China Research

Presentation by Hubert Fromlet, Linnaeus University, at LNU’s annual conference “Baltic Sea Region and China Day” in Kalmar on
October 19, 2015

Summary

I wrote already in my latest, spontaneous blog that I really appreciate the choice of Angus Deaton as this year’s winner of the Nobel Prize in Economics. I had him on my list of probable winners several years in a row, also in 2014. But since I had no opportunity to update this list of candidates in the last few weeks, I wanted at least to present my list of six preferred research areas. Among these preferred research areas were development economics/poverty and consumption/savings – very much aiming at the important research by Angus Deaton. In private, I found that it should be his turn – now in 2015.

Deaton made it finally. This choice is a good answer to discussants who do not regard economics as sufficiently scientific. Of course, it seemed to be difficult at certain occasions in the past to single out the benefits for humanity that were expected by certain observers to come from the research of the winners of the “Riksbank’s Prize in Economic Sciences in Memory of Alfred Nobel”. This time, this benefit analysis seems to be much easier or at least more obvious.

Let’s look – for exemplification – at China for some moments. Since 2012/2013, we know that China wants to create a new economic growth model by giving (private) consumption considerably more space as a driving force for economic growth than so far. Currently – if we trust Chinese GDP statistics for a moment – consumption stands for about 40 percent of GDP. This is considerably lower than in other comparable emerging economies. The Chinese have until now – as far as I know – not mentioned an objective for the future percentage share of consumption. Up to 50 percent in one decade or so may sound realistic.

The future application of a number of results and recommendations from Deaton’s research may make the difficult Chinese transit road to more consumption (somewhat) less bumpy. The Chinese may, for example – with Deaton’s research and conclusions as a starting point – look at

# the need of using best possible statistics and of improving statistical quality (urgent),

# the need of measuring certain statistics more correctly and – often – more frequently (urgent),

# the importance of household surveys as such and their quality (urgent to start up),

# methods to manage repeated individual data surveys for time series,

# systematic classification of income groups via micro data
=> from micro to macro (urgent),

# patterns of consumption between different income groups, from poor to wealthy people,

# reactions of the urban and rural population on policy/income changes
=> from micro to macro,

# classification of consumption choices, composition of consumption goods
=> from micro to macro,

# distribution between consumption and its natural counterpart – household savings,

# the link from individual consumption behavior to macro aggregate numbers and conclusions,

# welfare measurements for(mainly) poverty

To summarize: China can learn from Deaton’s research. The importance of Deaton’s research can be mainly explained by his ambition to use good statistical standards and to create working links from individual (micro) data to macro (aggregate) levels. (Repeated) surveys serve as an important instrument. Deaton deals with the economy of households. But I believe that parts of his research methods also could be applied to the corporate sector. The link between micro and macro is an approach that we also use in parts of our university’s emerging market research – but also the other way around, i.e. the link from macro to micro when helpful.

The more China will be learning about its different consumption patterns, the better the chances of (partial) success in China’s new growth policy. Such a development would be good for companies dealing with consumption goods and services in China – and for the Chinese nation as well.

 

Hubert Fromlet
Senior Professor of International Economics, Linnaeus University
Editorial board

 

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Here we go again. China’s GDP-growth has been published for the third quarter only 19 days after the end of September. This is an incredible effort for a country when regarding the enormous size of the Chinese economy (no 2 in the world measured in Purchasing Power Parity, PPP). By the way, the first preliminary results for the corresponding GDP growth rate in the U.S. will be published on October 29.

GDP-growth in China for q3 came in at 6.9 % compared to the same quarter last year. This was exactly what I expected in previous blogs , i.e. 7% plus/minus 0.1. But is this a number we can believe in?

