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A globalised renminbi can transform both China and London

[Reprinted with permission from the Financial Times 18 Oct 2013 (EnglishChinese)]

The Chinese will see how the lifting of controls is linked to economic success.

This week George Osborne announced steps to make London a global trading hub for China’s currency. If the internationalisation of the renminbi proceeds and the chancellor of the exchequer’s plan succeeds, London will – so it is hoped – again flourish as a leading financial centre. The nature of that flourishing could well differ from what we saw before 2008, but the prosperity will feel the same. Can it happen? Yes. Will it happen? That depends on a number of considerations. Will it be a good thing? Almost surely.

via http://upload.wikimedia.org/wikipedia/commons/2/25/City_of_London_at_night.jpg

City of London at night (via Wikimedia.org Commons)

Too often, when observers say renminbi internationalisation will never happen, what they mean is they cannot imagine the renminbi – with less than 3 per cent share of world official currency reserves – undermining the exorbitant privilege enjoyed by the US dollar as the world’s reserve currency.

But neither internationalisation of China’s currency nor London’s benefiting from it require that to happen. These are both relatively modest undertakings. They hinge on just one thing: the currency simply has to become a force in global currency markets.

True, this will require renminbi use in the financial markets to exceed single-digit shares. By how much? Well, to paraphrase singer Miley Cyrus, no one’s got that memo yet. But already the renminbi’s share is rising on pretty much all measures of world currency use. That is what matters.
To understand whether this will continue, we need to think about the risks and opportunities that arise from world markets accepting the renminbi more widely.

Even without full official convertibility, the currency is already significant. Full convertibility could occur overnight by fiat if the Chinese authorities thought the moment propitious.

Confidence and trust in China’s management of the renminbi are higher than in US management of the dollar or European Central Bank management of the euro. The supposed absence in China of market transparency, government flexibility and the rule of law have little bearing on acceptance of its currency. Only perceptions of risk and return matter – and government dysfunction in the US is doing everything possible to convince the world that dollar risk is significant.

China has a population about four times that of the US and an economy only half its size. It trades as much with the rest of the world as the US does. And the potential for continued economic growth remains strong. There are problems but also solutions. China invests more than many observers think reasonable but its western regions remain poorer than significant parts of Africa, and its capital stock and infrastructure per worker remain low. It no longer has a particularly young workforce – but its 340m elderly people quietly doing tai chi in the park will make for a more stable society than a similar number of young men with poor job prospects. Yes, there is a “middle-income trap” in the developing world, but all the countries that have found sensible ways to escape it had characteristics exactly like China has today.

Since 1980, the nation has steadily pulled the world’s economic centre from west of London to east of the Mediterranean. Through all this, the city’s position as a place worthy of confidence and trust, as an intellectual and cultural centre and a hub for learning and higher education, has remained constant. But, given the shift in global economic performance, it is an anomaly that the renminbi is not yet a significant force in world currency markets: the pressure for it to become one is strong.

Beijing knows it. It has warmed to the idea of making London a renminbi global trading hub. It has also established the Shanghai free-trade zone, where international finance is carried out under liberal global rules, which has the notable support of Premier Li Keqiang.

The Shanghai free-trade zone promises to do for China and global finance what the Shenzhen special economic zone did for China and the global manufacturing supply chain. The rest of the country will see how closely entwined are modern economic success and the lifting of controls on information flows, as well as currency flows – in Shanghai, in London. That will be significant, not just for London’s prosperity but also for pointing to how China itself will change.

[This was first published 18 October 2013 in the Financial Times (English, Chinese)].

Is China’s Economy Crashing?

Bearishness on China has gone viral. Two years ago talk was of China’s economy saving the world. Today observers have swung to the opposite extreme, one expressed elegantly by Paul Krugman as “the Chinese model is about to hit its Great Wall, and the only question now is just how bad the crash will be.”

The reasons for pessimism are legion. China’s economy has already seen its annual growth rate fall from 12% in 2010 to 7% in 2013. When the crash comes, it will not be a gradual downturn. It will be sudden. And it will stick around.

In this view China’s undoing rests on multiple missteps. China’s local governments and state-controlled banks have over-extended credit. The resulting debt-fuelled bubble in asset and real estate prices will surely burst, revealing large hidden non-performing loans.

