The Hindu Business Line : China's growth enigma

As is true currently, China's truly remarkable pace of growth for over two decades has been punctuated with concern about bouts of deflation or overheating. Macroeconomic management in China appears to have more to do with dealing with these cycles around a relatively high trend rate of growth, rather than with realising and/or sustaining that trend itself. C. P. Chandrasekhar and Jayati Ghosh examine this unusual nature of long-term growth trends in China.

ASSESSED in terms of growth performance as revealed by official Chinese statistics, the government of that country appears to have little to worry about. As Chart 1 shows, China has recorded an annual trend rate of GDP growth of 9.8 per cent during the quarter century ending 2003.

Though there has been a slight deceleration in growth between the 1980s and the period thereafter, the figures seem to tally with the Chinese perception that the potential rate of growth of that country is around 9 per cent, and that China has on average managed to realise that potential for more than two decades.

Needless to say, sectoral figures do point to some change in the nature of Chinese growth. In particular, there has been some noticeable deceleration of growth in the primary and tertiary sectors during the 1980-1990 and 1991-2003 periods. And breaking these periods down into shorter five-year spans (Chart 2) suggests that there has been a persistent and significant deceleration in primary sector GDP growth from the first half of the 1980s.

There appears to be a similar deceleration in tertiary sector GDP growth as well, though growth rates appear to have stabilised at relatively high levels over the last decade.

What is clear, however, is that crucial to the consistently good growth performance in China has been the growth of the secondary sector, within which industrial production has been the clear leader (Chart 3). What is more, the growth of that sector has substantially made up for the deceleration in growth elsewhere.

This structure of growth is of relevance because, despite the overall high trend rate of growth, discussions on the need to manage bouts of deflation or "overheating" recur periodically in Chinese economic discussions.

Thus, the Chinese economy is seen to have experienced a long period of deflation from 1997 to 2001, and recovered from that only in the second half of 2002 (Chart 4).

Yet, the annual rates of growth during 1998 and 2001 varied between 7.1 and 7.8 per cent in three of those years, and between 8 and 8.8 per cent in the other two — rates which would be considered creditable in other contexts.

Further, no sooner had growth recovered to touch 9.3 per cent in 2003 and 9.7 per cent in the first half of 2004, economists and the media started speaking of the dangers of "overheating" and the need to ensure a "soft landing".

One way in which this can be interpreted is to suggest that the perception is that the dynamics of the Chinese economy is such that it is constantly riding a Harrod-type knife-edge along its potential growth trajectory. Any tendency for the system to exceed or fall short of that rate of growth results either in an inflationary spiral or deflationary downturn, which needs to be corrected with strong state action.

The problem it appears is not one of raising the potential rate of growth of the system, but of preventing violent fluctuations of growth around that potential.

That being said, it is necessary to understand what the principal sources of growth are in the Chinese economy. Arithmetically, at any given level of the incremental capital-output ratio (ICOR), the rate of growth depends on the rate of investment or the ratio of investment to aggregate income.

So the proximate determinant of high average rates of growth must be the high investment rates. Available figures indicate that the ratio of fixed assets investment to GDP in China stood at 41.4 per cent in 2003 and 47.4 per cent in 2003.

There are two features of these numbers that need to be noted.

First, since these are only figures of the ratio of investment in fixed assets to GDP, the rate of saving in China must be even higher than these extraordinary levels. And given the high levels of fixed assets formation, it is not surprising that growth rates tend to be high.

Second, the figures suggest that fixed asset formation rates are extremely volatile, resulting in the fluctuations around the trend growth rates that are disconcerting to Chinese policymakers.

To explain this volatility, we need to examine the composition of fixed assets formation and the behaviour of individual components. As Chart 5 shows, as is to be expected, productive investment captured by the components "capital construction" and "innovation" account for a significant share of fixed assets formation. (Capital construction refers to the new construction projects or extension projects of enterprises, institutions or administrative units mainly for the purpose of expanding production capacity or improving project efficiency. Innovation refers, in general, to the technological improvement of original facilities, including renewal of fixed assets, by the enterprises and institutions.)

However, what is interesting is the high share of real-estate development in the total. This category includes the investment by real estate development companies, commercial building construction companies and other real estate development units of varied ownership, in the construction of residential buildings, factory buildings, warehouses, hotels, guesthouses, holiday villages, office buildings, and the complementary service facilities and land development projects, such as roads, water supply, water drainage, power supply, heating, telecommunications, land levelling and other projects of an infrastructural kind. It excludes simple land transactions. Thus, the item includes real estate development by central and local government bodies as well as investment in residential construction. The former includes investment by local government bodies in economic development zones and what have come to be referred to as "image projects" launched by local leaders to beef up their public stature. The latter includes a substantial amount of private residential construction that is under way, especially in urban China, in the wake of relaxation of laws governing residential property ownership.

