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The Sky Is not Falling, IV

Sep 23 , 2015
  • Lawrence Lau

    Ralph and Claire Landau Professor of Economics, The Chinese University of Hong Kong

In 1997, at the height of the East Asian currency crisis, I wrote an article, “The Sky is not Falling (天塌不下来),” basically saying that the Chinese economy would be able to emerge from the crisis more or less unscathed. The Chinese Government at the time decided not to devalue its currency, the Renminbi, even though every other East Asian economy, except Hong Kong, had done so. The policy of holding the exchange rate of the Renminbi steady at the time was opposed by many people in China, especially by exporters, but ultimately it proved helpful not only to China itself, but also to the other East Asian economies. China emerged from the 1997-1998 East Asian currency crisis relatively unscathed and also earned the gratitude and respect of the East Asian countries and regions.

In September 2008, the external environment facing the Chinese economy was similarly negative, though in a totally different way. The failure of Lehman Brothers in the United States caused a major financial crisis, the magnitude of which had not been seen since the Great Depression of 1929. And the crisis of confidence was spreading to Europe and the rest of the world. Overnight, credit and liquidity dried up completely in the U.S. and Europe. There was panic almost everywhere. The Chinese and East Asian economies faced abruptly reduced demands for their exports by more than 50 percent as the United States and Europe fell into recession.

At that time, I wrote another article, “The Sky is not Falling II (天塌不下来 (二)),” arguing once again that the Chinese economy would be able to not only survive but also continue to grow through the global financial crisis, based on the possibility of the partial de-coupling of the Chinese and East Asian economies from the U.S. and European economies. And, sure enough, despite the financial turmoil and economic slowdown and recession in the U.S. and some of the Western European countries, the Chinese economy was able to manage to continue to grow, based mostly on its domestic demand alone, and achieved real rates of growth of GDP of 9.1% in 2009 and 10.3% in 2010. Any doubts concerning the validity of the partial de-coupling hypothesis should have been dispelled by the actual performance of the Chinese and East Asian economies (except Japan) during this period.

At the beginning of 2012, at the height of the European sovereign debt crisis, I wrote yet another article, “The Sky is not Falling III (天塌不下来 (三)),” explaining why the Chinese economy should be able to achieve a “soft landing” and continue to grow at around 8% per annum amidst the European sovereign debt crisis, based on its own domestic demand. The actual real rates of growth achieved by the Chinese economy in 2011 and 2012 were 9.3 % and 7.7% respectively.

Since 2013, the Chinese economy has been in the process of adjusting to a “new normal”–a lower rate of growth, more environmentally conscious, less export-oriented, more service-sector focused, less tangible inputs-driven and more innovation-driven. The rate of growth of the Chinese economy has since been slowing down gradually from double-digit rates to 7.7% in 2013 and 7.3% in 2014. The slowdown in the rate of growth is actually consistent with the Chinese economic plan. The rate of growth of Chinese real GDP is expected to stabilize around 7% going forward, with similarly reduced rates of growth for its exports and imports. However, with the recent bursting of the Chinese stock market bubble in July and the slight but unexpected devaluation of the Renminbi of approximately 4% in August, the world markets have panicked and doomsayers have been coming out in droves, predicting the imminent collapse of the Chinese economy. Today, I write yet another article, “The Sky is not Falling IV (天塌不下来 (四)),” explaining why the Chinese economy should be able to make a smooth transition to a “new normal”, with an average annual rate of growth of around 7% over the next few years, based once again on its own domestic demand.

What is different this time is that the “crisis” was not due to external developments as the previous crises were. The current crisis was a crisis of domestic and international confidence, caused by the slowdown of the Chinese industrial sector and the unfortunate Chinese domestic economic events such as the bursting of the stock market bubble and the attempted refinement of the foreign exchange trading mechanism. Notwithstanding these events, which were widely misinterpreted in different ways, I shall argue that a “hard landing” for the Chinese economy is most unlikely. This is mainly because given the large and widespread excess production capacities in the Chinese manufacturing industries, as long as there is aggregate demand, there will be aggregate supply. Thus, the Chinese economy is not supply-constrained. Since the Chinese Government, with the many policy instruments at its disposal, is uniquely capable of managing domestic aggregate demand, it will have no problem in maintaining a real rate of economic growth of around 7% going forward.

However, given the excess manufacturing capacities in many industries and the excess supply of residential units in almost all except the very first-tier cities, private-sector fixed assets investment is not likely to be a robust source of increase of aggregate demand as it once was. Lowering the rate of interest alone is not going to induce additional private-sector fixed investment in either manufacturing industries or residential housing. Close to zero nominal rates of interest have prevailed in the United States, Japan and the Euro Zone for many years, but they have not caused any significant increase in real fixed investment even as they have driven up asset prices to new highs. This is ample proof that monetary policy alone cannot be effective in stimulating the real economy. What is needed is the maintenance and restoration of public confidence in the economy which can only be achieved through concrete governmental policy and action.

Neither is export likely to be a source of increase of aggregate demand, given the relatively slow recovery of the U.S. and European economies and the continuing rise in the Chinese wage rate and the significant appreciation of the Renminbi of approximately 25 percent since 2005. The 4% devaluation in August was too little to have any significant impact. Moreover, it is really not in the best interests of China to devalue the Renminbi enough to go back to labor-intensive light manufacturing such as toy-making, with the low standard of living that such activities imply. It is far more important, from China’s point of view, to continue the process of internationalizing the Renminbi, so that it can be directly used for the invoicing, clearing and settlement of international transactions. For this purpose, the Renminbi exchange rate vis-a-vis the U.S. Dollar must be kept at a stable level.

Chinese household consumption has been growing approximately 50 percent faster than real GDP during the past few years. But because of its low share in GDP, approximately 30% in 2014, it will not give a sufficiently large boost to aggregate demand to make a material difference as yet. (Total final consumption, which includes both household consumption and government consumption, reached 60% of GDP in the first half of 2015.) In order for household consumption to become a major driver of aggregate demand, real household disposable income must increase significantly faster than real GDP. Even then, it will take a while before household disposable income exceeds one-half of GDP.

Thus, in the short and medium terms, any significant growth in aggregate demand must come from public infrastructural investment and public goods consumption. The Government is expected to take the lead in both. Increasing public infrastructural investment and public goods consumption to boost aggregate demand at this juncture has two additional advantages. First, given the idle manufacturing capacities, the marginal social cost of the public infrastructural investment and public goods consumption is low. Second, the provision of public goods amounts to a redistribution of real income in kind, since, for example, both the rich and the poor breathe the same air and drink the same water, so that it can reduce the de facto degree of income disparity in China.


The Sky is not Falling, I

The Sky is not Falling, II

The Sky is not Falling, III

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