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After China’s Gilded Age, A Different Progressive Era

Much of the commentary on Credit Suisse’s recent research note on China in 2015 has latched onto the comparison it draws between China’s economic development over the past 30 years and that of late 19th century America, the Gilded Age: massive and fast industrialization and rising incomes and income inequality with their attendant social problems. Scratch deeper and you will also find parallels in corruption, food and product safety and the emergence of large powerful industrial groups.

The policy lessons are dependent, of course, on what comes next. In the U.S., the laissez-faire of the Gilded Age gave way to the regulating Progressive Era in which government involvement in business and wealth redistribution increased markedly. As the FT’s Lex notes, America’s public finances deteriorated equally markedly, never to recover.

China already has close government involvement in business and closing the wealth gap between rural poor and urban rich was a priority for the Hu-Wen leadership as it will be for its successors. Corruption is, as always, being tackled. China’s equivalent of the robber barrons, or at least the least-well connected ones, are being brought to book; the state-owned combines, if not exactly being trustbust, are at least being reined in. Maybe China is just concatenating its versions of what were two distinct eras in the U.S. Or maybe one can only take historical analogies so far.

Beijing’s policy priority is restructuring the economy so the country can pass through the Great Wall, the per capita income levels at which fast-growing emerging economies tend to stop growing without institutional change. That has social implications, especially income redistribution and the provision of more social services, which are front and center of the new 5-year plan, and some political risks to the Party in a growing middle class that expects the provision of both. But it is largely economic driven in its policy dimensions.

In short, if Credit Suisse’s analysts are right, China’s Gilded Age is being followed by an economic Progressive Era rather than the socially-cast one that the U.S. created. Thus the risks to China are largely economic. What Credit Suisse’s analysts say could go wrong is that:

1) the key coastal provinces in China are unable to achieve the productivity gain or generate enough domestic demand after the migration of low-end labour intensive industries to inland provinces;

2) government(s) at different levels are unable to adjust to their new role, [i.e. to spend more money in providing social services and less in infrastructure and industrial investment,] and change the pattern of government financing in face of new demand; and

3) monetary policy and the financial sectors are unable to ensure monetary and price stability.

One popped property bubble and China’s public finances could look as ugly as any in the West.

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November Inflation Number Underlines Need For Speedy Action

Consumer price inflation hit 5.1% year-on-year in November, the fastest growth in 28th months and well up, as expected, from October’s 4.4%. The expected interest-rate hikes haven’t been announced yet, though we still expect to see them before the end of the year. There may have to be some managing of the yuan’s exchange rate first to cool capital inflows (and that may be more political than technical managing).

Fighting inflation and mopping up the excess liquidity that is fueling it are the priorities for 2011 agreed at the annual top-level economic meeting that has been going on over the weekend, Xinhua reports, though that was true before the meeting, too. What is also true is that the longer clamping down on inflation is left, the harder it gets to do.

The National Development and Reform Commission said on Sunday that consumer price inflation will probably fall below 5% in December as the price controls announced in late November take effect. Another truth is that supressing inflation is not the same as reducing its underlying causes.

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Setting The Scene For A Higher Inflation Target

Inflation, at 4.4% in October and widely perceived to be on the rise, is way above the government’s target of 3% for the year. Food price controls have been imposed. Inflation, perennially politically sensitive, has become policymakers’ number one concern.

Louis Kuijs, senior economist in the World Bank’s Beijing office, questions the fuss. He says that by emerging markets standards 4-5% inflation is “moderate” and should not be “seen as a major problem”. The risk, Kuijs says, is pushing inflation down too far will hinder relative price changes that are needed to adjust the structure of the economy, i.e. getting rid of distorting price subsidies for resources and utilities , particularly energy and water.

Somewhat higher tolerance to modest inflation could help bring about some of the structural reform and change that the government is aiming for.

Kuijs says that policymakers should focus on monetary policy.

