I think Williams is right, and I agree that those calling for additional interest rate cuts and more rapid investment and credit expansion are wrong. Why? Because what is happening in China may be just what China and the world need. After many failed attempts, over the past six months we may be seeing for the first time the beginning of China’s urgently needed economic rebalancing, in which China reduces its overreliance on investment in favor of consumption.
Regular readers of my newsletter may be surprised to see me say this. For the past four or five years analysts have been earnestly assuring us that the rebalancing process had finally begun, and I had always insisted that it couldn’t have begun yet. Why? Because as I understand it rebalancing is almost arithmetically impossible under conditions of high GDP growth rates and low real interest rates. Once the real numbers came in, it always turned out that in fact imbalances had gotten worse, not better. Typically many of those too-eager analysts have resorted to insisting that the consumption data are wrong, although even if they are right this does not confirm that rebalancing had taken place since errors in reporting consumption have always been there.
But this time seems different. Now for the first time I think maybe the long-awaited Chinese rebalancing may have finally started.
Of course the process will not be easy. Debt levels have risen so quickly that unless many years of overinvestment are quickly reversed China will face debt problems, and maybe even a debt crisis. The sooner China starts the rebalancing process, in other words, the less painful it will be, but one way or the other it is going to be painful and there are many in China who are going to argue that the rebalancing process must be postponed. With China’s consumption share of GDP at barely more than half the global average, and with the highest investment rate in the world, rebalancing will require determined effort.
How to rebalance
The key to raising the consumption share of growth, as I have discussed many times, is to get household income to rise from its unprecedentedly low share of GDP. This requires that among other things China increase wages, revalue the renminbi and, most importantly, reduce the enormous financial repression tax that households implicitly pay to borrowers in the form of artificially low interest rates. But these measures will necessarily slow growth.
The financial repression tax, especially, is both the major cause of China’s economic imbalance and the major source of China’s spectacular growth, even though in recent years much of this growth has been generated by unnecessary and wasted investment. Forcing up the real interest rate is the most important step Beijing can take to redress the domestic imbalances and to reduce wasteful spending.
And this seems to be happening. Beijing has reduced interest rates twice this year, and reluctant policymakers are under intense pressure to reduce them further. The students in my central bank seminar at PKU tell me that there are new rumors about the way the cuts were implemented. “Usually it is the PBoC that submits a proposal of rates cut to the State Council,” one of them wrote me recently, “but this time (July 5th) it was the State Council who handed down to the PBoC the decision to cut rates, so that the PBoC was not fully aware of the rates cut before July 5th.”
If my student is right (and this class has an impressive track record), this suggests that monetary easing is being driven by political considerations, not economic ones, which of course isn’t at all a surprise. But even with the rate cuts, perhaps demanded by the State Council, with inflation falling much more quickly than interest rates the real return for household depositors has soared in recent months, as has the real cost of borrowing. China, in other words, is finally repairing one of its worst distortions.
But this necessarily comes at a cost. Raising the real borrowing cost cannot help but reduce investment growth and increase cashflow pressure on local governments, and so with the rise in real rates China’s GDP growth rate must fall sharply. China bulls, late to understand the unhealthy implications of the distortions that generated so much growth in the past, have finally recognized how urgent the rebalancing is, but they still fail to understand that this cannot happen at high growth rates. The problem is mainly one of arithmetic. China’s investment growth rate must fall for many years before the household income share of GDP is high enough for consumption to replace investment as the engine of rapid growth.
As China rebalances, in other words, we would expect sharply slowing growth and rapidly rising real interest rates, which is exactly what we are seeing. Rather than panicking and demanding that Beijing reverse the process, we should be relieved that Beijing is finally resolving its problems. Andy Xie has a typically intelligent article on just this subject in last week’s South China Morning Post. In it he warns:
China has cut interest rates twice in a month, showing the government’s grave concern for the weakening economy. But it is the wrong medicine. Side effects will include worsening inflation, saddling credulous property speculators with debt and weakening the banking system’s ability to handle the looming bad-debt crisis. The renminbi may come under devaluation pressure, too.
Cutting interest rates is doubling down on a bad hand; the policy of printing money to fuel bubbles was wrong in the first place. To revive the economy, China must cut taxes, slim down the government, retrench state-owned enterprises, strengthen the rule of law, and give businesses incentives to focus on quality, technology and brands.
Except for the “worsening inflation” part, I agree. He goes on to conclude: “Trying to revive the bubble now will only crash the economy.”
