Beijing's crisis response risks making things even worse
with Tom Holland
Charles Dumas is one of the small group of economists who saw the current financial crisis coming. Back in 2006, he published a book called The Bill from the China Shop in which he warned that the rapid build-up in American household debt would prove unsustainable and would lead to a credit crunch and a hard landing for the United States economy when the property bubble burst.
Today he is more cheerful than many economists, arguing that this leg of the financial correction is pretty much over bar the shouting. However, he does warn that mainland officials have badly misjudged their response to the credit crunch and that, if they fail to recognise their mistake soon, then they could inadvertently cause the second down-leg of a W-shaped global crisis.
The trouble is that many in Beijing believe the greatest threat to the mainland economy is a slowdown in output growth as a result of softening exports as the developed world slides into recession. Slowing output, they argue, means less ability to create jobs for the armies of migrant workers flooding into mainland cities from the impoverished countryside, rising unemployment and mounting social discontent.
To avert this nightmare scenario, the authorities have halted the appreciation of the yuan against the US dollar, cut interest rates and increased loan quotas to boost investment at home, and are widely said to be preparing a massive economic stimulus package. As a result, mainland officials are confident that gross domestic product growth will remain high this year and next, with the elite Chinese Academy of Social Sciences forecasting GDP expansion of 10.1 per cent for this year and 9.5 per cent next year.
Mr Dumas thinks that would be a disaster. He points out that after five years of double-digit expansion, the mainland economy has been running at well above its trend growth rate - about 9.5 per cent a year - for a long time now.
As the first of the two charts below illustrates, that rapid expansion has carried the absolute level of mainland GDP well above the optimum implied by the trend rate, opening up a significant positive output gap. And as the second chart shows, positive output gaps tend to fuel uncomfortably high inflation, like the sharp food price rises the mainland has experienced over the last year or so.
Stimulating the economy now in an attempt to create jobs will only further widen the output gap, exacerbating inflation. Moreover, as Mr Dumas points out, in an economy in which food makes up a third of consumer's shopping baskets, inflation will inevitably show up in higher food prices. And higher food prices will tend to raise agricultural incomes, persuading more farmers to remain on the land rather than to take low-paid jobs in the cities, reducing the need to create jobs.
So, instead of trying to support growth by boosting exports and investment, Mr Dumas argues Beijing would do better to allow growth to slow to 8 per cent for a couple of years, which would close the output gap and rein in inflation.
At the same time, the authorities should rebalance the economy away from wasteful investment and an overreliance on cheap exports by raising interest rates above the inflation rate and allowing the yuan to appreciate.
Doing both would involve scrapping capital controls, but that would be a small price to pay. The result would be a shift up the manufacturing value chain and higher consumer spending, including on imports, which would help trim the country's troublesome trade surplus.
It sounds an ideal outcome, especially when you consider the alternative. That would involve accelerating inflation pushing up the price of mainland exports, without any corresponding boost in US exports to the mainland.
The result under that scenario would be a rise in imported inflation in the US, triggering an increase in interest rates that could easily cause a second down-leg in the current crisis. And it would come stamped 'Made in China'.