Theme: The current global financial crisis is having a significant negative
impact on the Chinese economy.
Summary: The current global financial crisis is having a significant negative
impact on the Chinese economy, affecting exports, foreign exchange
reserves and structural adjustments. The Chinese Government’s
reaction has so far been effective in boosting short-term economic
growth, but has been insufficient to ensure sustainable long-term
growth and new risks could arise. Policy suggestions include how to
stimulate household consumption effectively, how to mitigate the
pressure of unemployment and how to diversify China’s foreign exchange portfolio.
The US subprime crisis which broke out in the summer of 2007 evolved into
a global financial crisis after the bankruptcy of Lehman Brothers in
September 2008. The subsequent liquidity squeeze and credit crunch
caused a world-wide economic slowdown. The US, the Euro Zone and
Japan all slipped into recession in 2008, a situation that is likely
to persist at least into 2009. The emerging countries have faced not
only a dramatic decline of economic growth, but also a surge of
capital outflows. A financial crisis could break out in the central
and eastern European economies, driven by significant current account
deficits, heavy debt burdens denominated in foreign currencies and a sudden stop or even reversal of capital inflows.
As the largest developing country and an export-driven economy, it would
have been impossible for China to dodge the impact of the global
financial and economic crisis. First, China is over-dependent on
exports to stimulate its economic growth and the weakening of
external demand will be a heavy blow for the Chinese economy.
Secondly, at the end of 2008 the People’s Bank of China (PBoC,
the Chinese central bank) had foreign exchange reserves worth US$1.95
trillion, of which a large part were denominated in US dollars,
especially US treasury bonds and agency bonds. The potential
devaluation and downgrade of its US treasury or agency bonds
resulting from the deepening of the subprime crisis will erode the
international purchasing power of China’s foreign exchange
reserves. Third, to prevent a slowdown of economic growth, the
Chinese government might postpone or even cancel some structural
adjustment policies which are necessary to ensure the sustainable
growth of the Chinese economy, such as bursting the price bubble in
the real estate sector and increasing the flexibility of the RMB’s exchange rate mechanism, among others.
The Chinese government has taken timely and bold countermeasures to
mitigate the impact of the global financial crisis. Since the third
quarter of 2008, the Chinese authorities have adopted a combination
of an active fiscal policy and a loose monetary policy. The
appreciation of the RMB against the US dollar has been halted since
the second half of 2008. Although these measures are quite useful to
stimulate short-term economic growth, they cannot ensure long-term
sustainable growth and might generate new risks. Therefore, the
Chinese government should speed up the structural readjustments which
will help to transform China’s growth model and stimulate domestic consumption.
Impact on China’s Exports
China’s economic growth is over-dependent on the growth of net exports. In
2008, its export-to-GDP ratio reached 32%, and its
exports-and-imports-to-GDP ratio was 59%. The contribution of net
exports (goods and services) to GDP growth was over 20% in 2007.
Moreover, as a labour-intensive sector, exports absorbed a mass of non-skilled workers from rural areas.
The G-3, which account for 46% of the external demand for China’s
exports, have all slipped into recession due to the impact of the
global financial crisis. Emerging markets, such as Hong Kong, Taiwan,
South Korea and the ASEAN countries, which are China’s major
export markets, have also slowed down dramatically. As a result of
the weakening external demand, China’s exports have declined
significantly since the fourth quarter of 2008. Both exports and
imports have registered a contraction (yoy) since November 2008 (see
Figure 1). However, due to the decline in world energy and commodity
prices and to China’s shrinking internal demand, imports have
decreased much faster than exports, causing a surge in the trade surplus.
Figure 1. China’s exports and imports (%, Left; US$100 mn, Right)
Sources: Ministry of Commerce of the PRC.
As a result of the global financial crisis a large number of export-led
private enterprises in China’s coastal provinces have gone
bankrupt, with around 20 million unskilled workers losing their jobs.
Furthermore, the slowdown in China’s exports, along with the
decline in real estate investments, has led to a decrease in GDP growth from 13% in 2007 to 9% in 2008.
The exact reason why the Chinese government has put export growth at the
top of its list of priorities is that the export sector can absorb
excess labour. The huge number of workers released from bankrupt or
poorly-operated enterprises has caused a surge in the real
unemployment rate, which could lead to social unrest. Hence, the
Chinese government has continued to apply tax rebates to export
goods, increasing its intervention in the foreign exchange market to
prevent the further appreciation of the RMB against the US dollar,
and lowering its environmental and energy-consuming criteria.
However, external demand is an uncontrollable variable so the Chinese
government’s capacity to stimulate exports is facing great challenges, especially in an environment of protectionist pressure.
