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As leaders from the world’s wealthiest countries gather in China for the G20 Summit, Mohamed A. El-Erian and Michael Heise face off over China’s rising economic power. This is the first part of a two-part series.
Western critics often focus on potential problems in China’s economy but ignore the long list of successes, such as lifting hundreds of millions of people out of poverty in recent decades, says Allianz Chief Economist Michael Heise.
While the road ahead is bound to be bumpy, China will succeed in maintaining its impressive economic performance and playing an even more influential role on the global stage, says Mohamed A. El-Erian, the Chief Economic Advisor at Allianz.
Along the way, China will need to address serious challenges: Its state-owned companies are overly indebted and the country lacks an adequate social safety net. China will need to build pension, health- and life insurance systems for the rapidly rising number of retirees.
Is China on track for steady growth? What is the potential for disappointments?
Michael Heise: China will be a growth driver for many years to come in the world economy. The main question is how smooth or how bumpy this process will be and this depends very much on whether policy makers address the main risks.
The biggest risk is, in my view, the credit boom, especially in state owned enterprises, which means there has been a misallocation of financial resources in the economy. There is the risk of bubble-building.
The way the government addresses this risk will decide, to a large extent, whether the direction and the transition of the Chinese economy will be gradual and stable as it has been in the past. Policy makers have to be commended for this so far. It has been impressive.
Mohamed A. El-Erian: I share Michael’s view that the current slowdown from very high historical growth rates will not translate into a hard landing and that Chinese officials have done a good job of managing a structural transition in the midst of a fragile, complex and ‘unusually uncertain’ global economy.
From a development perspective, China is in the trickiest phase – one that very few countries have managed to successfully navigate. It’s what economists call ‘the middle-income transition’ – like a teenager becoming an adult. Lots of things have to change, and economic policy management is challenged to evolve accordingly.
China is dealing with this transition in the midst of slower global growth, pockets of domestic financial excesses and also a global monetary system that has been distorted by experimental central bank action in systemically-important advanced economies. So it is inevitable that it will be a bumpy process.
But isn’t it a bit too late to manage this well? The debt to GDP ratio is already frighteningly high.
Michael Heise: It is worrying to see the debt ratio, especially in the non-financial corporate sector, rise as it has done, from somewhere around 85 percent to currently 174 percent of GDP from 2008 onwards. That is a very steep rise and it is unsustainable. It was caused mainly by lending to the state owned enterprises which are often inefficient and have built up massive over-capacity in some sectors.
This is the most important thing that Chinese policy makers have to address. They need to reign in debt growth and cut capacity in state-owned enterprises often kept alive by loans from state-owned banks.
Cutting capacity, of course, is a difficult issue for the Chinese government as jobs are at stake; therefore I have some understanding for the slow actions of the government. But if the issue is not addressed more forcefully now, the debt bubble will spin out of control and cause much more painful adjustments in the future.
Then this is similar but different to the situation that Western central banks face, Mohamed, would you agree?
Mohamed A. El-Erian: There’s no doubt that debt levels need to be addressed by policy makers. Having said that, the mistake would be to apply Western experience to China without taking into account some very specific factors there.
If I may, here are a few examples to illustrate what I mean: First, China is a relatively closed economy, so it is not easy to have a forced deleveraging because of large and disorderly capital outflows. This is not like what you saw in Greece, for example, or in a typical emerging country.
Second, China has lots of financial assets, including sizeable international reserves. As such, and while the authorities wish to avoid mistakes, China can afford to make some mistakes in terms of debt management. It’s not a typical developing country when it comes to its asset/liability mix.
Thirdly, a lot of the problems are in state owned enterprises and in quasi-public entities. Here, again, financial deleveraging cannot be forced on the system by fleeing creditors and hesitant equity holders.
So I would certainly endorse the view that dealing with pockets of financial excesses is a priority but I would caution against thinking the system can be forced to deleverage like we have seen in other emerging markets and that we saw in the more advanced economies in 2008 and 2009.
Also, the original sin, which used to be a big problem for the developing world, was that you borrowed abroad in foreign currency, in dollars, but you mainly generated local currency revenue. So you had a fundamental currency mismatch. You can't, of course, print dollars. But China does not have that original sin.
“China does not have the original sin of having borrowed excessively in foreign currency.” – Mohamed El-Erian
How will China fit into the global economic order?
Mohamed A. El-Erian: The first question is, can the world accommodate China? History suggests that established powers have difficulty making room for emerging powers. The simplest example these days is the hesitation to increase China’s vote in multilateral institutions commensurate with its economic and financial importance. China is clearly under-represented, given the size of its economy, finances and influence. So there is a question as to how well can the global economy accommodate the growth of China, and how readily will the established powers in Europe and the US make room for China.
