Goodbye, gradualism

The nature of China’s economic“landing” – whether the economy will slow gradually or sharply as it descends from stimulus-fueled growth of the past three years – remains one of the world’s most hotly debated topics. With so many variables at play – from bank debt to international trade and real estate– economists are remarkably divided about the country’s future.

If one were to separate the bears from the bulls, economist Stephen Roach, now a non-executive chairman of Morgan Stanley Asia and a lecturer at Yale University, would fall firmly in the latter camp. Roach has been drawn to China in part because of the ability of its central planners to implement dramatic economic reforms over the last decade.

Yet even he admits that China’s economic planners face enormous challenges, the most significant of which is an economy that is excessively dependent on exports and infrastructure investment. Roach spoke with China Economic Review about this and other obstacles the country will face in 2012.

What do you see as the biggest challenge for China in the upcoming year?

The biggest challenge for China is to change the growth model quickly, from external to internal demand. The government has been talking about moving to internal demand for a number of years, but it’s been a very gradual process. The crises that we’ve seen in the United States and in Europe underscore the fact that the adjustments need to occur urgently. This cannot be a slow and gradual process of “crossing the river and feeling the stones.” China’s two largest markets, the United States and Europe, are in the early stages of a massive deleveraging scenario, and that will limit any gains in Chinese exports. With external demand remaining under pressure and China facing a major need to absorb surpass labor and avoid social instability, the challenge right now is immediate– not a year from now or two years from now.

Have we seen any tangible progress on rebalancing in the past year?

There has been progress. Consumer demand is growing fairly rapidly in a number of major areas, such as the automobile and appliance markets. But the gains have been concentrated largely in coastal China, and growth has lagged in central and western China. There continues to be ongoing migration of workers from the countryside to the city, and that’s very important for boosting average wages of Chinese people. So there has been progress; but has there been accelerated progress? I would say no. That would be my criticism of the 12th Five-Year Plan: The speed of implementation remains gradual, and needs to pick up dramatically. I don’t think the political transition is going to have a negative impact on implementing the strategy. The strategy for the new leadership is in the template of the 12th Five-Year Plan, and both Xi Jinping and Li Keqiang were members of the Standing Committee that approved the plan.

You’ve argued that the currency bill in the Senate late last year was misguided. When it comes to China, what should lawmakers be focused on?

The US does not have a bilateral trade problem with China, it has a multilateral trade problem. The reason we have a multilateral problem is that we don’t save as a nation. When you don’t save, you have to import surplus savings from abroad and run massive current account and multilateral deficits to attract the capital. So if you try to fix the trade problem without addressing the saving cause behind it by putting trade sanctions on China, the Chinese will just go somewhere else. American workers will be worse off, because that somewhere else is most likely a higher-cost producer that puts pressure on American consumer purchasing power. So I think this is a false solution, motivated by politicians who want to go to the people and say: “We want to fix your problem.” But in fact they’re not fixing the problem, because they’re not addressing the bad policies which have depressed US savings.

China’s banks have been under pressure in equity markets on worries of credit quality deterioration. How serious is that threat in your view, particularly offbalance sheet debt?

It looks like – but it’s not altogether clear– there will be some deterioration in the credit cycle over the next year, given the enormous overhang of local government debt that is now evident. Some of the debt – we don’t know exactly how much– was probably misallocated into poor projects that will fail. Whether or not that takes the [non-performing loan] ratio from where is it now, 1%, to 2% or 5%, we don’t know. You can debate it endlessly. I’d be willing to bet that the increases would be small: Half of the debt existed before the crisis, and of the US$850 billion of new debt, most of it reflected the acceleration of projects that had long been planned by central and provincial governments. Off-balance sheet? All you have in off-balance-sheet credit risk is rumor. No one has metrics that allow you to measure the full extent of off-balance-sheet risk.

Michael Pettis at Peking University has argued that the rise of Asia is linked with the expansion of global liquidity over the past decade. What’s your view on that connection, and what would that imply for future growth?

I don’t share the view that Asia is a liquidity story. I think the rise of Asia has largely been driven by an exportled Chinese economy. To the extent that the export growth in China was driven by consumption bubbles in the developed world, then there are reasons to question the sustainability of Chinese export growth. There are liquidity aspects that have accompanied the export story, but they are a secondary factor in driving pan-Asian growth. The primary factor is the linkages of the Asian production platform to trade flows going into the developed world.

Do you think that tightening measures have largely remedied the inflation problems in China, or do you expect that to reemerge as a focus in 2012?

I won’t say that the battle against inflation is over, but Chinese authorities have done a good job addressing what could have been a serious problem. They’ve used a variety of tools to deal with inflation, most importantly administrative actions to deal with food price increases. They’ve aggressively tightened required reserve ratios in the banking system to slow down excess lending. There’s been a slight pick-up in the rate of renminbi appreciation, and five interest rate hikes by the People’s Bank of China in the last year and a half. I think it’s a fairly comprehensive assault that seems to paying benefits. While the government may be willing to relax some policies to support economic growth, I don’t think it’s going to take its eye off inflation.

What do you think about the push by top Chinese officials to have Western countries recognize it as a market economy?

China is a blended economy. There is a dynamic and rapidly growing marketbased private economy, but there is still a sector that is under the heavy control of the state. So it’s hard to paint China black or white, market or nonmarket. I think that the reforms that have enabled the emergence of this market-based piece of the Chinese economy are its greatest strength, and they should be encouraged. But the government is very reluctant to just let the system go and be driven purely by the invisible hand of the market. Some of those concerns are understandable in light of the crisis of the last three years. If there’s a lesson for me it’s that selfregulating markets are also risky. It’s important to find the balance between these two approaches.

What are the factions that are pushing for financial liberalization or opening up of the markets within China, and how do you expect that to play out?

I think interest rate liberalization is a really important missing piece of the equation for Chinese people. Deposit rates are offering negative returns in real terms. Historically, that spread between deposit and lending rates has been very important in providing funding for the Chinese banking system, but that’s not a sustainable answer for any country. You don’t want to have artificial funding for financial institutions in a way that suppresses the income of those who put their savings on deposit. So I think that needs to change.

How would you compare China with other exporting countries? Do the prospects look better for China to fire up demand?

It’s not easy just to fire up internal demand – there are a lot of moving pieces in the equation. I’m reasonably certain that if the world were to fall sharply again in the next year, like it did in 2008 and 2009, the Chinese government most likely would not be able to use the same approach to stimulate that it did three years ago because of the debt and property issues. The options are more limited. That’s why it’s all the more critical to move aggressively to stimulate internal private consumption. You can’t continue to deal with crisis with a model that remains as unbalanced as China’s current one. The premier had it right when he said nearly five years ago that the biggest flaws in China’s economy were that it was unstable, unbalanced, uncoordinated and unsustainable. Those characteristics are now putting the Chinese economy in a more vulnerable light than it would be if it were better balanced.