Zhang Yongsheng, Enterprise Research Institute of DRC

Research Report No.247, 2007

China's macroeconomic conditions are good on the whole. Nonetheless, there are some signs of an economic overheating. In October 2007, the consumer price index (CPI) rose by 6.5%, the industrial added value was 18.5% higher year-on-year, and the trade surplus reached a record high of US$27.05 billion, 13.5% higher than the same month in the previous year. In addition, the asset prices on stock market and real estate market have risen excessively fast, the problem of excess liquidity has become ever more prominent, the foreign exchange reserve has been very large and has repeatedly posted new record highs, and the RMB has faced a strong revaluation pressure from both the market and relevant foreign countries. All these problems plaguing the Chinese economy are very similar to the situation of the economic bubble of Japan in the 1980s. For this reason, many people fear the Chinese economy might suffer a similar scenario as Japan did. This kind of concern is reasonable. All the problems confronting the Chinese economy are closely related to China's balance of payments disequilibrium. Under such circumstances and with serious imbalance, China's export-driven high growth cannot sustain. To avoid a recession similar to Japan in the 1990s, China must fundamentally transform, as fast as possible and at the minimum cost, its imbalanced growth mode into a balanced one, and transform the investment-dependent growth mode into an efficient one. If China can successfully complete the two transformations, the quality of its economic growth will be significantly improved, and the whole economy can be kept on a good-and-fast track.

I. Root Causes of China's Macroeconomic Problems

The direct causes of China's macroeconomic problems are the internal and external imbalances. In order to encourage the development of an export-oriented economy, China has for long implemented a series of policies on exchange rate, foreign trade, tariff and export rebate to encourage export and offered exceptionally favorable policy to foreign investment. The exchange rate of the Chinese currency has been kept at a relatively low level to stimulate export and attract foreign investment. These measures have greatly boosted commodity export and foreign investment. As for the country's balance of payments, both current account and capital account have posted surplus, and trade surplus has been one of the main driving forces for China's GDP growth. In 2006, the net export growth contributed about 20% to the country's GDP growth. The fast growth of the "double surplus" in the balance of payments has made it difficult for the central bank to effectively hedge against the huge excess liquidity. As a result, the asset prices on the stock and real estate markets have continuously risen, the foreign exchange reserve has become increasingly larger, and the Chinese currency has faced a growing revaluation pressure. As long as there is no fundamental change in the basic situation featuring huge "double surplus", the above problems are unlikely to be solved in a fundamental way. And the longer this situation continues, the farther the exchange rate, the amount of foreign exchange reserve, the balance of payments and asset prices will deviate from their equilibrium levels, making it more difficult for them to return to the equilibrium levels. This will be a vicious circle.

Coinciding with the internal and external economic imbalances is a structural imbalance of the Chinese economy. In terms of supply structure, China is, at a large extent, currently producing according to the demand of the overseas consumers rather than that of the domestic consumers. An obvious sign of this structural imbalance is that the share of the manufacturing sector is far higher than required by the real domestic demand and the share of the service sector is far lower than required by the potential domestic demand. This structural imbalance is closely related to the country's export-oriented strategy and its overemphasis on tapping the so-called comparative advantages. Guided by the export-oriented development strategy and the strategy of utilizing the comparative advantage of cheap labor, China's manufacturing sector and in particular the export processing industry with supplied materials have played key roles in turning China into a "world factory". On the other hand, the service industry has been visibly underdeveloped, even compared with those countries at the same level of development. As services are difficult to import from foreign countries, China's import demand is unlikely to rise noticeably even if there is a huge disequilibrium of balance of payments.

If China's economic structure remains unchanged and if the net export falls drastically all of a sudden due to a sharp appreciation of RMB or other reasons, the domestic demand will be unable to smoothly digest the manufactured products originally produced for export. This will lead to a deflation, a fall in the economic growth rate, and a slowdown in the growth of job opportunities. This was what happened to China when the 1997 Asian financial crisis triggered a sharp fall in its export. Some Chinese scholars suggested at the time that domestic demand be spurred to digest the commodities originally designed for net export. But that was unrealistic in practice. A fall in net export when both the supply structure and the consumption structure were out of balance was bound to induce a coexistence of deflation and shortages of goods or services (the products of the monopolistic sectors such as education, medical care and transportation will be in short supply). Increased import naturally can help realize the balance of payments. But if the exchange rate of the Chinese currency is apparently lower than the market equilibrium level, increased import cannot be spontaneously realized by the market force. The government, indeed, can increase some imports through mass procurements, but this move will be grossly inadequate to ease China's huge trade surplus.

The root cause of the internal and external imbalances of the Chinese economy is the long-pursued export-oriented development strategy. After World War II, the mode of export-oriented growth was universally adopted by both the newly industrialized countries and the developing countries. The achievements were remarkable indeed. The main feature of this mode of growth was that the states encouraged export and import substitution and used tariff, exchange rate and other policies to develop export-oriented economies. Over the past 30 years and in particular after China's entry into the World Trade Organization, China's fast economic growth was largely attributed to this mode of export-oriented growth. In pursuing the export-oriented strategy and a government-led economic development, overemphasizing the so-called comparative advantages often induced the states to use exchange rate, foreign trade, tariff, excessively low resource prices and other market-distorting policies to expand export. As a result, the comparative advantages played a "self-fulfilling" function. With government support, some industries that originally did not have comparative advantages came to possess the so-called comparative advantages when compared with other industries and as such China became a cheap "world factory of manufactured goods". This has led to internal and external economic imbalances. There is nothing wrong to emphasize comparative advantages. But the government's interventionist ideas behind this emphasis can bring about harmful results.

To some extent, we can regard the mode of government-led export-oriented growth as a mixture of the mercantilism in the 16th ~ 18th centuries and the state interventionism and planned economy that emerged after the Great Depression in the 1920s and the World War II. The newly industrialized countries (or regions) in Asia that adopted this mode of export-oriented growth and scored economic takeoff all comprehensively adjusted their growth mode and economic structure later. And their currencies (such as the Korean won and Japanese yen) that had been undervalued in conformity with the mode of export-oriented growth all appreciated later. As the sizes of these countries or economies are not comparable to China, it is impossible for China to rely on this mode for an economic takeoff for a long time. The most serious lesson is the burst of the Japanese bubble economy. In the past, China has been actively pursuing this mercantilist development strategy. At present, however, the country is passively hijacked by this mode of growth since transforming this mode of growth involves a heavy cost. Coupled with China's tradition to pursue government-led economic development for a long period of planned economy, this mode of growth can further aggravate internal and external imbalances. As the size of the Chinese economy expands and as the country's economic development steps up to a new stage, the defects of this growth mode will be increasingly eminent. China badly needs to adjust this mode of growth and related guidelines so as to adapt itself to the needs of the new situation of economic development. If this adjustment can be accomplished smoothly, the mode of economic development China has adopted since it began reform and opening up can claim to be very successful on the whole. Otherwise, China may repeat the burst of the Japanese bubble economy and its economic development may experience major setbacks.

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