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Growing pains of a giant

A booming Chinese economy is helping to protect Australia from the global debt crisis, writes John Garnaut.

A booming Chinese economy is helping to protect Australia from the global debt crisis, writes John Garnaut.

Yu Yongding, a statesman of Chinese economics, worries that his country's famed meritocracy is giving way to sycophancy, cynicism and mediocracy.

He talks about policymaking dysfunction, about the dynastic cycle of revolution and decline, and how there seems to be no policy challenge that is so great or so pressing that China's collective decision makers can't manage to put off until tomorrow.

But the respected and fiercely independent economist says there is one problem that China does not face: an imminent hard landing.

"Recently there is lots of pessimism over the Chinese economy," says Yu, Professor of Economics at the Chinese Academy of Social Sciences and a former member of the monetary policy committee of the People's Bank of China.

"Lots of foreigners tend to swing from this extreme to the other. In this next four or five years I cannot see any possibility of a really hard landing or inflation getting out of control. The reason is the strength of China's fiscal position."

The Chinese economy has some big problems, to be sure, and they are generally getting worse. The exchange rate peg is pulling macro-economic policy off its axis. The size and structure of the stimulus package of three years ago has eviscerated the integrity of investment decision-making at all levels of the state-dominated economy.

And China's political process has been paralysed by uncertainty - or perhaps mediocracy and cynicism - in the lead-up to next year's 18th Communist Party Congress.

But those are problems for a later day and right now the economy is going strong. The sector that matters most for Australia's resource-dependent exporters - construction - is booming.

Only in China could you say that growth in housing sales "decelerated" in July to 18 per cent from the previous year, while housing starts grew 34 per cent. And all that spectacular growth is from a base that is now enormous. The volume of floor space under construction in China today is now double what it was three years ago, the last time China saved Australian from recession.

Professor Yu's short-term confidence and the monthly data flow will be reassuring news for the Prime Minister, Julia Gillard, who this week said China stood between Australia and the gathering global storm.

Australia is now banking more than $8 billion a month from iron ore and coal exports, thanks to steel mills in China. When China doesn't buy directly from Australia, it forces up the price for everybody else.

"I think people just need to look at all the facts," Ms Gillard said, explaining that Australia had its best terms-of-trade figures in 140 years.

"When we look at our own economy, I think people understand now that a quarter of our exports go to China with its huge demand for our resources."

China now devours 25.5 per cent of Australian exports and the US takes just 4 per cent. The direct effect of a US recession on the Australian real economy would be something of a sideshow. Even the indirect impact, felt through softening Chinese exports and declining confidence, may not be decisive either.

So far there is no sign that the bursts of financial market bloodshed in recent weeks have hurt demand for the bulk commodities that the Treasurer, Wayne Swan, says have made the Australian economy "the envy of the world".

Iron ore spot market prices have been edging higher for six-straight weeks to hover this week below $US180 a tonne. And unlike three years ago, the big supply contracts are priced against a lagging spot market average, which means most Australian iron ore will continue to be shipped at close to record prices at least until the end of this year (unless buyers walk away from contracts).

The Chinese economy is still being driven by the momentum that comes when 1.4 billion people strive to attain lifestyles they see in the developed world. And these days it's no longer about Shanghai aspiring for a skyline as spectacular as New York. Rather, huge but relatively unknown cities such as Wuhan are striving to emulate Shanghai.

July quarter GDP figures show a stunning reversal in Chinese growth patterns. In first place was Chongqing, the inland megalopolis, growing 16.5 per cent from a year before. In last place was Beijing, growing at 8 per cent, just behind Shanghai with 8.5 per cent.

On Wednesday the Trade Minister, Craig Emerson, wound up a tour of China's "second-tier" cities. They included towns like Chengdu (population nine million) and its regional competitor Chongqing (10 million), which saw a 137 per cent increase in foreign direct investment in the first half of this year.

"By 2020 China will have 93 cities that are bigger than Sydney," Dr Emerson told Weekend Business yesterday. "Looking at the cranes on the skyline of these massive provincial cities was a daily reminder of the difference between the financial economy and the real economy."

Dr Emerson makes another point that is easy to overlook. As China gets richer its consumption patterns will inevitably change. Already it is the biggest buyer of Australian export services, including education and tourism.

"China's second great transformation will be away from a growth model that is heavily dependent on exports towards domestic consumption and an associated lift in the importance of services," Dr Emerson says. "Australia in a very strong position compared with just about any country on earth."