Some weeks ago, the National Bureau of Statistics in Beijing announced that major improvements of Chinese GDP statistics should be started in the calculations for this year’s third quarter. So far, quarterly GDP measurements were derived from cumulated numbers (for example, q1-3 minus q1-2 to come to the third quarter). According to Chinese official statements, this simple method should be replaced by measuring “the economic activity of each quarter”. However, when analyzing the official summary for the third quarter, I still cannot recognize any major change.

Furthermore: What are “scientific growth stimuli” as quoted below? And suddenly supply side economics gives “measurable “GDP-stimulating results? Probably, more time will be needed to single out the real start, content and potential progress of the announced statistical reform.

Sure, the intention is good. But what does this mean to the trustworthiness of Chinese GDP statistics? I still have my doubts. The current – nominally still quite good number for GDP growth in the third quarter – could be achieved according to the NBS by “adopted scientific measures to stabilize economic growth, promote reforms, enhance restructuring, benefit people and control country risks, implemented effective range-based, targeted and discretionary macro regulation, further deepened reform and opening up, encouraged mass entrepreneurship and innovation and increased supply of public goods and services. ..” Somewhat contradictory are the statements that “China was facing (add: in the third quarter) increasing downward pressure of the domestic economic development “ and that “the world economy was weaker than expected” – and stable GDP growth was achieved all the same.

Consequently, China will meet its GDP-growth target of 7% for the whole of 2015 despite the mentioned problems. Who can believe in the 6.9-percent number of today which has been achieved without mentionable carry-over effects?

However, I would be very glad if these doubts gradually could be evaporated. Such a development would be good for China itself – but also for global markets of each kind, Swedish companies and investors in China included. Visible statistical improvements would fit well for a giant country and major global player like China on its way to become the largest economy in the world, as I have been pointing at before in quite a number of papers and articles.

 

Hubert Fromlet
Senior Professor of International Economics, Linnaeus University
Editorial board

 

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Chinese economic policy certainly has ideological and political power-conserving characteristics. However, more profound studies of Chinese economic policy also lead to the conclusion that important results from Western economic research more lately have been well integrated in quite a number of Chinese economic strategies and objectives. Evidence can, for example, be found, in the important reform package from the Central Committee’s Third Plenum in November 2013. Many of its 60 objectives and suggested policy changes seem to be well-anchored in economic research we are used to, dealing with the market economy, institutions, endogenous growth, the supply side, human capital, entrepreneurship, competition, etc.

“Impossible trinity”

Recently, another practical application from economic research was striking me. I am talking about China’s willingness to go more visibly for market-oriented exchange rates. We still have to see to what extent this new policy orientation will come true in reality. But the approach as such is interesting. It points at a phenomenon which is called “impossible trinity” by Western academic researchers.

Without getting too theoretical, one may say that research and experience have proved – look, for instance, at the Asian crisis from 1997/98 – that a central bank cannot meet the following three targets or conditions at the same time, instead just two of them:

• inflation target (or sovereign monetary policy)
• exchange rate target and
• free cross-border capital flows.

Formally, China has nowadays neither an inflation target nor free cross-border capital movements but is about to loosen its still existing kind of exchange rate target (vis-à-vis the U.S.dollar). Altogether, the phenomenon of “impossible trinity” cannot really be observed in the China of today. But what about the China of tomorrow? In a longer perspective, things may look like quite different.

I believe that China would like to be recognized as a country that can afford freely moving financial flows over its geographical borders (though it could take time to get there). Being considered – as it is currently the case – as a country with an underdeveloped financial sector is certainly not in line with all the positive visions and strategies Chinese political leaders have for the real economy. Without a modernized domestic banking system and a widely deregulated capital balance with mostly free cross-border money flows, China will be lagging considerably in international rankings. In other words: China really will make serious attempts in the next decade or so to achieve a system with more or less open financial borders. Whether this high ambition can really be verified or not, is quite a different question. But we know that preparation time for such an important move could be – and should be – quite long.