After the spectacular increase in monetary aggregates since the end of 2008, monetary growth will before long need to come down to rates broadly similar to nominal growth.

Which is a sharper tug on the reins than now being undertaken, even allowing for the shift in lending policy from “moderately loose” to “stable” and the latest hike in banks’ reserve ratios today.

China’s annual top-level meeting on economic policy for the forthcoming year opens this weekend. It will focus on how quickly the Chinese economy can grow without overheating. With Kuijs’s remarks being published in state media, this Bystander wonders if this isn’t all a bit of pump-priming for a new, higher, inflation target for 2011 to go along with the expected interest rate rises and a 1 trillion yuan (150 billion) reduction in the new-loans quota to 6.5 trillion yuan as policymakers seek to steer a soft landing from the stimulus spree of the past two years.

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China Formally Switches Monetary Policy To What It Already Is

The newly announced switch from the current “moderately loose” monetary policy to that old favorite, “prudent”, next year is no more than a formal anointment of what has been going on for months: the withdrawal of the 4 trillion yuan ($600 billion) monetary stimulus to combat 2008’s global financial crisis to be replaced by the 2010 focus on the battle against inflation. The statement followed a Politburo meeting reviewing the new 5-year plan that starts next year.

Easy credit led to a lending boom that the central bank is now striving to rein in through reduced loan quotas, interest rate hikes and increases in banks’ reserve requirements. At the same time it has been introducing measures to reduce the demand for property, the final destination of much of the new lending. Yet inflation hit a 25-month high of 4.4% year-on-year in October and is expected to have been higher in November, way above the target of 3% and despite moves to reverse food price rises which account for about a third of the inflation number.

The brakes are being applied but not too abruptly. Growth has been slowed to 9.6% year-on-year in the third quarter, down from 10.3% in the second and 11.9% in the first. Beijing won’t want to see the economy decelerating for much longer, and will want to see it remaining robust enough to absorb further interest-rate rises and increases in banks’ reserve ratios. The Politburo left policymakers plenty of room to fine tune: macro-regulation should be more “targeted, flexible and effective” while fiscal policy  should be “proactive”, the statement said. Proactive fiscal policy might just mean the introduction of a property tax, as a new IMF Working Paper recommends.

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More Forecasts Of A Slowing Chinese Economy

The OECD’s monthly snapshot of the outlook for the country’s economic activity over the coming six months, its composite leading indicators index (left), has been looking grimmer for some months. Its latest number, for September, has fallen below the baseline 100, implying, the OECD says, “that the level of industrial production will fall below its longer-term trend”. Put another way, the economy is going to slow. At 99.6 the index is at its lowest level since April 2009.

The OECD’s growth outlook is in line with the latest forecast for China’s economy from the World Bank, which expects growth slowing from 10% this year to 8.7% in 2011. The silver lining in the OECD’s numbers is that they show continuing growth in China’s export markets in the U.S., Japan and Germany.

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The Long March To Rebalancing China’s Economy

The World Bank’s latest quarterly update on China’s economy, published earlier this week, highlights a policy conundrum facing Beijing. The growth driver has swung back to exports from domestic demand as the effects of fiscal and monetary stimulus wear off and the global economy recovers from the Great Recession. Yet the new five-year plan calls for the economy to be driven more by domestic demand and less by exports, and there is wide agreement beyond the country and considerable inside it, too, that that is the direction in which China needs to move if its economy is to continue its development and if global imbalances are to be redressed. How to get back on track without causing short-term disruption, political or economic, and how to do so during a significant leadership transition and when the new five-year plan proposes implementing an equally significant formal change of focus from growth (economic) to development (economic and socio-political)?

