The crisis and China: Shocks, responses and consequences

While many analysts are looking to China to pull the world economy from its current downturn, the fact remains that China has been dependent on exports to the West, especially the US, to sustain its growth. If China is to rely on its own domestic demand to replace this faltering external market, it has to address the imbalance within its own society in terms of income and wealth.

Andong Zhu

IN the past three decades, China has achieved rapid economic growth, which has attracted a lot of attention in recent years. However, even putting aside its environmental and social problems, many observers believe that China's rapid growth is not sustainable if it doesn’t change the pattern of growth.

The current pattern relies too heavily on international trade. According to the National Statistical Bureau of China, in 2000, the investment ratio, i.e., the share of investment in GDP, was 35.3%, but last year, it reached 43.5%, the highest in 30 years (Figure 1). And in the past five years, the average investment ratio was 42.8%. At the same time, China's foreign trade dependency ratio, i.e., the sum of imports and exports divided by GDP, increased from 44.3% in 2000 to 75.3% in 2007, before declining to 63.4%, according to the World Bank.

In terms of either indicator, it is not easy to find a comparable big country in the world which records such levels. With too much investment, the danger of excessive production capacity would increase, and with too much foreign trade, the economy would be more vulnerable to outside shocks. It was at the point of time when these indicators reached an unsustainable level that the crisis struck.

The shocks

There are several channels through which the world financial and economic crisis affected China, such as depression of confidence in the Chinese economy, the losses Chinese firms incurred in the international financial market, and the drop in the international demand for Chinese exports.  For example, though it is clear that the stock market bubble could not be sustained indefinitely, the world crisis certainly contributed to the timing and depth of the plunge in the Chinese stock market. The Shanghai Stock Exchange Composite Index dropped 72% from 6092 on 16 October 2007 to 1706.7 on 4 November 2008 (Figure 2).

The most important transmission channel for the crisis may be international trade. According to recent research, about 58% of China's GDP growth variation can be explained by external factors. With the developed economies falling into recession, China's exports dropped sharply. As the processing trade accounts for a big portion of Chinese foreign trade, imports also dropped sharply in China too. From Figure 3 we can see that before the crisis, the growth rates of both imports and exports were around 25%, and in 2009, they were around -22%.

Due to all these factors, China's economic growth dropped sharply. Compared with the same quarter in the previous year, the GDP growth rate dropped by more than half, from 13.4% in the fall of 2007 to 6.1% in the spring of 2009 (Figure 4).

The responses

Faced with this adverse situation, the Chinese government responded swiftly and strongly. In the first half of 2008, the major macroeconomic target of the Chinese government had been to cool down the over-heated economy (the CPI inflation rate was 7.9% at that time; see Figure 4). After increasing the interest rate six times in 2007, the Chinese government increased the required reserve ratio (RRR) of deposit five times, from 14.5% to 17.5% in the first half of 2008. Then, after successfully organising the Olympic Games in August 2008, attention was shifted to the macroeconomy. It became increasingly clear that with the world financial and economic crisis, the Chinese economy was heading towards a sharp and brutal slowdown. Thus, the direction of macroeconomic policy was changed to ‘guaranteeing growth’.

From 16 September 2008 to 25 December 2008, the one-year loan interest rate was lowered five times, from 7.47% to 5.31%, while the RRR was lowered four times to 14.5%. A set of policies was adopted to stimulate exports when it became apparent that external demand would decrease sharply. Among all the polices carried out by the Chinese government to stimulate different sectors, including the stock market and real estate market, the most impressive move was the 4 trillion RMB ($586 billion) stimulus package announced on 9 November 2008 (see Figure 6 for the package details after revisions).

In 2009, the Chinese government stopped adjusting the interest rate and RRR. Instead, it began to increase money supply and new loans directly. Figure 7 shows clearly the sharp increase in M2 money supply and new loans. Between 2004 and 2008, the average growth rate of M2 was around 17% and average amount of monthly new loans was around 270 billion RMB, but in the first eight months of this year, the average M2 growth was more than 25% and average monthly new loans were more than 1016 billion RMB. Just in the first half of the year, the accumulated new loans reached 7.37 trillion RMB, 0.59 trillion RMB more than the new loans made in both 2006 and 2007.