Inflation or exchange rate targeting

There is good reason to believe that China is working for an inflation target in the medium or longer term which induces – in general terms – an independent monetary policy. It is a well-known but uncomfortable fact for Chinese political leaders that their country particularly in the past decade has been affected by an increasingly unfavorable distribution of income. In times of very high GDP growth, such a development could be tolerated since the whole population was enjoying better economic conditions all the time – though urban residents were generally spoken clearly in the lead, very much supported by the booming housing sector. But relatively high inflation is really counteracting a fairer distribution of income. (I refrain here from applying the current, rather deflationary tendencies).

Today, however, we can predict that future Chinese economic growth will be more dampened. Thus, it will become more important to combat uneven income distribution. This objective can be supported substantially by an officially targeted, relatively low inflation rate. I would guess that China is working in such a direction.

Exchange rate targeting, however, would make these considerations and changes more or less impossible. Sovereign monetary policy cannot be conducted at the same time as a country prefers exchange rate targeting. But why should China in the medium- or long-term future choose exchange rate targeting at the expense of inflation targeting? Sure, certain future economic reforms will succeed – but other reforms and developments will fail and put pressure on the currency. Flexible exchange rates can usually tackle policy failures or losses of competitiveness more effectively than fixed exchange rates. Global markets can – hopefully – react more smoothly. Transparency tends to improve over time in a system with flexible exchange rates. Liberalized capital flows simply urge for more reliable information from China.

In this case, foreign and domestic Chinese investors will increase their pressure on Chinese political leaders and institutions for improvements of communication. In the longer run, we will probably know more exact details about real GDP growth, unemployment, bad loans of the banks, (local) government debt, etc. Disappointing statistical numbers will at certain points lead to challenges for the Chinese exchange rate.

In other words: China wants most probably to move (slowly) to a (managed) floating currency in order to meet possible occasional major moves or distortions of its exchange rate more flexibly than would be possible with fixed exchange rates – in line with conclusions from the “impossible trinity” which also includes strongly or completely abandoned cross-border capital controls.

Thinkable way forward

Scenarios for Chinese exchange rate policy may develop as follows when considering the “impossible trinity”.

Existing today:

# Inflation targeting? Yes, partly (not officially)

# Exchange rate targeting? Yes, recently somewhat loosened

# Cross-border capital control? Yes

=> no major conflict with “impossible trinity” (two conditions met at the same time)

In a couple of years:

Inflation targeting? Yes, more visibly

Exchange rate targeting? Yes, but decreasing

Capital cross-border control? Yes, but decreasing

=> still no major conflict with “impossible trinity” (but all three conditions more or less partly met)

In the longer run, 5-10 years from now:

Inflation targeting? Yes

Exchange rate targeting? No, or relatively limited

Capital cross-border control? No, or relatively limited.

=> no major conflict with “impossible trinity” if above-mentioned preconditions in place (should be a policy priority!);
improved conditions for “impossible trinity” – but not quite “clean”.

Result

According to the above-mentioned scenario, China will be most probably aiming at gradually meeting the characteristics and the conclusions from the “impossible trinity”- in a decade or so – more clearly than it seems to be the case today. The recent change of China’s exchange rate policy can possibly be regarded as an important step in the right policy direction. Today, however, we have no evidence that this recent change of exchange rate policy will be sustainable in the longer run. Hopefully, this will be the case – despite the fact that the appropriate velocity for certain structural financial policy changes (capital balance!)really can be discussed.

As the first alternative, I would plead for gradual and cautious changes when focusing on a future, workable “impossible trinity” – but without leaving the right, steadily reforming direction. This includes the two objectives inflation targeting and free cross-border capital moves and, consequently, the abolition of exchange rate targeting.

The second alternative – going for exchange rate targeting and free international capital from and to China – would take away the opportunity of an independent monetary policy. A terrible option!

The third alternative – maintaining capital controls and applying both an inflation target and an exchange rate target – would certainly not fit with a modern China.

 

Hubert Fromlet
Senior Professor of International Economics, Linnaeus University
Editorial board

 

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