions that encourage excessive household savings. It urges more reforms to enhance the social safety net and make the tax system more progressive.

It promotes greater exchange rate flexibility and deeper foreign-exchange markets to help the financial system prepare for increased capital flow volatility. It calls for increasing the role of the market and reducing the dominance of the public sector in many industries. It highlights the need to continue to move to a more price-based monetary policy framework and to address the misalignment of centre-local fiscal responsibilities.

All are laudable policy points, for which the Fund has long argued. The report summarises its prescriptions thus:

• Adjust macro policies and allow for a more flexible exchange rate. The announced policy measures are sufficient to stabilize growth in 2019 provided there are no further increases in tariffs. If trade tensions escalate further, additional stimulus, mainly fiscal, would be warranted.
• Improve external policies and frameworks by working constructively with trading partners to better address shortcomings and enable a trading system that can more readily adapt to economic changes in the international environment. The global economy would benefit from a more open, stable, and transparent, rules-based international trade system. China can also benefit from further opening up and other structural reforms that enhance competition.
• Continue strengthening the financial sector by fully implementing the announced regulatory reforms, strengthening bank capital, especially for smaller banks, and enhancing macroprudential tools to address vulnerabilities from rising household debt. Developing a clear resolution regime would facilitate the exit of weak banks. Removing the implicit guarantees and hardening the budget constraints for state-owned enterprises (SOEs) would improve credit allocation and limit SOEs’ advantage in accessing credit.
• Boost competition by opening up non-strategic sectors, particularly in services, to private and foreign enterprise, and unifying product markets across localities.
• Modernize policy frameworks by eventually moving to a single policy rate in the monetary policy framework, reducing the misalignment of centre-local fiscal responsibilities, and further improving transparency and statistics.

The elephant in the room is identified with masterful understatement by the first sentence of the accompanying press release: “The Chinese economy is facing external headwinds and an uncertain environment”.

The consultation and report predate the latest round of tariffs announced (and partially delayed) by the United States on Chinese exports and the Trump administration’s labelling of China as a ‘currency manipulator’, a designation that will drag the IMF unwillingly into that aspect of the trade war between Washington and Beijing.

It already has had Fund officials dancing gingerly around the question. In their view, China has not for some years been a predatory currency manipulator in the way US President Donald Trump now suggests to keep the yuan cheap to help Chinese exporters. If anything, of late, Beijing has been propping up the currency.

As this Bystander has previously noted, the conflict between the Trump administration and China goes beyond bilateral trade. It extends to structural issues related to the foreign investment regime, intellectual property protection, technology transfer, industrial policy, cybersecurity and the economic role of the Chinese state.

On many of these fronts, Fund staff would be happy for Washington to make headway, provided that it lead to more opening up of China’s economy in line with their long-standing policy recommendations. They would be less pleased, however, if any U.S.-China agreement resulted in managed trade. That, they believe, could negatively affect the multilateral trading system, and lead to an even more uncertain and challenging environment than we now have.

Even in the likely event that the two countries do not reach a comprehensive and durable agreement any time soon, persistent uncertainty is likely to weigh on both the near and longer-term economic outlook as China’s access to foreign markets and technology may be significantly reduced. That would mark a decoupling of the two largest economies that would be anything but ethereal.

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