Cooling China: do international policymakers yet grasp all the global consequences of China's coming investment boom?

International Economy, The, Summer, 2004 by David Hale

The Chinese government shocked global financial markets not long ago when it announced further measures to slow the country's buoyant investment spending. The government said that it would curtail bank lending to certain sectors where it perceived a risk of overheating (real estate, steel, cement, aluminum) and increase the amount of equity that firms provided to qualify for new loans. As capital spending has been the Chinese economy's dominant growth engine during the past eighteen months, the announcement triggered a slump in commodity prices, east Asian stock markets, and currencies sensitive to commodity prices such as the Australian dollar. Many American and Japanese equities fell as well.

China has made three attempts during the past twenty years to slow its rate of economic growth and curtail inflation. The first attempt during the late 1980s produced a de facto hard landing in the economy. Real GDP growth slowed from double-digit levels during the mid-1980s and 11.3 percent in 1988 to 4.1 percent in 1989 and 3.0 percent in 1990. The slowdown was successful, though, in reducing inflation from over 20 percent to barely zero during 1991.

In the policy adjustment of 1993-94, Zhu Rongji was the central bank governor. He took over the central bank because money growth was running at 30 percent and there was a clear perception that monetary policy would have to change dramatically. Mr. Zhu also attempted to improve the head office's control over lending by the regional branches of the central bank. The central bank of China plays a larger role in the economy than other central banks because during the early decades of communist rule it was the country's primary financial institution. It did not devolve lending powers to the commercial banks until the early 1980s. As recently as 1993, it imposed a reserve requirement as high as 28 percent of M2 while it used credit quotas until 1995. The Chinese financial system today retains many features of a command economy but the commercial banks enjoy a fair measure of independence. Reserve requirements are now equal to about 5 percent of M2. The government uses window guidance to influence lending rather than formal quotas. Bank lending exceeds 130 percent of GDP. As a result of China's high level of monetization and the large amount of cash in the economy, the central bank balance sheet is equal to 50 percent of GDP.

The policy tightening of the early 1990s slowed the growth rate of domestic demand from 15-16 percent during 1992-93 to 10.6 percent during 1994, 11.5 percent during 1995, 10.1 percent during 1996, and 6.0 percent during 1997. The growth rate of investment slumped to about 10 percent from over 60 percent. But the government took other measures with the exchange rate to compensate for the domestic slowdown. There was a 30 percent devaluation of the yuan from January 1994. The government also announced it would rebate 17 percent of export taxes from January 1994. As a result of these actions, export growth accelerated from 4.4 percent in 1993 to 36.3 percent in 1994 and 23.1 percent in 1995. As the American economy was enjoying a recovery from the slowdown of the early 1990s, exports to the United States grew at a rate of 31.1 percent during 1994 and 14.4 percent in 1995. Mr. Zhu's monetary policy conquered inflation. The inflation rate declined to zero by 1997 and there followed a period of deflation until recently.

The economic background to the concerns about overheating today are very different from the early 1990s. First, the inflation rate is only

about 3.6 percent compared to 20-30 percent ten years ago. Second, the Chinese currency is unlikely to be devalued because foreign exchange reserves are growing rapidly in response to speculation about a possible revaluation. The challenge facing the central bank is to sterilize these reserves. Thirdly, there is little evidence of consumption growing rapidly because of consumers hoarding goods. On the contrary, with the exception of food, there is still deflationary pressure in many sectors of the Chinese economy. Finally, the money supply has been expanding at a rate of about 20 percent compared to 30 percent during the early 1990s.

These differences suggest that the government should be able to curtail growth without driving the economy into recession. The major concern of the authorities is the fact that the investment share of GDP has risen to about 45 percent from 35 percent during the mid-1990s. When east Asian countries such as Thailand and Korea had such high investment ratios during the early and mid-1990s, there were financial crises a few years later. The investment boom in Thailand had produced a glut of commercial real estate, especially office towers. The investment boom in Korea had produced excessive amounts of manufacturing capacity, especially in steel. The United States also experienced boom-bust cycles in railway construction during the late 19th century but its total investment share of GDP during the 1870s averaged only about 19 percent of GDP, or less than half of China's current rate.