The outgoing leadership of President Hu Jintao and Prime Minister Wen Jiabao has increasingly emphasized the socio-political aspects of growth under its banner of promoting a harmonious society. The new five-year plan specifically embraces them: the reduction of regional wealth gaps, lessening income inequality, restoration and expansion of social services and more environmental protection. At the same time, it has made sure to deliver 8%+ GDP growth, the minimum deemed necessary to keep the lid on any social instability threatening the Party’s legitimacy to govern. When the global financial crisis hit, the leadership reacted quickly and decisively with its stimulus.

The World Bank now reports that GDP growth has slowed from 10.6% in the first half of the year as the stimulus impact faded and investment and urban consumption decelerated. The Bank says that slowdown has now ceased. It is forecasting 10% growth for the year as a whole, a slight increase on its previous quarterly forecast. It says the growth rate will ease to 8.7% in 2011 as investment falls further and the global economy’s recovery remains moderate, fragile and uncertain. This Bystander thinks the Bank’s 2011 number to be too low and that China’s growth will be closer to this year’s than to the Bank’s forecast. Beijing’s policymakers have got the growth rate into a comfort zone and will want to keep it there. They have anyway in their back pockets new pubic investment programs likely to be started next year to speed up development of inland cities and to promote strategic new industries as insurance if the global economic winds blow unexpectedly ill.

Beyond the external risk to the domestic economy from the fragility of the global economy, the Bank identifies three homegrown risks that could also undercut its growth forecast: a property bubble, strained local government finances and bad bank debt. It notes that measures continue to be undertaken to minimize them, even if success is mixed. Property prices are proving particularly intractable despite an endless barrage of measures to rein in property speculation. In addition, weather-related higher food prices could keep inflation above the government’s 3% target for a while though core inflation remans in check, and price controls and stockpiles give the authorities some scope to hold rice and wheat prices.

However, the global inflation outlook is uncertain and likely to be volatile depending on how much liquidity central banks pump. (China took a pop at the U.S. Federal Reserve’s second round of quantitative easing on Friday.) While the exchange rate could bear some of the strain of that adjustment, Beijing won’t be moved into letting the yuan appreciate any faster against the dollar than it has been. That is one reason we think the People’s Bank of China will continue to raise interest rates, as an alternative damper on inflation despite the hot money rate rises would attract.

The Bank reaffirms its preference of market-based incentives to reorient the economy to greater domestic demand. It would like to see the cost of energy, capital and polluting raised and that of labour lowered. It does not advocate lower wages but tax changes and productivity gains to encourage consumption and employment. Manufacturing wages have been rising anyway since the mid-1990s, at least until the onset of the global financial crisis in 2008 put a brake to them. It is worth noting that productivity gains were more than enough to offset the cost of the increases in as much as unit labour costs fell over the same period and have been little changed since 2008.

The Bank also says that “rebalancing of the economy won’t happen by itself—it will require significant policy adjustment”. Which is easier said than done. Boosting private-sector development means opening areas of the economy where state champions are being groomed. It means stopping the big state owned banks making loans based on their connections to state owned enterprises rather than on true credit risk considerations. It means less direct local government control over economic development, via both planning and regulation. We don’t see any of those measures in the next five-year plan. Indeed, its headline policy is to steer more development to the interior to minimize regional wealth gaps.

The swing of economic power during the financial crisis back to state owned enterprises and away from the private sector doesn’t bode well. The new five-year plan calls for the development of service industries, where state-owned interests are less entrenched than they are in manufacturing industry, but it also calls for China’s multinationals, which are predominantly large state owned enterprises to become more vertically integrated. The danger is that they will crowd out the private sector in most everything from finance and technology to foreign direct investment that is now meant to bring China the higher-value-added technology and human expertise to upgrade its domestic industries and to offset the looming long-term problem of skills shortages and an ageing workforce.

Beyond the inherent conflict of state-directed capitalism, letting the private sector expand its reach, even to develop domestic demand, threatens vested political interests. These do not want reforms such as to the intergovernmental fiscal system that now channels tax revenues to them, or any undoing of the close ties between the Party’s princelings and big state-owned enterprises, or any competition for the business interests of powerful state institutions such as the military. Does the prospective new leadership, including president-apparent Xi Jinping, himself a princeling, have the stomach or capability, let alone the political mandate, to take on such battles?

