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The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

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June 16, 2016

Experts Debate Policy Options for China's Transition

After nearly three decades of rapid economic growth, China today faces the challenge of economic rebalancing against the backdrop of slow and uncertain global growth. Although investment and exports have been a motor for growth, China is increasingly experiencing structural issues: widening inequality, overcapacity as a consequence of policy distortions, unsustainable environmental costs, volatile financial markets, and rising systemic risk.

On April 28–29, I attended the First Research Workshop on China's Economy, organized jointly by the International Monetary Fund (IMF) and the Atlanta Fed. The workshop, held at the IMF's headquarters in Washington DC, explored a series of questions that have emerged as China shifts toward a new growth model. Is this the end of the growth miracle? Will the Chinese renminbi one day be as important as the U.S. dollar? Should the rapidly increasing shadow banking activity in China be a source of concern? How worrisome is the rapid rise in China's housing prices?

Panelists shared their views on these and other issues facing the world's second-largest economy (or largest, if measured on a purchasing-power-parity basis). Plans are under way for a second workshop to be held in 2017.

The following is a nice summary of the research discussed at the workshop. It was originally published in the IMF Survey Magazine, and was written by Hui He, IMF Institute for Capacity Development, and Nan Li, IMF Research Department. Thanks to the IMF for allowing me to repost it here.

Is China's economic growth sustainable?
Understanding the source of China's tremendous growth was a recurring theme at the workshop. "China's economy combines enormous dynamism with huge distortions," observed Loren Brandt (University of Toronto). Brandt described his research based on China's firm-level data and emphasized that firm dynamics (entry and exit), especially firm entry, have been the main source of the productivity growth in the manufacturing sector.

Echoing Brandt's message, Kjetil Storesletten (University of Oslo) discussed regional growth disparities and showed that barriers preventing firms from entering an industry account for most of the disparities. Such barriers are more severe for privately owned firms in regions in which state-owned enterprises (SOE) dominate, he said.

In his keynote speech, Nicholas Lardy (Peterson Institute for International Economics) offered an upbeat view on China's transition to a new growth model, one in which the service sector plays a larger role than manufacturing. The bright side of the service sector, he noted, is its continued strong productivity growth. The development of financial deepening and the stronger social safety net are contributing to increased consumption, which helps to rebalance the economy.

However, he emphasized, SOE reforms remain critical as the service sector cannot provide a silver bullet for a successful transition.

Central bank's policy decisions
Several participants tried to discern how the People's Bank of China (PBC) conducts monetary policy. Tao Zha (of the Atlanta Fed's Center for Quantitative Economic Research and Emory University) found that the PBC reacts sharply when the gross domestic product's growth rate falls below its target, increasing the money supply by 11.5 percentage points for every 1 percentage point shortfall.

Mark Spiegel (Center for Pacific Basin Studies) discussed the trade-offs involved in Chinese monetary policy—for example, controlling the exchange rate versus maintaining inflation stability. He also argued that the heavy use of reserve requirements on banks as a monetary policy tool might have an unintentional consequence to reallocate capital from SOEs to more efficient privately owned firms and could therefore offset the resource misallocation caused by the easy credit to SOEs that banks granted in the high growth years.

Renminbi versus the dollar
Eswar Prasad (Cornell University and Brookings Institution) argued that China's capital account will become more open and the renminbi will be used more widely to denominate and settle cross-border transactions. But he also noted that legal and institutional constraints in China were likely to prevent the renminbi from serving as a safe-haven currency as the U.S. dollar does today.

Moreover, he said, the current sequencing of liberalization initiatives—that is, removal of capital account restrictions before appropriate financial market supervision and regulation and exchange rate reform—poses financial stability risks.

Shadow banking and the housing market
Recently, volatile Chinese financial markets and continued housing price appreciation have raised serious financial stability concerns.

Michael Song (Chinese University of Hong Kong) argued that rapidly rising shadow banking activity is an unintended consequence of financial regulation. Restrictions on deposit rates and loan-to-deposit ratios have led to the issuance by banks of "wealth management products" to attract savers with higher returns. Because these restrictions had a greater impact on small banks, the big state banks had more room to undercut the smaller banks by offering wealth management products with higher returns and then restricting liquidity to them in interbank markets, ultimately making the banking system more prone to liquidity distress and runs.

Hanming Fang (University of Pennsylvania) found that, except in big cities such as Beijing and Shanghai, housing prices in China's urban areas between 2003 and 2013 more or less tracked rising household incomes. In his view, the Chinese housing boom is thus unlikely to trigger an imminent financial crisis. He warned, however, that housing prices may fall rapidly if economic growth slows dramatically, and that such a development could, in turn, amplify the economic downturn.

Rising wage inequality
China's rapid growth over the past two decades has been accompanied by rising wage inequality, an issue highlighted by two conference participants. Dennis Yang (University of Virginia) explored the distributional effects of trade openness in China and found a significant impact on wage inequality of China's accession to the World Trade Organization in 2001.

Chong-En Bai (Tsinghua University) argued that the decline after 2008 of the skill premium—that is, the ratio of the skilled labor wage to the unskilled labor wage—can be explained by the Chinese government's targeted credit extension to unskilled labor-intensive infrastructure sector (as part of the fiscal stimulus following the global financial crisis). Such distortionary policies might have short-run growth benefits but could lead to long-run welfare losses, he said, especially when rural-to-urban migration has run its course.

April 11, 2016

The Rise of Shadow Banking in China

China's banking system has suffered significant losses over the past two years, which has raised concerns about the health of China's financial industry. Such losses are perhaps not all that surprising. Commercial banks have been increasing their risk-taking activities in the form of shadow lending. See, for example, here, here, and here for some discussion of the evolution of China's shadow banking system.

