Andy Xie says the government must develop demand-side support for the economy when the housing bubble is deflating, and nurture a growth cycle powered by productivity. This means a shift away from commerce to innovation
China’s bond yield topped 4 per cent last week, up by about 50 basis points in two months. That clearly reflects a tightening monetary stance. Meanwhile, China’s nominal gross domestic product growth rate accelerated to 11.2 per cent in the third quarter, from 7.8 per cent a year ago, almost entirely due to an increase in the GDP deflator – the broadest inflation gauge.
Monetary tightening is obviously justifiable. Yet, the small increase in interest rates has sent shock waves through the economy. For an economy with nominal GDP rising to 11 per cent, how could a 4 per cent bond yield or a 6 per cent bank lending rate be considered tight?
To be fair, there are new quantity restrictions, especially in the property sector, and the increase in credit in October was below the average in 2016. Still, the renminbi credit increase has averaged 20 per cent above last year’s. With so much credit pumped into the system already, why is there a feeling of tightening credit at this early stage?
The answer tells us why the Chinese economy is not in a normal state. Two related aspects explain why China’s economy is so liquidity-hungry.
First, the economy is investment-led. That means pushing productive capacity to the maximum. It leads to a low return on capital and dependence on credit for expansion. It also means that the state sector that does most of the investing needs an ever-bigger share of liquidity in the economy to keep going. The most important tool for such monetary redistribution is the property bubble. By fuelling property speculation, the monetary growth is disproportionately allocated to the state sector.
In the current economic structure, monetary tightening will quickly lead to a shutdown of the property market. Investment will slow soon after, and commodity prices will decline sharply. The fear of inflation will soon turn into one of deflation. Then, from a cyclical perspective, the case for loosening monetary policy will build up. And, when the growth shortfall triggers a fear of instability, the monetary spigot will be turned on again. The property bubble will grow again, and the problem of overcapacity will worsen. The economy is trapped in this cycle.
This time, the government is sincere about bursting the property bubble. But it can be successful only if an alternative and healthier growth model emerges. Otherwise, its best intentions will be crushed by the cascading events to come.
To escape the trap, the government must develop demand-side support for the economy when the bubble is deflating, rebalance the economy to maintain stability over time, and improve structural efficiency to nurture a new growth cycle led by productivity.
First, to support demand, liquidity needs to flow through non-property channels. The most effective channel is to stop the collection of money for welfare funds. This money goes into national savings and funds investment. Since China is overinvested, lowering the savings rate is a good thing. The collection rate could be temporarily cut by between a third and a half. The rate could be revised again once the economy is healthier.
Credit can be channelled through borrowing by healthy local governments. For example, tier-1 cities should have the freedom to issue bonds. Some tier-2 cities with healthy finance should also be allowed to issue bonds in the context of a long-term development plan. The debt market for healthy local governments should evolve into the principal financing channel for urban development, replacing the property market.
Second, China’s overinvestment is a threat to its own and global stability. It destroys return on capital, foments financial bubbles, and magnifies global imbalances. To balance the economy, the government must cut the ability of different branches to mobilise resources for investment. As the property market is the main instrument, deflating it is a major step towards rebalancing.
The political force behind the property bubble is the desire to develop everywhere there are people. It ignores economies of scale. Successful development inevitably leads to the geographical concentration of economic activities and people. Yet, a political desire for decreasing inequalities between the different regions has been a driver in China’s macroeconomy over the past 15 years. China’s long-term stability depends on recognising that economic concentration is inevitable and desirable.
The right policy in that recognition is to elevate more cities to provincial status. Shenzhen and Nanjing, for example, could immediately qualify. A dozen more cities could be nurtured to become a province in a decade or so. The government needs to recognise that most people and economic activity will be concentrated in 20 to 30 mega cities. That is good for efficiency and good for the environment, as the cost of pollution control will fall.
Lastly, China needs to shift business and popular imagination away from get-rich-quick schemes, towards a demand for quality, originality and long-term reputation. A merchant mentality is deep-rooted in Chinese culture. It is good for maximising short-term efficiency, but an overactive merchant mentality is bad for long-term prosperity. The endemic presence of fake goods reflects an overstimulation of this type of mentality.
China became a poor country in the last millennium because good merchants didn’t produce any technological breakthroughs – the lifeblood of long-term growth. China developed rapidly from copying existing technologies. It must now recognise that it needs more home-grown technology to sustain growth. The national focus must shift from finance and commerce to intellectual property.
Andy Xie is an independent economist