Yet the need to rebalance China’ economy is greater than ever. Its sheer size and role in the world is significantly greater than at start of even the current five-year plan–which also had rebalancing the economy towards more domestic demand as an objective, don’t forget. It will be a long process; a multiple five-year-plan project. And politically very difficult. For now, political short-termism drives China’s economic policymaking just as much as it does policymaking in all the world’s heavyweight economies.

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China’s Visible Vs Invisible Hand

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All seems to be going to plan as the Party’s annual meeting draws to its close. Vice-Premier Xi Jinping (left) has been appointed as vice-chairman of the Central Military Commission, seen as an essential way station on his path to the presidency in succession to Hu Jintao who steps down as head of the Party in 2012 and as president the year after. Though Xi didn’t get the expected CMC vice-chairmanship last year, the top job is now his to lose.

Hu is also currently head of the commission, as is customary for China’s top leader. Control of the military underpins the Party’s hold on power while its ability to continue delivering economic growth for all underpins its legitimacy to govern. The new five year economic plan for 2011-15 takes continuing growth as a given and will concentrate on closing the social stability threatening wealth gaps that have opened up between rich and poor and between coastal and inland areas.

The ever strengthening ties between the Party, state and officials and the policy of promoting national champions in strategically important industries (129 companies who now account for two-thirds of GDP) will give Xi and his likely prime minister, Li Keqiang, a means to do that: a visible hand on the tiller of economic development rather than the invisible hand of the market. The princeling Xi’s reported pro-business sentiments may be better regarded as being supportive of a cosy relationship between Party and state officials and big business. Indeed, the industrial champions have a formal role under the new five-year plan to ensure its smooth fulfillment. An unintended but inevitable consequence may be growing friction between the means of implementing the goals of the economic plan of the new leadership and the aspirations of countries like the U.S. and the E.U. who want China to become a full market economy.

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IMF Sees China’s GDP Growth Brisk But Moderating

The International Monetary Fund has left its forecast for China’s economic growth this year and next unchanged from July projections, at 10.5% and 9.6% respectively. At the same time the IMF’s latest World Economic Outlook raises its projected growth rate for the world economy by one-fifth of a percentage point for this year to 4.8% but lowers its projection for 2011 by one-tenth of a percentage point to 4.2%. Those numbers, though, stand in stark contrast to last year’s 0.6% contraction of the global economy. China grew at 9.1% in 2009.

The IMF summarizes China’s economic outlook thus:

In China, real GDP grew at 10.3% (year over year) in the second quarter, compared with 11.9% in the first quarter. Sustained growth in retail sales and industrial production confirms that private sector activity has advanced beyond the lift from government stimulus. Overall, growth is projected to average 10.5% in 2010 and 9.6% in 2011, driven by domestic demand. The slight moderation in recent activity is expected to continue through 2011 in light of tighter quantative limits on credit growth, measures to cool off the property market and limit bank exposure to this, and the planned unwinding of fiscal stimulus in 2011. On average over 2010–11, private domestic demand is poised to contribute two-thirds of near-term growth, and government activity about one-third, whereas the contribution from net exports will be close to zero. Notwithstanding the robustness in domestic demand, the pickup in inflation in 2010 reflected mainly higher food prices rather than core inflation.

Nothing hugely surprising in any of that, though the zero net contribution of exports in 2010-11 suggests that the IMF sees continued anemic recovery in the developed economies, and that that will be offset by the continuing growth of China’s imports from around the Asia-Pacific, including natural resources and semi-manufactures, that are ending up being consumed domestically rather than reexported. The share of growth contributed by private domestic demand also may be eye-opening to some of Beijing’s critics in the developed economies, but again reflects China’s growing role as the driver of the region’s economies, and how the re-balancing of China’s economy is underway, albeit in a frustratingly if inevitably chaotic, complex and protracted way.