The increase in risk taking by banks has occurred despite a rapid decline in money growth since 2009 and the People's Bank of China's efforts to limit credit expansions to real estate and other industries that appear to be over capacity.

One area of expanded activity has been investment in asset-backed "securities" by China's large non-state banks. This investment has created potentially significant risks to the balance sheets of these institutions (see the charts below). Using the micro-transaction-based data on shadow entrusted loans, Chen, Ren, and Zha (2016) have provided theoretical and empirical insights into this important issue (see also this Vox article that summarizes the paper).

Recent regulatory reforms in China have taken a positive step to try to limit such risk-taking behavior, although the success of these efforts remains to be seen. An even more challenging task lies ahead for designing a comprehensive and sustainable macroprudential framework to support the healthy functioning of China's traditional and shadow banking industries.

October 1, 2007

Why Did The Chinese Stop Sterilizing?

I'm feeling optimistic that the full-time return of macroblog is imminent, but before its official there's something I have been meaning to ask.  A point I used to make way back when is that, in theory, a country that pegs the value of its currency below the freely floating market value will eventually "solve" the "problem" of the exchange rate misalignment by inflating away to the value of its money. 

How does that work?  In simple terms, to constrain the price of an undervalued currency a central bank will, in effect, print its own money in order to purchase the currencies against which it is undervalued.  In other words, increase the supply of your own currency while at the same time increasing the demand for other currencies. But, all else equal, increasing your domestic money supply will ultimately lead to domestic inflation, which in turn reduces the currency's exchange value.  Enough inflation and the currency will no longer be undervalued.  Hence, problem solved.

Which is why the case of China has been somewhat puzzling. No doubt about it, the People's Bank of China has been accumulating official reserves -- that is, purchasing assets (mainly debt) denominated in foreign currencies (mainly dollars)  -- at a pretty hefty pace for some time now.  But, until very recently, there was not much to show in the way of the inflation requested (if not mandated) by theory.

Mechanically, the reason for this is sort of apparent: Up until very recently, the PoBC has been sterilizing their foreign exchange actions.  In other words, the Chinese central bank has been undoing the effects of its exchange rate interventions with offsetting domestic monetary operations that muted growth in the overall money supply.  That is, as I said, until recently:      

July 16, 2007

China Skeptic

When it comes to Chinese economic growth, this is the type of story to which we have become accustomed...

Goldman Sachs said it is forecasting second quarter GDP growth for China of 11 pct year-on-year, overcoming the high base from a year earlier, with CPI growth of 4 pct for June.

... and this is the type of picture we have come to expect:

   

Output_per_worker

   

That sort of data is impressive -- even scary -- but Jeremy Haft, writing in today's Wall Street Journal (page A12 in the print edition), suggests there may be less to those pictures than meets the eye:

If you visited a typical Chinese factory, you'd see why. It lacks capital, technology and know-how. Its workers place obedience over quality. And it sits along an endless chain of middlemen.

On average, it takes China 17 separate parties to produce a product that would take us three. Unlike Japan in the 1980s, little companies drive China's economic growth, not big ones. China's industries are composed of hundreds of thousands of tiny factories and farms -- plus traders, brokers, haulers and agents, all of whom take control of the goods and materials but add little value to the product. With every additional player in the chain, the cost, risk and time grow. Effective quality control in this environment is difficult.

So is effective cost control. Despite cheap labor, making goods in China is often more expensive than in the U.S. Far from being a bottomless ATM of cheap consumer goods, China is a risky, costly and time-consuming place to do business.

Yet polls show a majority of Americans believe China has mastered basic manufacturing -- and it's now barreling into our high-tech backyard. That's false. As the product recalls demonstrate, China can barely make low-value goods reliably, much less higher-value ones. The problems are structural, not the result of a few bad apples.

To that last point, consider this not-long-ago assessment from the OECD:

China’s staggering economic growth rate has stood at almost 10% for the last 20 years. One cause is strong exports underpinned by low production costs. Information and communication technology now claim the lion’s share of China’s export trade, accounting for approximately 30% of its exports in 2005. The year before, China ranked as the largest exporter of IT products, outstripping the EU, Japan and the US. Since 1996, China’s IT goods trade has been growing at almost 32% a year...

That certainly sounds like some "barreling into our high-tech backyard," but the underlying reality is complicated:

Some 55% of China’s total exports are attributed to production and assembly-related activities, and 58% of these are driven by foreign enterprises, of which 38% are entirely foreign-owned. In fact, among the top 10 high-technology companies by revenue, not one of them is Chinese...

Although regarded as the world’s largest potential IT market, China has not reaped the full benefit of its large-scale IT output, particularly in terms of productivity. Apart from mobile phones, the vast majority of Chinese do not yet use IT. In general, IT spending is lower in China (about 4.5% of GDP in 2005) than in leading OECD countries (about 9% of GDP in 2005).

One paradox is that while low IT costs brought about by China’s competitive supply has helped OECD-based firms upgrade, reorganise and boost productivity, the actual uptake of IT within Chinese firms is lagging behind too. Notions like supply-chain management, resource planning or knowledge management software that are standard currency in dynamic OECD firms are still rather undeveloped in China.

All of which leads Mr. Haft to suggest that the Chinese century may take awhile to develop:

To compete head-to-head with the American economy, China will have to revolutionize the very way its industries are organized. It must shake out the thousands of low-value middlemen and integrate the tiny factories into larger, more competitive companies. It must train a workforce in modern technology and business practices. And, it must instill transparency and a uniform rule of law. Such an effort could span generations.

Indeed.