The consequences

With all these stimulus policies, the growth rate of the Chinese economy recovered to 7.9% in the second quarter of 2009 after having reached a low of 6.1% in the first quarter. Now most observers believe that it would not be a problem for the Chinese economy to grow at 8% this year and some international institutes have even adjusted their forecast of China's GDP growth in 2009 to 9%.

However, this doesn't mean all the difficulties have been overcome. When the crisis (in Chinese, it means 'danger and opportunity') hit China, many hoped China could turn the danger into opportunity and shift to a sustainable growth pattern, i.e., make economic growth less dependent on foreign trade and investment. But this requires private consumption to fill the gap left by net exports and investment, which, in turn, needs an improvement in income inequality. This is not easy to achieve, given the resistance from powerful interest groups who have benefited from the prevailing growth pattern. Therefore, it is understandable that policies to decrease income inequality are either not strong enough or not even formally proposed at all.

Consequently, we find that now investment has become even more important for economic growth in China than before. As we can see from Figure 3, exports decreased by more than 20% in the first eight months of this year. And during the same period, net exports decreased by almost 20%. With the developed economies still mired in recession, we don’t expect Chinese exports to increase at the same pace in future as before the crisis. In other words, the crisis has forced the Chinese economy to depend much more on domestic demand.

In domestic demand, though automobile sales increased by 30% to reach 833 million in the first eight months of this year, we don't expect the private consumption ratio and the final consumption ratio to increase much. Compared to the same period last year, the growth rate of total retail sales in the first eight months of this year is even lower by about 7%. Even if we consider the impact of inflation, the growth rates in the two periods are similar. Therefore, it is easy to reach the conclusion that the recovery of the Chinese economy was mainly led by investment.

This is confirmed by the statistics. According to the National Development and Reform Commission, in the first eight months, total urban fixed assets investment increased by 33.0% compared with the same period last year, reaching 11.3 trillion RMB. This growth rate is even higher than that of last year by 5.6 percentage points, even without taking into account the decrease in the prices of capital goods. Thus, it is logical to expect the investment ratio to increase to another historic high this year. In other words, the imbalance among the components of aggregate demand in the Chinese economy, especially domestic demand, will be even more severe this year.

The injection of huge amounts of liquidity into the economy did avert a more serious slowdown. But it also caused other problems, such as an asset market bubble and inflation. Though the Chinese economy is still suffering deflation in both the Consumer Price Index and Producer Price Index, many people expect inflation in the near future. Therefore, many entered the asset market to avoid losses associated with inflation. From Figure 2 we can see that the Shanghai Stock Exchange (SSE) index increased from 1706.7 on 4 November 2008 to 3471.4 on 4 August 2009. With the real economy lagging behind, this high level of stock prices cannot be sustained. Therefore, the SSE index subsequently dropped by more than 20% from this latest high, to 2763.7 on 30 September 2009. Now the price-earning ratio of stocks in China is about 23, still a relatively high level.

Housing prices experienced a rapid increase after 2003. In 2007, the average housing price in the 36 major cities increased by 1,000 RMB, or 20% in that single year. Many people expect the housing bubble to burst in 2009 so that normal people can afford housing. However, after a modest decrease, house prices began to increase again in February. Now, according to some estimates, on average, a family in Beijing needs 27 years' income to buy a 100-square-metre apartment. With fewer and fewer people who can afford to purchase an apartment, the housing price has to drop in the near future. In some cities, the decrease in real estate prices has already begun. However, since the housing sector is such an important one in the Chinese economy, the bursting of the housing bubble and a collapse in real estate investment would once again exert downward pressure on the Chinese economy. Some scholars are thus talking about a 'W-shaped' recovery now.

In the long term, with lower labour cost than developed countries and much better infrastructure than those countries with even lower wages, the Chinese economy will be an ideal manufacturing base for the world. However, with many economies suffering recession, the rise of nationalism and protectionism may be inevitable. If that happens, international trade would not recover to the levels of the past several years and China will have to rely on its domestic demand. However, as mentioned earlier, in the middle and long run, the Chinese economy has to rely much more on private consumption  than it now does. This would require an improvement in income inequality, which, in turn, calls for (re)nationalisation of private firms, more protection for labour and a better social welfare system. Realising this will not be easy. What will happen in the future will depend on the evolution of the social structure of Chinese society.         u

Andong Zhu is a Professor at the School of Humanities and Social Sciences in Tsinghua University, Beijing.

*Third World Resurgence No. 228/229, August-September 2009, pp 27-30