The  Fund points up that making a smooth transition from external to domestically driven growth is the main policy challenge for what it calls “key emerging economies” — for which read China. To that end, it also says:

In economies with excessive external surpluses, removing distortions that drive high household or corporate saving rates and deter investment in non-tradable sectors would facilitate the rebalancing of growth to domestic sources. Such rebalancing will also require further deregulation and reform of financial sectors and corporate governance, as well as stronger social safety nets in key Asian economies.

Pushing for such structural reform rather than banging on about the yuan-dollar exchange rate might be the more profitable course for those wanting to sell more into China.

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China’s Economic Rebalancing Act

The Asian Development Bank’s latest update to its quarterly economic outlooks leaves China’s gross domestic product growth for the year unchanged at a forecast 9.6%. But it notes that the pace of growth has started to moderate and will continue to do so as the effects of the government’s fiscal and monetary stimulus wears off and recovery in China’s export markets in the developed world stays sluggish.

Despite exports being a net contributor to GDP in the second quarter this year for the first time since the onset of the global recession, the ADB is forecasting that China’s GDP growth in 2011 will slow by half a percentage point to 9.1% as those trends continue.

The ADB also reiterates the need to shift the economy from being driven by investment and exports to domestic demand.

Longer term, failure to decisively implement the agenda to rebalance the PRC economy risks jeopardizing the sustainability of growth. A greater emphasis on private consumption demand, as against the current investment-driven economic growth model, would promote longer-term growth and raise living standards. Growth in consumption has been limited by the declining share of household income in total income, while the shares of enterprises and the government have increased.

ADB economists believe that China won’t be able to sustain its current pace of growth over the long-term with its current development model under which a rising rate of investment is needed to maintain its target rate of economic growth. At some point investment will stop rising (even China will eventually run out of money) and growth will slow unless another source of demand replaces it. The ADB expects China’s average annual GDP growth over the two decades to 2030 to be 5.5%, compared to the annual average of 9.4% between 1981 and 2007, though it could average 6.6.% growth in 2010-2030 with greater rebalancing of its economy.

China’s growth since Deng Xiaoping opened the economy at the end of the 1970s has been a remarkably success, though its growth rates have been much the same as those of Japan and South Korea at similar stages of their economic development. China’s economy, however, is on a different scale to those of both its neighbors, which is what really makes the achievement so impressive. It is investment that has got it there, but won’t be able to keep it there alone. As even Prime Minister Wen Jiabao has said recently, “In the case of China, there is a lack of balance, co-ordination and sustainability in economic development.” How China finds its balance will shape the global economy over the next two decades.

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China’s Economic Competitiveness Still Lags Its Growth In Muscle

China has moved up two places to 27th in the latest annual rankings of national competitiveness published by the World Economic Forum. Hong Kong and Taiwan, which are ranked separately, are at 11th and 13th, unchanged and down one, respectively. Hong Kong remains the most competitive economy in the Asia-Pacific region thanks to its financial markets and improved infrastructure.

The report says that “China shares with mid-range European countries the relative handicap of rigid institutions and very low innovation. But the country is quickly catching up on infrastructure and market efficiency and will increasingly benefit from its expanding market size.” It also notes that  “market size, flexible labor markets, and strong innovation are at the core of the U.S. competitive advantage.” The U.S. ranks fourth overall, down two places from last year’s survey. Switzerland remains no 1 overall.

China is the only one of the four Brics to have improved its ranking this year, and so extends its lead over them. The lift of two places comes almost entirely from improvements to China’s financial markets. The report also says that “China has made small strides in the quality of higher education and training, but there remains considerable room for improvement in what constitutes an important area going forward. In addition, although the labor market is indeed quite efficient, a lack of flexibility constitutes a major challenge.”

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