The Impact on China’s Foreign Currency Reserves
At the end of 2008, China’s foreign exchange reserve had reached
US$1.95 trillion. Although the PBoC does not disclose the proportion
of currency and assets of its foreign exchange reserves, it is
possible to make a rough estimate based on external data. For
instance, according to the IMF’s COFER statistics, up to the
third quarter of 2008, assets denominated in US dollars, euros,
pounds Sterling and yen in the portfolios of developing countries’
reserves totalled respectively 61%, 28%, 6% and 3%. There is no
evidence to show that China’s reserves are significantly
different from those of other developing countries. The asset
composition of China’s foreign exchange reserves can also be
estimated through the statistics disclosed by the US treasury on the
overseas holdings of US securities. According to the preliminary
report on foreign portfolio holdings of US securities at the end of
June 2008, China held US$535 billion in US treasury bonds, US$544
billion in US agency bonds, US$27 billion in US corporate bonds and
US$100 billion in US equities. Even considering that the PBoC sold
agency bonds and bought short-term treasury bonds in the second half
of 2008, it can still be concluded that China’s foreign
exchange reserves are heavily allocated in US dollar-denominated assets, especially US treasury and agency bonds.
Following the subprime crisis, the US government has applied very loose fiscal
and monetary policies. Paulson’s US$700 billion TARP programme,
Obama’s US$789 billion stimulus package and Geithner’s
US$2 trillion financial stability plan will together create a
record-high fiscal deficit, which should reach an estimated US$1.75
trillion in 2009, over 12% of the US GDP. The Fed has cut the
benchmark rate from 5.25% to 0-0.25% and has been pumping money and
credit into the economy through various types of innovative
mechanisms. From the bankruptcy of Lehman Brothers in mid-September
2008 to the end of the year the Fed’s balance sheet has grown from US$950 billion to US$2.27 trillion.
To finance the rescue package, the US government has only two choices.
The first is to issue more treasury bonds, at least US$2 trillion in
2009. If the demand for US treasury bonds is unable to keep pace with
the supply, their market value will decrease. As the largest holder
of US treasury bonds, the PBoC will therefore suffer a significant
loss. The second choice is that, if other investors are unwilling to
continue to buy US treasury bonds, the Fed will become the buyer of
last resort, meaning that the US government will take up the printing
of bills. Unavoidably, the inflation rate will surge and the US
dollar will depreciate against other major currencies. Therefore, the
international purchasing power of China’s portfolio of US dollar-denominated assets will shrink markedly.
The Impact on China’s Structural Adjustments
An indirect but critical effect of the global financial crisis on the
Chinese economy is that, to mitigate the impact on the domestic
economy and to stimulate short-term economic growth, the Chinese
government might postpone or even cancel some of its structural
adjustment policies. However, these structural adjustments are
absolutely necessary for the sustainable growth of the Chinese economy.
One example is that, to stimulate short-term economic growth, the Chinese
government might resort to reviving real estate investment, which
means that it might give up trying to burst the property price
bubble. Obviously, from the third quarter of 2008, both central and
provincial governments have loosened the controls on property sector.
The percentage of down payments and the interest on loans to buy a
second home have been reduced. The criteria by which commercial banks
grant loans to developers have been lowered. Property developers can
again obtain easy financing, reducing the possibility for them to
drive down property prices. Considering that there are still obvious
bubbles in the property markets of many coastal cities, to loosen
controls means that the Chinese government will postpone the
necessary adjustment in property prices. However, bubbles always
burst at some point. The longer the adjustment is postponed, the
greater the final impact of the collapse will be. The Chinese
government should take note from the Japanese experience in the late 1980s.
The misalignment of the RMB’s exchange rate has been one of the
major factors to have caused the Chinese economy’s external and
internal imbalances. To solve this problem, the Chinese government
started to reform the RMB’s exchange rate mechanism in July 2005. Its de
facto pegging to the US dollar was replaced by managed floating with
reference to a basket of currencies, and the pace of the RMB’s
appreciation against the dollar accelerated from July 2005 to the
first half of 2008. However, after the aggravation and spreading of
the global financial crisis, China’s exports declined
significantly. To sustain the relative competitiveness of China’s
export goods, the PBoC increased its intervention in the foreign
exchange market to prevent the further appreciation of the RMB from
the third quarter of 2008. In an environment of declining external
demand and increasing trade protectionism, it is doubtful that
managing the RMB’s exchange rate will help stimulate China’s
exports. To make things worse, the bank’s heavy intervention in
the foreign exchange market will sustain or even aggravate the country’s external and internal imbalances.
The Chinese Government’s Reaction to the Global Crisis
Following the bankruptcy of Lehman Brothers, the Chinese government changed its
policy emphasis from curbing inflation to ensuring stable economic
growth. The macroeconomic policy combination includes an active
fiscal policy, a loose monetary policy and a stable exchange rate
policy. In terms of fiscal policy, a RMB4 trillion (US$588 billion)
investment plan was released in November 2008, one of the largest
fiscal rescue packages world-wide. As for monetary policy, the RMB’s
deposit and loan interest rates have been cut from 4.14% and 7.47% to
2.25% and 5.31% respectively. The required reserve ratio has declined
from 17.5% to 13.5%. The credit quota applied by the central bank on
commercial banks was cancelled in the fourth quarter of 2008. Bank
loans increased by RMB1.62 trillion in January 2009, one third of the
increment recorded in 2008. As for its exchange rate policy, the PBoC
has increased its intervention in the foreign exchange market since
the third quarter of 2008, halting the appreciation of the RMB against the US dollar.