It should be expected that the relaxation of residential property ownership rules must have resulted in the conversion of savings accumulated in the past into investment in residential property. This spurt, together with the high degree of volatility of local government development expenditures, has made real estate development the most volatile part of fixed assets formation. According to economist Yongding Yu of the Chinese Academy of Social Sciences: "During the early 1990s, the growth rate of investment in real estate varied between 11.7 and -1.2 per cent."

This kind of volatility is partly facilitated by the manner in which capital formation is financed in China. As Chart 6 makes clear, budgetary appropriations and foreign investment account for small shares of between 4.4 and 7 per cent of total fixed assets formation in 2002 and 2003.

The major finance comes from three sources all of which involve a substantial degree of borrowing. Domestic loans refer to loans of various forms borrowed by investing units from banks and non-bank financial institutions. "Raised" funds refer to extra-budgetary funds for investment in fixed assets received by investing units from central government ministries, local governments, enterprises and institutions. And "other funds" refers to funds for investment in fixed assets received from sources other than those listed above, including capital raised through issuing bonds by enterprises or financial institutions, funds raised from individuals, and funds transferred from other units. All of these involve some degree of direct or off-budget borrowing.

The importance of expenditures of this kind financed in this fashion becomes clear when we realise that the fiscal stimulus for growth in China is limited. Fiscal revenues in 2000 stood at just 15 per cent of GDP, and it is the growing desire of the Centre to control expenditures that is seeing an increase in that ratio to 20 per cent by 2004. But even of these expenditures a considerable share goes to current expenditures rather than capital formation. This is illustrated by the priorities for fiscal policy set by the government for 2004, which include expenditures that support the rural sector; education, health and science and technology; transfers to poor provinces; tax reforms; and wages and salary expenditures of government.

Hence, expenditures financed through other means account dominantly for the spurt in fixed assets formation. Clearly then it is the flexibility to acquire funds that enables different entities to undertake such investment expenditures that raises the investment income ratio and keeps growth going at high levels. And given the observed volatility of these expenditures it must be true that finances to undertake such expenditures are easily available "on demand".

Credit to finance such expenditures has indeed been easily available because the transition from a controlled to a more decentralised monetary system has implied a relatively lax monetary policy. This has resulted in a situation where local government functionaries, who influence appointment of banking and other functionaries at the local level are able to easily access funds for their projects. More recently, the decision to maintain a pegged exchange rate while liberalising capital flows into and out of the country, has forced the central bank to buy dollars by selling yuan (RMB) so as to pre-empt any appreciation of the currency. This has resulted in the accumulation of reserves in excess of $500 billion. The increase in the foreign exchange assets of the central bank this implies is not easily sterilised, since the government has almost exhausted its holding of government securities because of past sales aimed at sterilising capital flows that lead to reserve accumulation.

As a result, the high-powered money base of the central bank has expanded and the Chinese economy has been characterised by an easy money situation that makes available the funds that finance sometimes unwarranted capital construction projects.

This is of course not a problem inasmuch as it helps keep the Chinese economy growing at its estimated potential rate. The problem is that when growth is triggered with such expenditures, it propels further such expenditures and the resulting expansion soon runs into bottlenecks of various kinds, especially bottlenecks in the power, steel and other infrastructural areas. Inevitably, inflation ensues.

The problem confronting the Chinese Government is to deal with the inflation that results in such circumstances of "overheating". Since capital inflows are "autonomous", so long as the exchange rate is pegged, it is difficult to control money supply. What the government can try and do is engineer an increase in (administered) interest rates. But there is no evidence that the kind of investment expenditure being spoken of is interest rate sensitive.

Further, increases in interest rates could create a host of problems. In the first instance they can, just as a possible revaluation of the yuan, result in a spurt in capital inflows into the economy, worsening the exchange rate management problem. Second, they would adversely affect the viability of the already weakened state-owned enterprises, default by whom would worsen the non-performing assets problem of the banks.

All this results in a situation where the Chinese Government falls back on administrative measures, including the use of central "commands" and guidelines to hold back runaway rates of investment. The difficulty is that once such commands and guidelines are carried down to decision-makers at lower levels in what is still politically a centralised system, they remain in place till the government retracts these guidelines and works to ensure that the message reaches down to where it matters. In the meantime, a bout of deflation is a possibility. And if this occurs in a context of the kind created by the East Asian crisis, that adversely affected China's exports, such deflation can indeed be prolonged. "Stop-go" around a high trend seems to be an inevitable feature of the current conjuncture.

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