China to the Rescue: Growing Out of the Financial Crisis

SINGAPORE: While there is an emerging consensus on what ails the world economy there is no agreement on the treatment. Instead of a global economic policy a variety of national ones are being cooked up to satisfy national tastes that often contradict each other. The time has come – it is actually overdue – to recognize that stimulating global demand, bringing it into line with global supply, is the only cure.

The diagnosis reveals that global demand is too low, resulting in excess production capacity, exercising downward pressure on investment, wages, and property prices. The prescription calls for a rebalancing of demand and supply. Excess supply through over investment in the ‘fat’ years, combined with an inventory built up, aggravate the policy dilemma. Experience tells us that cutting excess supply is an agonizing process that easily undermines confidence in a recovery, harming long-term growth prospects.

Individual countries may try to remedy excess production capacity by exporting more goods, but this shifts the calamity from one country to another doing no good for the global economy. If policy makers are allowed to walk down this path, protectionism will throw a spanner in the works of recovery as countries race to retaliate against each other.

But first we have to do away with the illusion that global growth will return to five percent. Growth will likely land one, maybe two, percentage points lower and stay there for a while, as the world waits to see how a rebalanced and restructured global economy will fare.

Taken together the US, Europe, and Japan account for more than half and may be even two-thirds of the global economy depending upon the calculating method. Europe is trying hard to reform its economy, but results are still disappointing. Japan is facing a low-trend growth, if growth at all, due to demographics and the inability to restructure.

And we are unlikely to see private consumption drive US economic growth as it has done for many years. The paradigm has changed. The halving of the oil price from summer 2008 to summer 2009 should have led to higher private consumption, but it didn’t. A number of factors – the stock market, bankruptcies, and bailing out of GM to mention a few – depressed the willingness to spend and it is not clear to which extent better data will renew consumer confidence.

Personal saving as a percentage of disposable income has rocketed from zero in April 2008 to nearly seven percent in May 2009; the highest figure in more than six years. Demographics too are turning against the US. Economics tells us that private consumption for an individual peaks around 45-50 years of age and the baby boomers have passed that mark. There is no basis, then, to expect private consumption in the US to rise or even correspond to the level around and prior to 2007. And without private consumption a recovery is unthinkable.

This leads to the conclusion that increasing demand can only be found outside the traditional heavyweights. The newcomers are China, India, and Southeast Asia plus a number of other countries around the globe. But as only China – and partly India – is playing in the big league, examining that country should prove instructive.

And it looks pretty good.

But the first step is to repudiate the thesis that China’s domestic demand is still weak, signaled by the persistent balance of payments surplus. If domestic demand were rising as share of GDP, imports would pull the balance of payments towards a smaller surplus, runs the argument. But it is falling. The World Bank predicts China’s surplus will fall to 8.3 percent of GDP in 2010 and 7.2 percent in 2011 from the 11 percent in 2007.The argument also overlooks the dramatic fall in commodity, food and energy prices: if the economy were unchanged, imports would have gone down, boosting the surplus further (they account for 28.8 percent of total import). Persistent domestic demand, holding up much better than exports and by doing so limiting the fall in imports, seems to be the best explanation for a falling, not rising surplus. Of course, the reported stockpiling of commodities by China’s large state-owned corporations could have played a role too.

Secondly, the composition of China’s imports suggests domestic consumption is changing. Parsing the data, when one separates imports used to produce exports primarily for the US from imports destined for domestic demand an interesting dynamic emerges. Imports for production of exports fell much sharper than imports for domestic demand. The fact that this trend has persisted over almost two years – since mid-2007 – implies China’s economy is being restructured.

Thirdly, recent figures suggest that real household spending is nine percent higher than a year ago, resulting in a hike in private consumption’s share of total demand. Retail sales are rising even more –15 percent year on year – though this includes government purchases. On this basis it is plausible to assume that household spending together with government programs should prevent a fall in China’s GDP growth below the six-to-eight percent bracket.

The room to maneuver for stimulatory measures is still available for China. But this is not the case for the US and Japan, where public budget deficits have reached the breaking point with further measures likely to undermine whatever confidence in the economies are left. The US is running a deficit estimated at 13.2 percent of GDP and Japan looks forward to as much as 11 percent according to the pessimists.

In the end, the world cannot expect the US to lead the way out of recession and rebalance the global economy. On July 10, Larry Summers, Director of the US President’s National Economic Council said to Financial Times, “I don’t think the worst is over” and added “The global imbalances have to add up to zero and so, if the US is going to be less the consumer importer of last resort, then other countries are going to need to be in different positions as well.” To rebalance the world economy we need to look to growth from countries like China instead of the US.

Moreover, as the rising savings rate in the US is likely to slow down the recovery, it will be easier to reduce balance of payments imbalances that have harassed the world for so long. Indeed US exports rose and imports fell in May resulting in the lowest trade deficit for nearly nine years. If this trend persists, and basic economic figures suggest it will, US borrowing will fall, inducing global capital to flow into productive investment rather than US treasury bonds. (Of course, mounting healthcare cost, additional stimulus and greater welfare benefits could alter the situation.)

A reallocation of capital to healthier economies would make the goods and services market work in tandem with the capital market. This would not only benefit the global economy, harmed by the financial crisis, but also help weak economies overcome their imbalances. Most important of all: it would achieve a rebalancing without cutting global demand thus avoiding a global slump. But the US must pay a price. China would begin to lead the global economy replacing the US – a bitter pill, indeed.