Prepare for Chinese economic change

Unstable, unbalanced, uncoordinated and unsustainable: the words used by China's own premier about the state of his economy. But this is all about to change - so what can investors expect?

Those were not my words at least not when I heard them firsthand in Beijing, last Friday, 15 March. In uncharacteristically blunt language, China's Premier, Wen Jiabao, used the occasion of his annual press conference following the conclusion of the National People's Congress to send a very clear message about the state of the Chinese economy. He explicitly characterized macro conditions as "unstable, unbalanced, uncoordinated, and unsustainable." I have never known a senior policy maker or political leader anywhere to leave it like that without rising to meet his own self-imposed challenge. Premier Wen has put his reputation firmly on the line. China, in my view, now has no choice but to continue tightening as it attempts to bring its rapidly growing and unbalanced economy under control.

China's changing economy: monetary tightening

The ink was barely dry on the Premier's observations when China's central bank followed the next day with a rare Saturday announcement of an immediate monetary tightening the third interest rate hike in 11 months, which reinforces five increases in bank reserve ratios implemented over the past nine months. The latest 27 basis point hike in the policy lending rate came only a day after Zhou Xiaochuan, Governor of the People's Bank of China, sent a crystal-clear warning, "(F)rom a macro perspective, after serious study, we decided to place further controls." In central banking circles, it doesn't get any more direct than that. Suddenly, China's once opaque policy authorities are amazingly transparent owning up to the seriousness of their macro control problems and setting in motion what I believe will ultimately be a much more determined shift to policy restraint than has been evident in a long time.

To some extent, this shift has been data driven. While China's January-February statistics are always hard to read because of Lunar New Year's distortions, there can be no mistaking the reacceleration of economic and financial activity in early 2007. Over the first two months of this year, export growth surged to 41.5% y-o-y a dramatic acceleration from the still rapid 27% pace of 2006. Similarly, average growth in fixed asset investment came in at 23% in January February 2007 little changed from the 24% pace of 2006 and far from the long-sought slowdown of this overheated sector that now makes up over 45% of Chinese GDP.

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At the same time, industrial output growth reaccelerated to 18.5% in the first two months of this year reversing the deceleration to sub-15% readings in late 2006 and close to the peak comparison of 19.5% evident last June. Moreover, despite a seemingly determined monetary tightening campaign, bank lending growth reaccelerated to nearly 17% over the January-February period well above the 13% pace in 2006; RMB loans in February, alone, were nearly three times those extended in the same month a year ago. Finally, on the heels of the spike in export growth, the trade surplus ballooned to nearly $24 billion in February fully nine times levels hit a year earlier; that signals what most senior Beijing officials believe to be a very rapid accumulation of foreign exchange reserves in early 2007, which only further complicates China's already daunting liquidity management challenge.

China's changing economy: major challenges to rebalancing

In short, the data flow in early 2007 depicts a Chinese economy that is once again defying the efforts of a three-year tightening campaign. With the exception of a few soft months over the past three years, a white-hot Chinese economy has largely been unresponsive to the current off-and-on tightening efforts that were first initiated in the spring of 2004. Beijing has talked tough on the macro control front, but this talk has not achieved satisfactory results. Persistent excess liquidity, in conjunction with a still highly fragmented banking system and an investment decision-making process that is driven mainly by provincial and local considerations, have undermined policy traction.

As Premier Wen Jiabao indicated at the conclusion of the National People's Congress on 15 March, this is a major challenge to the Chinese leadership. He left little doubt as to his intent by adding this is "not the time for complacency with respect to the economy." Quite simply, the Chinese leadership cannot afford to let the world's fourth largest economy lapse back into the boom-bust pattern of yesteryear. In my view, Beijing seems quite focused on delivering on the macro control front in 2007.

These concerns were very much the focus of the just-completed China Development Forum an annual gathering in Beijing that follows immediately on the heels of the National People's Congress and provides official China with an opportunity to clarify and expand its message. I have been privileged to attend all but one of these Forums since its inception in 2000 and find it to be invaluable in getting a read on the Beijing agenda. This year's theme said it all "China: Towards New Models of Economic Growth." It is a clear recognition by the State Council China's cabinet and whose Development Research Center is the official sponsor of the event that the Chinese economy is at a critical juncture.

China's changing economy: a new Model China

The Old Model dominated by a recycling of massive domestic saving into an equally massive investment boom that then supports an all-powerful export machine has outlived its usefulness. Official China not only concedes the twin perils of excess capacity and a protectionist backlash to open-ended exports but also worries increasingly about the negative externalities of the current model namely widening income disparities, excess resource consumption, and environmental degradation.