China's long-term growth trajectory is not a straight line. This week's data showed China's inflation rate has risen to 6.5 per cent, well beyond Beijing's comfort zone, even while growth was slowing down.

Zhang Bin, an economist at the Chinese Academy of Social Sciences, says inflation has almost certainly peaked, thanks partly to financial markets hammering the price of oil and mostly because soaring pork prices are ushering in a glut of new supply.

Still, he will head down to the provinces next week to see how rising wages and input costs might leave pork prices structurally higher than they were before.

Dr Zhang expects monetary policy to be loosened in the last quarter of the year, either by quietly loosening credit quotas or by dropping bank capital adequacy ratios down from their present record

high levels.

Sharemarket investors and Australian mining executives are still scarred from August 2008. They sat in corporate boxes at Beijing's birds' nest stadium for the Olympic Games - as did Chinese policymakers - and failed to notice the carnage that tight domestic monetary policy was doing to the domestic economy around them.

By mid-2008 the real estate market had already been suffocated by a lack of credit. Steel, electricity and construction were all well down from earlier peaks. By September - even before Lehman Brothers collapsed and the global financial turmoil became a full-blown crisis - it was too late.

The financial market chaos being played out on Chinese television screens compounded a downturn that was in progress anyway, as exporters were hit and domestic traders moved to liquidate their stocks. Regardless of what the official figures said, large swathes of the Chinese economy were stone-dead in October and November 2008, and it took the world's biggest stimulus package to jolt them back to life.

It is likely that the political masters who sit above China's central bank have learned from their experience in letting inflation get out of hand and then tightening monetary policy too hard and too late. But if history is destined to repeat themselves, then the same policymakers can afford to do a diluted version of what they did last time and bail the country out.

"If things get much worse and exports collapse, we expect China to ease macro policy to stimulate growth again," a UBS economist, Wang Tao, wrote in a research note.

"The bad news is that China has already increased its leverage massively in the past three years to invest in infrastructure, and there is less scope to do so now. In sum, in the case of another severe global downturn ... China will still do relatively well, but do not expect it to save the world again."

China is three years into a local government debt binge which has funded a slew of economically unviable infrastructure and real estate projects and added perhaps 30 percentage points to China's debt-to-GDP ratio. This recent pattern is clearly unsustainable.

But China's recent extravagance comes off a virtuous base. The country's national savings rate last year was higher than 50 per cent. Ms Tao estimates that China's total government debt is not bigger than 50 per cent of GDP.

The United States ratio of public debt to GDP, in contrast, is 79 per cent, without even counting local and state government debt. Japan's government debt to GDP ratio is 228 per cent.

There are few countries that can sustain the unsustainable for as long as China can, due to the massive range of levers available to the Communist Party state.

Those reserves may well be needed. But economists cringe at the prospect of another massive stimulus plan after watching the corruption, governance problems and misallocation of resources that accompanied the last one.

It is difficult to overstate the frustration - perhaps despair - that has beset China's public intellectuals about the state of policymaking generally and specifically in economics.

Respected economists struggle to list even one substantial economic reform that has been imposed by the Hu-Wen administration.

They say the sweeping changes of the late 1970s and 1980s (such as putting farms back in the hands of households) and the decisive interventions of the late 1990s (such as closing poorly performing state-owned enterprises) are simply not possible today.

They tend to follow varied paths of reason but arrive at the same end point: the absence of political reform and the absence of economic reforms are deeply entangled.

Professor Yu Yongding, the former central bank adviser, holds up China's pegged currency as Exhibit A.

"We started talking about the problem of China's twin surpluses when foreign exchange reserves were $US200 million," Professor Yu says. "Then it increased to $US300 billion in 2003 and we voiced our concerns very strongly.

"There are so many opportunities, but each time the government hesitates and wants to find a better opportunity, so now we have $US3 trillion in foreign exchange reserves.

"We still have to take action because compared with $US4 or $US5 trillion dollars a few years later, now is a very good opportunity."

Professor Yu says it is now too late for a mere upward revaluation. Nothing short of fully floating the renminbi - "stop intervention", as he prefers to call it - will be sufficient. And despite the mounting costs of inaction, he says there is no chance of any substantial reforms before the leadership transition in the Party (October next year) and State Council (March 2013).

"Consensus is most important among these decision makers," Professor Yu says. "And it is very hard to reach consensus because you cannot imagine, even among experienced politician, that they know about these things.

"We should draw a line between politicians and civil servants. Good governance is predicated on meritocracy, but merit now has been greatly eroded by sycophancy and cynicism. This is very dangerous."


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