20110129 Considering China’s risks seriously

Considering China’s risks seriously

By Gerard Lyons

A stopped clock is right twice a day. However, it is of no use for telling the time. This is worth bearing in mind when looking at the Chinese economy this year. For much of the last decade, there have been some who have predicted imminent doom and gloom for China. Like a stopped clock, they have said the same thing for some time.

Meanwhile, China has continued to go from strength to strength. Its economy has soared. Its influence has grown. Asia has benefited.

The question that needs to be asked is whether this is the year that problems in China will emerge. Is now the time when the stopped clock is right?

China’s risks are different from those in the West, where debt problems persist. Across Asia, inflationary pressures are rising and policy needs to be tightened.

The challenge for China is that in recent years it has tied itself too closely to US monetary policy. In doing so, it has kept interest rates lower than necessary and its currency weak. Resolving these issues is vital and is now under way.

The US and China both need to set monetary and fiscal policies to suit their domestic needs. The US is doing this. Last year’s second round of quantitative easing was justified, despite the criticism it received outside the US. Facing deflation, the US Federal Reserve needed to do more. The government has followed with a huge fiscal boost over the new year. The net effect is the US economy will grow strongly this year, particularly in the first half.

Although the stimulus has reignited fears about US government debt, the reality is the US had no choice. A staggering 43 million Americans now receive food stamps, a clear indication of the scale of poverty. Chances are US policy will work in terms of ensuring growth, if not in solving all the country’s problems.

All of this highlights the need for Asian policy makers to follow the US. Not by copying US policy, but by setting monetary policy to suit their own domestic needs. The challenge is especially daunting for China.

The longer it takes China to tighten policy, the greater its eventual problem. Last year saw the authorities impose a loan quota. However, concerns about growth prevented them from tightening enough. This year, there is no reason to hold back as growth looks set to be strong, boosted by the 12th Five-Year Plan.

Although China’s policy tools worked well during the global crisis, there are now risks.

First, the growing size of the economy and of the private sector makes it harder to control the economy from Beijing.

Second, there is a need to rebalance the economy away from investment, toward consumption. While investment always sounds good, it is now so high in relation to GDP that not all of it may be worthwhile.

Third, China’s vulnerability arises from its under-developed financial sector. Thus, as income rises, there are limited options for investing household savings: into low interest-bearing bank accounts; into equities, where governance concerns persist; or into real estate, where prices are already sky-high in many cities. This makes the economy prone to bubbles.

China needs to avoid the lethal combination of cheap money, one-way expectations and leverage. A few years ago, the talk in the US was about the “Greenspan put,” that interest rates were kept low to support the equity market. China can’t fall into the same trap with property.

All this raises the risk of a near-term setback in China. Rising food prices and wages add to the sense of urgency. Either the authorities don’t address problems sufficiently, delaying the day of reckoning, or, more likely, they tighten policy sharply.

This tightening will entail further loan quotas, rising reserve ratios, sharply higher interest rates, property taxes in some regions and possibly steeper currency appreciation than the market expects.

The authorities would not want to derail the economy, but if there was any setback where growth suffered, it would have global ramifications, hitting commodities and trade, among other things.

Of course, if there were a growth setback, the stopped clockers would say they were right, and there would probably be much speculation about China’s growth being a bubble. That would be wrong.

Any slowdown in growth would probably be temporary. It would show the business cycle exists in China, and that, while the economic trend is up, there will be setbacks along the way. These would provide a buying opportunity and not a reason to doubt the economy’s rise. China’s growth is for real. It is not a bubble economy, but it is an economy prone to bubbles. There is a big difference.

In recent years, the markets have discounted the bad news in the US and finally taken seriously the flaws in the euro area. The near-term risks facing China, like many countries across Asia, need to be taken seriously.

Yet they also need to be kept in context, because they are unlikely to alter the longer-term positive outlook for growth. In our view, the world economy is in a super-cycle: A sustained period of high economic growth, lasting a generation or more. The global economy is twice the size it was a decade ago and is already above its pre-recession peak.

A central feature of this super-cycle is the shift in the balance of economic and financial power, from the West to the East, led by China.

This was highlighted at the recent meetings between US President Barack Obama and Chinese President Hu Jintao (胡錦濤) in Washington. Soon after becoming president, Obama changed the relationship with China. Under former US president George W. Bush, the US had a strategic economic dialogue with China. Obama turned it into a strategic “and” economic dialogue. This was significant. It emphasized the twin aspects of the relationship. Yet, as the US recovery has disappointed, there has been less of the strategic and more focus on the economic dimension of the relationship.

Although the US is the far larger economy, the relationship increasingly resembles one of equals. In modern times, the economic importance of China to the world economy has never been greater. It is vital for the world, for Asia, as well as for China that it addresses its inflation challenges now. This is no time to wait.

Gerard Lyons is chief economist and group head of global research at Standard Chartered Bank.