We do not doubt the Chinese government’s capacity to stimulate
short-term economic growth. Over 80% of the RMB4 trillion investment
package was allocated to infrastructure and property investments, and
the effect should gradually unfold in the second half of 2009 and in
2010. The surge in bank loans in the fourth quarter of 2008 and the
first quarter of 2009 will further facilitate these investments.
After a time lag of two to three quarters, the expansive
macroeconomic policies will push the economy to rebound. Hence, we
are relatively optimistic that China’s GDP growth might reach 8% in 2009.
However, the countermeasures the Chinese government has adopted so far might
not ensure sustainable economic growth and could entail some new
risks. First, China should transform its growth model from
export-driven to domestic demand-driven in order to sustain long-term
economic growth, which means that the government should try to
increase household consumption. However, the fiscal resources to
increase household income and provide social welfare are very
limited. Secondly, too many resources have been allocated to
infrastructure and property investments, and there is a potential
risk underlying them. As for infrastructure, there is already an
over-investment and excess capacity in certain fields, such as
motorways and hydroelectric power stations; in property investment
there are still obvious price bubbles in many coastal cities. A surge
in investments might aggravate resource misallocation and property
price bubbles. Third, the huge amount of banking loans granted from
the fourth quarter of 2008 to the first quarter of 2009 might trigger
a new surge in non-performing loans (NPLs) on the balance sheets of
China’s commercial banks, and NPLs will eventually become a
fiscal burden. Fourth, the PBoC has done little to diversify its
foreign exchange portfolio from US treasury bonds and agency bonds,
although these assets are becoming increasingly dangerous in the mid-term and long-term.
The Right Path: Speeding up Structural Adjustments
The global financial crisis is both a tough challenge and a precious
opportunity for China. Although the crisis is affecting China’s
exports, employment and foreign exchange reserves, it is also
generating external pressure for China to carry out structural
adjustments and providing a window of opportunity to expand overseas
investment. The Chinese government should fully utilise this
opportunity not only to sustain short-term economic growth but also to achieve long-term strategic objectives.
To stimulate short-term economic growth and to speed up structural
reforms, China should make increasing household consumption its top
priority. The most effective way to boost consumption is to increase
household income. Since the mid-1990s, the proportion of household
income in national income has been declining, while the proportion of
government and corporate income in national income has been rising.
This is the root cause of China’s low consumption. Therefore,
the idea is to increase the proportion of household income in
national income. On the one hand, the Chinese government should cut
personal income tax. On the other hand, it should urge state-owned
enterprises to disburse dividends to its major share-holder, central
or provincial government, in order to then increase unilateral
transfers from government to households. Moreover, the Chinese
government should employ more fiscal resources to provide social
welfare, such as education, heath care and social safety nets, which
could significantly reduce the uncertainties in household expectations about future income and expenditure.
To mitigate the pressure of unemployment, the Chinese government should
not over-rely on maintaining export growth, because declining
external demand and soaring protectionist pressures will weaken any
measure by which exports are stimulated. Alternatively, China should
promote employment by opening up and developing the service sector.
The latter is labour intensive, just like the export sector.
Therefore, the service sector has a great potential to absorb
unskilled workers released from the export sector. To boost
investments in the service sector, the Chinese government should
first break up the monopolies of state-owned enterprises in such
fields as finance, education, medical care, telecommunication and
transport and open these activities to private capital. Secondly, the
Chinese government should increase the flexibility of the RMB’s
exchange rate mechanism, because an undervalued real exchange rate
will tend to exacerbate the resource misallocation between the
tradable and non-tradable sectors, ie, too many resources will flow into the tradable sector.
The Chinese government should speed up the diversification of its foreign
exchange reserves exploiting the window of opportunity thrown open by
the global financial crisis. First, the PBoC should stop buying US
treasury bonds unconditionally. The Chinese government needs the US
government to provide some sort of guarantee on the market value of
US treasury bonds. For instance, the PBoC should henceforth only buy
TIPs. Another example is that the Chinese government could require
the US to issue convertible treasury bonds, giving creditors an
option to transfer the bonds into shares of US commercial banks held
by the US government, with the strike price not being much above the
price the US government paid to previously purchase the shares.
Secondly, a large proportion of China’s foreign exchange
reserves should be invested in the energy and commodity markets and
the global stock markets, because their valuations are far more
reasonable now than hitherto. Especially, investing in the energy and
commodity markets now will help the Chinese economy to hedge the risk
of price hikes in the future. Third, China should adopt some
innovative financing mechanisms to combine providing assistance with
the RMB’s internationalisation. For example, China could agree
with foreign countries to issue RMB-denominated treasury bonds
(‘Panda Bonds’) on the Chinese domestic market, with
foreign countries then using the RMB to purchase US dollars from the
PBoC. The proposed ‘Panda Bonds’ can not only provide
foreign countries with necessary funding but also strengthen the
status of the RMB as an international currency. Moreover, they could
provide new incentives for China to develop a RMB forward exchange-rate market.
Deputy Director of the International Finance Division, Institute of World
Economics and Politics, Chinese Academy of Social Science, Beijing