China boosted its economic growth through “unlimited supplies of labour”. (This phrasing was Arthur Lewis’s evocative description of a developing country’s large reserves of low-wage labour.) But no country’s labour reserves are truly unlimited. So when an economy hits its “Lewis turning point”, when labour reserves fall sufficiently that wages start to rise, low wage-reliant economic growth will sputter.

Early on, China reduced risk of imminent mass famine and deep poverty by its one-child policy. This slowed population growth and permitted an economic surplus that could be saved and invested. But that policy has also resulted in a rapidly ageing population, so that economic growth is now threatened both from having so many old and unproductive, and from shedding the demographic dividend (where an economy enjoys a growth boost through having many young, energetic workers).

But not just in its one-child policy does China err for the long run through actions thought beneficial in the short term. China’s investment rate of 50% of GDP boosts economic growth short-term, but piles up excess capacity longer-term. China’s export prowess drives economic growth short-term but exposes China to greater risk from international downturns, longer-term.

Finally, these last three decades China’s command-and-control approach to allocating resources might have successfully guided economic growth. But, in the eyes of critics, that system has also ended up generating steep inequality in opportunity and outcome, so that now the threat of social instability is kept in check only through ever-higher economic growth churning out jobs for China’s people.

The case for a crash in China’s economy does not argue that what is now in progress is a gradual slowdown (in the sense of, say, poor but fast-growing economies slowing as they move towards parity with the rich economies). Instead, the phrasing says exactly what it intends, a crash is imminent. China will be caught and held, bumping up against the ceiling of a Middle Income Trap that it cannot escape.

How compelling is the evidence?

But is the evidential basis for a crash in China’s economy definitive? Banking and financial problems are intricate. Just as many observers found difficult to read, ahead of the 2008 Global Financial Crisis, related problems even in advanced economies, even more difficult it is to assess China’s true financial position. Nonetheless, the weight of evidence appears to support the pessimistic view, that an imminent crash is increasingly likely.

The case for China’s crash, however, is based not on finance alone, but on real-side considerations. On these latter fronts, evidence is mixed. China still has 100mn people living on less than US$1 a day, mostly in the relatively under-developed west. If China’s east coast manufacturing belt now sees rising wages and escalating costs, and pollution and congestion, China’s west in contrast remains massively under-developed. Averaging east and west, China’s per capita income today remains lower than that of nine countries in Africa. Since Beijing, Shanghai, and other parts of the east coast manufacturing belt have better than world middle-class incomes, it is simple arithmetic to deduce that wages in the west remain profoundly low, covering a workforce about as large as that in all of the US or the European Union.

To integrate China’s western workforce into the national or indeed the global economy does not require physically transplanting those workers into China’s east coast factories and urban cities. It suffices that the output that workforce produces can be easily sold elsewhere in China. For that, China’s transportation infrastructure needs to be improved and extended. China needs more government investment, not less. That investment needs to be in infrastructure public goods, an undertaking that private enterprise hardly ever does well.

In the US, the continental economy is joined together by an interstate highway system. This came about through hard-fought Federal and Presidential action, in a sequence of Federal-Aid Highway Acts from 1938 until as late as 1956. In that time many US lawmakers objected to these plans for their unproductively enlarging the role of the federal government. Only by the 1970s did the US, through extended deliberate government policy, come to have the adequate transportation network that it now enjoys. “The interstate system, and the Federal-State partnership that built it, changed the face of America.” China needs the same.

Today, China’s infrastructure remains dismally below that in high-income economies. Its road network is 60% the length of that in the US. Its public airports number 10% that in the US. Despite China’s greater reliance on and the US’s disinterest in rail as a means of transportation, China’s train network today has just 40% the length of the US’s. For all the worries about over-stretched, misdirected finance putting up apartment buildings that then remain empty, China’s residential property per capita today has floor area less than two-fifths that in the US. Inappropriate investment will always be harmful regardless where it occurs, whether in China or anywhere else in the world. But overall does China over-invest? Does China’s investment rate of 50% of GDP indicate, by itself, inappropriate investment resulting in excess capacity? No.

In its export-oriented growth trajectory, China follows many emerging economies that correctly reckoned their internal markets insufficient in size, and thus sought economies of scale by providing for the global marketplace. It might seem peculiar to call inadequate a domestic population in China that numbers over a billion. But marketsize is measured in purchasing power, not number of consumers. Empirical evidence shows it is in rich urban cities where China’s consumption grows most strongly: in Tier 1 cities, increases in consumption outpace even historical growth in national GDP. Therefore, making China a more integrated economy by reducing the inequality in development across east and west will automatically raise domestic demand overall and reduce China’s reliance on the vagaries of international markets.

