China: Distorted And Flexible

Includes: FXI, PGJ
by: Scott Sumner

Paul Krugman has become very bearish on China:

All economic data are best viewed as a peculiarly boring genre of science fiction, but Chinese data are even more fictional than most. Add a secretive government, a controlled press, and the sheer size of the country, and it's harder to figure out what's really happening in China than it is in any other major economy.

Yet the signs are now unmistakable: China is in big trouble. . . .

It's all very peculiar by our standards, but it worked for several decades. Now, however, China has hit the "Lewis point" — to put it crudely, it's running out of surplus peasants.

That should be a good thing. Wages are rising; finally, ordinary Chinese are starting to share in the fruits of growth. But it also means that the Chinese economy is suddenly faced with the need for drastic "rebalancing" — the jargon phrase of the moment. Investment is now running into sharply diminishing returns and is going to drop drastically no matter what the government does; consumer spending must rise dramatically to take its place. The question is whether this can happen fast enough to avoid a nasty slump.

And the answer, increasingly, seems to be no. The need for rebalancing has been obvious for years, but China just kept putting off the necessary changes, instead boosting the economy by keeping the currency undervalued and flooding it with cheap credit. (Since someone is going to raise this issue: no, this bears very little resemblance to the Federal Reserve's policies here.) These measures postponed the day of reckoning, but also ensured that this day would be even harder when it finally came. And now it has arrived.

Overall a reasonable article, but I have a few quibbles:

1. Despite saying the data is "unmistakable," Krugman actually presents no evidence at all that China is suddenly in trouble. Or perhaps one piece of evidence; Chinese wages are rising rapidly, indicating that the endless flow of surplus labor is coming to an end. But there's one problem with this fact—it's been true for many, many years. Indeed, Chinese wages have been rising at double-digit rates for several decades. China may suddenly be out of surplus labor, but Krugman presents no data to support this hypothesis.

2. The interior regions of China are much larger and much poorer than the coastal areas. Krugman presents no evidence that the Chinese growth model cannot keep plugging away in the interior regions for many more years.

3. I actually agree with Krugman that China is reaching a turning point, where it will have to begin shifting toward a more consumer-oriented economy. However, I have a hard time seeing how China is approaching a cliff. One of two things will happen. The new government might cut back on subsidies to SOEs and allow more foreign investment. That would be good. Or they might continue over-investing in certain sectors. That would be wasteful, but not a cliff.

Krugman seems to overlook the fact that the Chinese economy is flexible, despite being highly distorted. If they decide to stop building ships and start building 100,000,000 washing machines per year, there is no country on Earth that can do that switchover as fast as China. Indeed no other country even comes close. The flexibility of the Chinese economy is mind-boggling.

So what could go wrong?

1. Unstable monetary policy–i.e. unstable NGDP growth.

2. Even if monetary policy is sound, they might continue over-investing. That would be wasteful, and reduce living standards in China. But it probably would not lead to an economic cliff.

Chinese growth will slow, but I doubt it will hit a cliff.

PS. China can keep its currency "undervalued", i.e. it can keep running CA surpluses if it wishes to. That's a completely separate issue that has no bearing on the "cliff" argument. Indeed if it was running persistent CA deficits people would also be warning about a "cliff."

PPS. Beware of "pessimism bias" among intellectuals. Intellectuals who are down on the U.S. will tell you that the orgy of housing construction in 2004-06 was "consumption," not investment. When the same intellectuals are down on China, they'll insist that all the excess housing construction is "investment" not consumption. The only common thread is that intellectuals like to make things look bleak. The U.S. "consumes" too much and China "invests" too much. If that's your narrative, then just adjust the facts to make it true. (Not saying Krugman is guilty here, but plenty of intellectuals are.)

HT: Tyler Cowen