China is slowing down. After growing by more than 10 per cent a year for more than a decade, its economy is decelerating. Dreams of double-digit growth are over, as premier Wen Jiabao admitted last week to the Chinese leadership. Many analysts have therefore concluded that China needs monetary easing. They are wrong.
There was some good news amid the Beijing gloom. On Friday we learnt that consumer price inflation had dropped to 3.2 per cent in February from 4.5 per cent the previous month.
Other data releases were, however, weaker than expected. Industrial output growth was sluggish. Retail sales growth had dropped sharply. This is important: because China must urgently rebalance its economy away from investment and towards consumption, any weakness in consumption growth is a bad sign.
The combination of good inflation numbers and bad growth numbers has led economists to call on the People’s Bank of China to goose the slowing economy by easing credit and perhaps even lowering interest rates. This, they argue, can spur consumption and investment growth, and with inflation dropping quickly, the authorities need not worry about igniting further price increases.
This advice is based on a fundamental misunderstanding of how monetary policy works in a financially repressed banking system. In the US, monetary easing tends to boost both investment (by lowering the cost of capital for businesses) and consumption (by lowering the cost of credit and increasing wealth).
But monetary easing doesn’t work that way in China. It does boost investment, as in the US. But Chinese monetary easing actually reduces consumption. Why? Because expanded credit and lower real interest rates increase the already very high financial repression tax imposed on Chinese households.
This implicit tax is the most important reason for China’s low household consumption rate, and increasing it will push consumption even lower as a share of gross domestic product. The PBoC must boost consumption by continuing to restrain credit growth and to force up the real deposit rate.
But with Chinese growth so overly dependent on investment, many analysts worry that tighter monetary conditions will cause growth to slow even more. They are right, but there are three reasons why this will still leave China better off.
First, by increasing the meagre returns to their high savings, it will allow household income and consumption to grow more quickly than the overall economy.
Second, China’s biggest risk – one that has afflicted every country in history that has followed a similar investment-driven growth strategy – is that debt levels become unsustainable. Chinese debt is already very high and growing much too quickly because ferocious investment growth funded by cheap debt is increasingly misspent. Tighter credit conditions are the only way to fix this.
Third, although tighter monetary conditions will slow growth substantially, this will not have the adverse social impact that so many fear. Why not? Because if China successfully rebalances its economy, household income growth will exceed GDP growth. Even if annual GDP growth slows to 4-5 per cent, in other words, real household wealth can grow at the 5-6 per cent a year that will keep households happy.
Some worry that slower GDP growth would lead to rising unemployment, but higher interest rates will force Chinese businesses to switch from a capital-intensive growth model dominated by inefficient state-owned enterprises to a much healthier labour-intensive growth model powered by nimbler small and medium-sized enterprises. China’s earlier attempts to rebalance by increasing wages have hurt labour-intensive industries and have actually worsened the imbalances. But this switch to a labour-intensive growth model would ensure higher employment per unit of GDP growth – or more bang for your renminbi.