China: Reform Policy vs. Optimal Policy

Reacting to New Growth Model

I had a much much longer post sketching out my concern with the Chinese hard GDP and Inflation target. My worry was that the CPC would subordinate reform progress in order to the achievement of GDP targets. I'm still wandering around the Philippines and haven't been following too closely.

My hope was for a move off of a hard target. Even if just a signal from the government to set the stage for a miss. The need for China to rebalance remains priority number one in my eyes. The reaction to a perceived miss on current GDP might lead to a policy response that would be more likely to produce sub-optimal future GDP numbers (due to failure to rebalance).



The post had been motivated by the March trade numbers and today's inflation numbers. First quarter GDP came in below target. This article suggests that fiscal policy tools may soon be deployed. This one hints at some monetary expansion. Both are a bit of a worry.

Then I saw this article detailing Premier Li's recent talk at the Bao Forum in Hainan:

"We will not take, in response to momentary fluctuations in economic growth, short-term and forceful stimulus measures. We will instead focus more on healthy development in the medium to long term."

The right focus in my opinion, and consistent with alot of the moves we've been seeing. This is simply an indicator of intention, but I don't see Chinese policy makers backing off the GDP targets that they've held up as a source of their legitimacy unless they meant it.

These words from Premier Li are incredibly important if they are an idication of how policy makers are looking at this. There is a whole lot of grey area that a black and white hit or miss monetary policy (like I'd advocate in a more developed economy) allows. Premier Li recognizes this:

"We have set our annual economic growth target at about 7.5 percent. As it is an approximate figure, it means there will be fluctuations. It does not matter that economic growth is a little bit higher than 7.5 percent or a little bit lower, as long as we can ensure relatively sufficient employment and do not have relatively big fluctuations, then economic growth will still be in reasonable range."

My concern stems from the fact that I don't think China can consistently hit 7.5% if meaningful rebalancing takes place in a fairly aggressive manner. The need for this aggressive approach simply acknowledges a greater downside risk from waiting it. Call it the Pettis concern, based on his book Avoiding the Fall: China's Economic Restructuring (discussed here).

Why Will China miss the 7.5% Target?

The difficulty in hitting 7.5% comes from basic math. China's growth path (which the 7.5% target does not significantly depart from) has been based disproportionately on investment (hence the rebalance). Increasing consumptions share must come at the expense of Investment share (both can grow, but consumption must outpace investment).

I think China can increase consumption share. The problem is that the growth rate on consumption has less impact on the growth rate of GDP then the growth rate of investment.

To illustrate this, lets frame this in exaggerated and simplified terms. If consumption is $100 and investment is at $200 resulting in GDP of $300 we get:

$300 = $200 + $100.

For GDP to increase by 10% via consumption alone we’d need 30% growth in consumption. However, if investment alone is to produce that 10% growth we’d only need investment to grow by 15%.

Using World Bank 2012 numbers GDP was $8.22 Trillion USD. Savings (investment) made up 52% (4.28T) of GDP while Consumption made up 35% (2.88T). Ignoring CA and plugging those numbers into my simplified example above, consider the difficulty in growing consumption share while maintaining a growth rate of 7.85%. The same dynamic is at play.

Sub-Optimal Policy Responses

Sub-Optimal policy responses in the developed world typically take the form of fiscal policy for fiscal policy sake (infrastructure investment should be done on their own economic merit not to boost AD in my opinion) or failure to hit mandates.

So fiscal policy is sub optimal by it's very nature (this is a contentious statement), and monetary policy is sub-optimal when the will to carry it out isn't there. This has been widespread and seems to be caused by the widespread aversion to inflation.

China's current state is decidedly different because of the unbalanced structural nature of the Chinese financial system.

Under financial repression, where savers and consumers essentially subsidize producers (via low deposit rates, low exchange rate, capital controls, etc.), fiscal policy will exasperate this by directly funding investment. Monetary policy, if done via traditional methods of pumping liquidity into financial markets, will simply compound the problems until the structural reforms have progressed far enough. I don't think we're there yet.

Least Bad Option?

Oddly, I'm actually more in favor of the government doing infrastructure investment for two reasons: controversially, I'm not convinced that they've completely saturated the economic value of these projects, and because there is no way around considering this the investment that it is.

Once financial repression has been rolled back enough the optimal macro stabilizer will revert to monetary policy (as it does in mature economies), prematurely overusing it will not only be counter productive (exasperating current imbalances) but will diminish the chances of it emerging as the clear and obvious optimal policy tool going forward.

That being said, for this transition period a focus on consumption share and/or wage growth or some sort of metric that will demonstrate rebalance is occurring and provide Chinese policy makers with both a framework for reform and political cover in the event that GDP can not keep pace is important.

Market Monetarist (and where I was introduced to NGDP targeting) Scott Sumner has discussed that nominal hourly wage targeting would be an optimal target and NGDP just comes closest to approximating this in a politically and practically viable package. Cue Premier Li:

"Currently, China's urban employment situation is continuing to improve while the income of residents, firms' profits and fiscal income have kept steady growth, consumer prices are stable and the growth of power consumption has increased. There are positive changes in (economic) structural adjustment as well. (These all mean) China's economy has been stable and generally good at the beginning of this year."

Hoping for Success

By entering items like these into the public discourse as Premier Li should hopefully give the CPC some breathing room as they undertake what is certainly the most ambitious and meaningful economic reform of my thinking life (I was too young during Perestroika to know what the hell was going on).

As always, I'm giving the CPC the benefit of the doubt. How many times along the reform and opening path they've blazed should this thing have fallen off the rails? It seems like this rebalance should have occurred earlier then now, but that's easy to say in hindsight. The timing of this rebalance, after the global economy has stabilized, may be one of those events we look back on with appreciation at some point down the road.

Either way, the success of the rebalance not only will materially impact the 1.3 billion Chinese but will impact the world at large. I'll be watching with great interest.