The Beijing Consensus is clear on the broad outlines of the New Model. As underscored by the 11th Five-Year Plan enacted a year ago, the goal is a more balanced economy that draws increasing support from private consumption and a more rational market-based allocation of saving and investment. The emphasis on the shift from the quantity to the quality of the growth experience permeated the discussions at this year's China Development Forum. Resource conservation and environmental concerns were at the top of the agenda as defining characteristics of the coming regime change.

Major disappointment was expressed by senior Chinese officials over the failure to hit the energy conservation and emission-reduction targets that were announced with great fanfare a year ago. This was ascribed to what the Chinese leadership now refers to as "structural pollution" the environmental degradation that is a painfully natural outgrowth of the structural disequilibrium of the old manufacturing-intensive growth model (see my 9 March dispatch, "Two Birds with One Stone," which reaches a similar conclusion). The debate was not over the endgame of the shift from the Old to the New model, but on the tactics required to manage this daunting but increasingly urgent transition. There was broad agreement that there has been too much talk and not enough action in recent years in the areas of macro management and rebalancing. As one senior official put it to me, "2007 must be a year of action the stakes are too high to do anything else."

China's changing economy: measures to be introduced

The give and take with senior Chinese policy makers is always the highlight of the China Development Forum. Minister Ma Kai, Chairman of the National Development and Reform Commission (NDRC) and the nation's leading macro manager, acknowledged in response to a question that I raised that Premier Wen has "increased our awareness of China's problems." While he hinted at more administrative measure to come underscoring likely increases in the area of land control and higher project-approval hurdle rates with respect to environmental impacts and energy consumption he did not pound the table in favor of restraint. His confident, but generally relaxed, demeanor over the state of the Chinese economy stood in sharp contrast with the far more determined tone expressed by China's Premier. I suspect Minister Ma is about to change his tune. To the extent Chinese authorities are likely to up the ante on tightening, and to the extent that monetary policy traction remains very much in doubt, the burden of restraint should fall increasingly on the central planners at the NDRC.

This conclusion became all the more evident at the closing session of the China Development Forum the annual audience with the Premier. I have watched Wen Jiabao grow into his job over the past four years. Today, he speaks with much greater conviction and confidence than he did several years ago in framing the China macro debate. It's not just the way he states the problems but it is also a new sense of command over the challenge and solutions. He welcomed the opportunity to elaborate on his worried characterization of the state of the Chinese economy.

China's changing economy: the 'four uns'

By unstable, he was referring to overheated investment, excess liquidity, and a sharply widening current-account surplus. By unbalanced, he was voicing concerns over urban-rural and east-west disparities. By uncoordinated, he was drawing attention to the regional fragmentation of the macro economy, to the sharp contrasts between excess manufacturing and an undeveloped services sector, and to the disparities between excess investment and deficient consumption. And by unsustainable, he was highlighting the twin perils of environmental degradation and excess resource absorption, as well as persistent tensions in the income distribution.

Collectively the "four uns" as they became known in our discussions this week in Beijing made a compelling case for the growth-model change that was the theme of this year's China Development Forum. As Columbia Professor and Nobel Laureate Joseph Stiglitz put it in our discussions, "China always adopts new models at key transition points in its development journey. This is one of those times."

China's changing economy: time is short

As I sit back and reflect over the message from this year's Forum and try to benchmark the discussions to those I have heard in each of the previous six years, I am struck by one major shift that there is greater determination than ever to get on with the transition to the new model. There is a new and important sense that time is growing short. Official China's frank admission of failure in hitting its energy conservation and environmental remediation objectives in 2006 only underscores the sense of urgency. So does the renewed spurt of rapid growth in early 2007. Premier Wen left no mistake of the significance of this new focus. He went out of his way to stress, "This is a strategic shift for China." It doesn't get much clearer than that.

For those of us in the West, this is a strong signal we need to update our perceptions of China. Think less of open-ended unbalanced growth and more of a somewhat slower and better balanced expansion. Think less of an industrial-production dominated model with destabilizing implications for natural resource consumption and the environment. Think more of a shift to consumption and "greener" growth. Think also of macro stabilization policies not just those of central bank but especially those of the central planners at the NDRC that will be used increasingly to up the ante on the tightening required to achieve these objectives.

But don't think for a moment that China will back down on the reforms that have driven nearly three decades of its extraordinary transformation. Time and again, China has used the reform process to spark key transitions in its development journey. I suspect a similar transition is now at hand. In the end, Premier Wen Jiabao said it all as he brought the 2007 China Development Forum to a close, "Our plan is in place. What is needed is action." And I suspect that is exactly what will happen over the course of this year.

By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley's Global Economic Forum