stephen roach - "the china disconnect"

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    Global: The China Disconnect

    Stephen Roach (New York)

    The world remains in the grips of a China mania. Although it still accounts for only about 4% of world GDP, China continues to be viewed as something close to a savior for an otherwise growth-starved world. It’s all about China’s “delta” -- visions of an open-ended 8-9% growth trajectory that enthralls western industrialists, investors, and policy makers alike. Meanwhile, the Chinese leadership is treading far more cautiously as it takes its slowdown campaign into a second year. This underscores an important disconnect: Just when the world seems to be counting on China the most, there is a growing risk the Chinese economy goes the other way.

    This disconnect shows up most clearly in the contrast between recent trends in global commodity markets and incoming data on the Chinese economy. Commodity prices rose sharply in February and early March, hitting 24-year highs for the broad composite gauges and 7-year highs for the industrials subsets. No economy has had a more significant impact in driving commodity demand in recent years than China. Our estimates suggest that China accounted for about 20% of total world consumption of aluminum in 2004, 30-35% of global demand for steel, iron, and coal, and close to 45% of worldwide purchases of cement. It’s not just the rapid growth rate of the economy at work. It is also the unique strain of a Chinese growth dynamic that is driven by industrialization, infrastructure, and urbanization -- all activities with intrinsically high commodity content. For that reason, alone, there has been an increasingly tight connection in recent years between the ups and downs of industrial commodity prices and fluctuations in Chinese industrial output.

    Largely for that reason, it is tempting to conclude that the latest surge in commodity prices is pointing to a sharp reacceleration in the Chinese economy. Such an outcome could spell heightened risk on the global inflation front -- a possibility that has already unnerved global bond markets. However, China’s incoming data flow cautions against that conclusion. While the Lunar New Year holiday always makes the Chinese economic statistics for January and February tough to read, the early numbers have surprised to the downside. That’s true of the January data on industrial production -- an 8.9% y-o-y gain as re-stated on a daily average basis to filter out the holiday-related impacts. (Note: China’s industrial output report for February is due out this week). That’s also true of the Chinese import dynamic, where the cumulative gains in January and February averaged only 8.3% -- a dramatic slowing from the 36% increase for all of 2004. The shortfall of import growth -- if, in fact, it is a reliable reading -- underscores the important possibility of a slowing in Chinese internal demand. A modest slowing in Chinese retail sales in January and February -- a 13.6% average gain versus 14.5% in December 2004 -- is a hint of just such a possibility.

    Apart from the data flow, there’s an even more critical reason to doubt the accelerating China growth story: The government is leaning the other way, and in this command-and-control economy, often times that is all you need to know. In his so-called “work report” to the National People’s Congress on March 5, Premier Wen Jiabao underscored the imperatives of staying with the slowdown policy gambit -- going even further than he did a year ago when he first broached this theme. Growth targets for fixed asset investment -- China’s most overheated sector -- were slashed to 16% in 2005; that’s well below the 26% gains of 2004 and less than half the 43% increase in 2003. The Premier also made special note of the perils of the Shanghai property bubble, a warning that was immediately followed by the imposition of a 5% capital gains tax on selected Shanghai property transactions. For those who have concluded that the Chinese economy has landed, think again -- the Beijing leadership is telling us that there is more to come on the growth deceleration front.

    If the Chinese economy is already slowing and the government wants it slow further, then what’s going on in commodity markets? Two possibilities come to mind -- the first being a resurgence of non-Chinese global growth. Unexpected weakness in Japan and Germany -- the second and third largest economies in the world -- argue against that possibility. Nor does America hold the answer. While the US economy has been firmer than expected in early 2005, it has not accelerated relative to the vigorous 4.4% GDP increase posted in 2004. Which takes us to the second possibility -- a speculative commodity play by financial investors. Morgan Stanley research suggests that the hedge fund community has not unwound the major long position it established in commodity markets in 2003 (see Hernando Cortina’s 8 March 2005 research note, “What Are Macro Hedge Funds Doing?”). Consequently, to the extent there has been a decoupling between commodity prices and Chinese industrial production growth -- and that there is no new candidate that fills the global growth void -- the role of financial speculation emerges as a prime suspect. If that conclusion is correct, a further slowing in Chinese industrial production growth -- consistent with both the fragmented data flow of early 2005 as well as the intent of the Chinese leadership -- could catch commodity speculators leaning the wrong way.