Secondly, can China live up to its global responsibilities? From an historical perspective, it is rather unusual to have an economy has become systemically important at a relatively low level of per capita income. China is, after all, the second largest economy in the world, if not the largest by some PPP measures. But it is still far from the top 20, let alone the top 10 when it comes to per capita income.
China’s role in the international economy is therefore likely to be bumpy. It will depend on whether it is accommodated easily by others, and it will depend on how easily China can reconcile its domestic obligations with its international responsibility. These are not easy questions.
Michael Heise: That’s a very interesting thought. The values and policy principles are going to remain quite different from what we are used to.
Many policy makers in the West don’t really acknowledge that yet. They think that China needs to converge to the West. We have to become accustomed to China having some positions that are different from Western economic values. We’re seeing that right at the present with Chinese companies buying into Western companies, be it pharmaceutical or chemicals or be it IT or robotics as here in Germany, and yet the other way around is rather difficult, that is, for Western companies to invest in China.
China will be a main driver for the world economy for some years. Growth rates should probably decline to somewhere between 5.0 and 6.0 percent in the medium term, perhaps in the next 5 to 10 years, a range were they could be seen as healthy and stable.
The path towards lower growth will probably be more bumpy than smooth as China becomes more exposed to the international markets. It has started to liberalize its financial system, which is positive, but also generates volatility in capital and exchange flows.
China will have to solve some other major problems as well. The aging population will burden the economy down the road. Financing retirement or health services for older people is not easy to cope with, given the fact that China`s per capita GDP is still at a rather low level.
“We have to get used to China having some positions that are different from Western economic values.” – Michael Heise
It does beg the question whether Western orthodox economic policy is a one-size-fits all approach, yet China seems to do quite well not following these orthodoxies, such as with the exchange rate.
Mohamed A. El-Erian: I suspect that, partly reflecting frustration at the unwillingness of the advanced economies to sufficiently accommodate the country in the multilateral system, China has led two initiatives. One is the creation of the new Asia Infrastructure Investment Bank, the AIIB, and the other is the creation of the New Development Bank with other BRICS countries.
So far, particularly in the case of the AIIB, China has worked hard to ensure that the governance element meets high standards. And there is hope that this alternative road that China is taking is in fact consistent with reforming the multilateral system overall, as opposed to fragmenting it. But the jury is still out, and just like on the domestic side, it is something that people are going to be looking at closely. The hope is that this can help act as a conduit for their reform of the international monetary system.
Michael Heise: The Chinese are trying not to follow the demand side policies that Western economies have followed with negative interest rates or quantitative easing. They are critical of that. They do employ fiscal spending policies, but their government deficits are less than in the West. They still have some firepower left.
There are other fundamental differences that won’t go away soon, such as in the principles and laws governing the economic process – the framework for the economy – such as the role of government-owned companies, the openness to international competition and to newcomers, the way credit is allocated. These differences will create some tensions in the coming years.
Few elements of Chinese economic policy have been more politicized than the yuan or the exchange rate.
Michael Heise: The devaluation of the renminbi since mid-2015 has not been a beggar-thy-neighbor policy. It follows many years of appreciation. Now it is in my view a sensible policy choice. China doesn`t have many levers to keep the economy moving at high speed without creating negative side effects. Reducing interest rates or generating more liquidity through monetary policy would make financial excesses get even worse.
Public investment to spur growth would exacerbate the problem of over-capacity in relevant sectors of the economy. So a gradual devaluation of the exchange rate is a natural policy choice. It helps to reflate the economy after years of appreciation. I wouldn’t criticize that and I expect a moderate devaluation of the Yuan to continue. It may not be liked by trading partners, but they will have to adjust.
Mohamed A. El-Erian: The currency is a good example of the tension between China’s domestic obligations and its international responsibilities. From a domestic perspective, China would favor a weaker currency. It’s an important contributor to cyclical growth at a time of major structural changes and a sluggish global economy. So from a domestic perspective, a weaker currency makes sense.
But from a global perspective, a notably weaker currency increases tensions, not only trade and financial market tensions but also when it comes to multilateral efforts to establish the Chinese currency as one of the global reserve currencies. Recall that it has been almost a year since the RMB was added to the IMF currency basket for its SDR.
What is likely to happen is that China will favor a currency devaluation as long as this does not increase global tensions too much; and if tensions rise, the authorities will likely hit the brakes on currency devaluation.
Read part two here.
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