Thus, it could be self-defeating to seek to force China to reduce its export orientation. This would turn China towards less dynamic sources of economic growth and make China poorer. That, in turn, would reduce domestic spending, making China then depend even more on exports subsequently.

But won’t China grow old before it gets rich? If the demographic dividend effect is indeed operative, then China’s economic growth will slow because of its ageing population. Moreover, Chinese society will need to set aside resources to provide for these unproductive old. But if the Chinese population becomes dominated by old people who will not work, then the economy will also need to generate fewer jobs. It is a strange thing to worry about old people being unproductive because they won’t work and, simultaneously, to fear that social instability will gush forth because an insufficient number of jobs is being created. There are certainly parts of the world that will have more young in the future than they do today, but which will be the more successful economy in 2030? One where 340 million old Chinese peacefully practise taiji in the park; or another where 100 million angry young Arab men take to the streets, unable to find gainful employment?

It would be useful, to assess the likelihood of China’s imminent crash, to have rigorous studies that evaluate all these considerations jointly, and in sufficient numerical detail so that the necessary tradeoffs can be explicitly weighed, one against the other. Absent such an investigation, however, looking at the empirical evidence as I have just done fails to convince that China’s economy must crash soon.

However, studies are available that measure increased statistical likelihood of a sudden permanent slowdown once developing economies reach a certain level of per capita GDP, regardless of the fine details in the structure of those economies. This “Middle Income Trap” might catch China.

World Bank, 2012: China and the Middle Income Trap

World Bank, 2012. China 2030: Building a Modern, Harmonious, and Creative High-Income Society

Among the most influential of such studies is that by The World Bank and the Development Research Center of China’s State Council, where a simple chart makes the key point: Who has been trapped at a Middle Income level, and who hasn’t?

In this chart each dot is an economy. Economies that have succeeded appear in the upper part of the picture; those that have failed, in the lower. In the chart the 45-degree line through the origin shows economies that by 2008 were only in the same position relative to the US as they had been in 1960. Thus, although those economies grew, they did so only at the same pace as the lead economy; they failed to improve from their initial position. Economies appearing below the 45-degree line did worse — they fell further behind even when starting out relatively poor. The World Bank report argues that if one divides up relative incomes, not unreasonably, into groups of low, middle, and high, then by 2008 only 13 economies had broken out of the Middle Income Trap. The remaining 88 were trapped.

Identifying the key common characteristics of the 13 successes will indicate whether China can evade the Middle Income Trap. In my view that lucky 13 fell into three categories:

  1. Five East Asian, Confucian tradition economies: Hong Kong China, Japan, Korea, Singapore, and Taiwan China;
  2. Four PIGS economies: Portugal, Ireland, Greece, and Spain;
  3. Four varied economies: Equatorial Guinea, Israel, Mauritius, Puerto Rico.

For policy-makers seeking to learn from the Middle Income Trap’s escapees, Group 2, the collection of PIGS economies, is almost surely not where one would go. Those economies had grown through unsustainable credit or debt expansion; they are hardly examples of economic success. Group 3 is varied: US economics and politics figure prominently for Israel and Puerto Rico, but not for the other two, both just small African states.

This leaves only Group 1. These five economies all share characteristics in common with China today. They are all East Asian with a strong Confucian tradition. They are all high-saving economies. They have all grown through export-oriented development, emphasizing manufacturing. None has comparative advantage in natural resources. They all see significant government intervention in their development process. None is what the West would consider a politically successful liberal democracy. They all, early on, leveraged China’s large, disciplined workforce through foreign direct investment, employment, and engagement with specific geographical parts of China. And, these last are, by definition, what China does.

(Hong Kong, Singapore, South Korea, and Taiwan are all of course much smaller than China. But the world has many more small economies than it does large.  Simply as a statistical proposition, for pretty much any criteria, one will typically find more small-ish economies than large ones.  Massive economies, moreover, have the advantage of economies of scale:  For economic growth China is likely, at the margin, to be even more successful than this already successful group of 5.)

Conclusion

The hypothesis that China’s economy will imminently come to a crash is a powerful, persuasively argued proposition. But empirical evidence fails to support that unanimity of vision. China’s economy might indeed crash. Then again, it might not. China’s economy has already surprised its many detractors for three decades. Will this time be different?

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