    The commodity story is only one facet of the Chinese growth saga. But like all stories in China, there is a real mystique about the role of economic growth. For the Chinese, growth considerations are actually secondary to two other over-arching objectives -- reform and stability. And in the end, if the leadership had to pick one of those two considerations, stability would win every time. Over the past 26 years, China’s power structure has taken great risk on the reform front -- a clear recognition of the failure of a state-owned economic model and a steadfast conviction that a “marketized” system is the only viable answer for sustained economic prosperity. Yet at every critical fork on the road to reform, decisions have always been evaluated in the context of their implications for stability -- stability in economic terms, social terms, and ultimately political terms. In his recent address to the National People’s Congress, Premier Wen underscored a key aspect of the stability issue -- economic pressures on the rural population. And on other recent occasions, the Chinese leadership has voiced similar concerns over issues of widening income disparities between coastal and western and China, as well as tensions arising from the “digital divide” between the IT literate and those lacking in this modern skillset. And, of course, the Chinese currency issue has long been viewed as central to considerations of financial stability.

    It’s at this point where the China disconnect comes into clear focus: The West looks at the Chinese growth story purely from a quantity perspective -- focusing on the magnitude of the aggregate growth rate. Yet for China, growth objectives are seen increasingly in quality terms. It’s a quality that pertains not only to considerations of income disparities but also to increased concerns about the safety net (i.e., pension and social security reform), infrastructure, health care and disease prevention, worker safety, and the environment. After several years of seemingly open-ended Chinese economic growth, the world is taking 8-9% growth for granted as the new Chinese norm. Yes, China does need rapid growth to absorb the 8-10 million workers that are displaced each year by state-owned enterprise reform. But for China, that growth must now be balanced and increasingly skewed toward a qualitative improvement in the overall standard of living.

    From China’s perspective, the stresses and strains of an overheated economy pose serious threats to stability. Last year, the Chinese economy was endangered by mounting bottlenecks and sharply rising prices of industrial materials. This year, the economy is being buffeted by sharply higher energy prices. In both cases, the materials requirements of excess growth were at odds with the overriding concerns of stability. And so the China slowdown remains very much on the minds of its leadership as it attempts to walk the fine line between its growth, reform, and stability objectives. Needless to say, the slowdown campaign has important implications for world financial markets. If China succeeds in slowing its economy, commodity prices would probably ease -- leading to a reduction in inflationary expectations in most major economies and a related easing of concerns in bond markets.

    The Chinese have more than their hands full in meeting a most formidable challenge. Apart from managing the growth of the real economy, there are new currency-related pressures building on its financial system: The risks of position losses on a massive overweight of dollar-denominated foreign exchange reserves are an increasingly worrisome consideration, as are the excesses of the credit cycle traceable to difficulties China is experiencing with its currency sterilization efforts. At the same time, China is walking an increasingly fine line on the trade tension front -- especially with respect to its bilateral relationship with the US. The risk is that American politicians and special interest groups up the ante on the “scapegoatting” of China as a means to vent their misplaced frustrations in coping with the inevitable perils of a saving-short US economy (see my 11 March dispatch, “The Stability Paradox”).

    All this underscores the key strategic tradeoffs that now confront China on the road to reform. Mounting tensions on the financial and trade fronts mean that China is less likely to take risks on the growth front. As a result, the tactics of growth management -- namely cooling down a still overheated Chinese economy -- should be viewed as an increasingly urgent objective in the current climate. That was the real message from Premier Wen, in my view -- a message that world financial markets are all but ignoring. For China, such a strategy, of course, is not without risk. If, in fact, the tightening measures go too far, the possibility of a growth accident cannot be ruled out. On the other hand, if tightening is relaxed, then China probably tumbles right back into the soup -- facing the twin risks of bottlenecks and rising inflation. It’s a tough choice and one that has to be managed with delicate care.

    In the end, nothing is more important to the Chinese leadership than stability. Yet for the West, all that seems to matter with respect to China is the extraordinary pace of its economic growth. There is an inherent contradiction between these two perspectives -- especially when the excesses of Chinese economic growth begin to bump up against its stability constraints. Yale sinologist Jonathan Spence has carefully documented this disconnect between the world’s view of China and China’s view of itself (see Spence’s, The Chan’s Great Continent: China in Western Minds, W.W. Norton and Company, 1998). He argues that it is nothing new -- in fact, he traces this bias back to Marco Polo’s 13th century accounts of his travels through China. His bottom line is that the West never seems to get China right -- that it almost always views China largely in the way it sees itself. More than 700 years later, and the same China disconnect is alive and well. The real risk today is that China and the West are operating at cross-purposes -- each contributing to the other’s tensions. The resolution of these tensions could well have important implications for world financial markets in 2005.



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