Reflections on the Global Financial Crisis and China’s Economic Development

9. Nov 2008

Christer Ljungwall China Economic Research Center, Stockholm School of Economics, ([email protected])

The current global financial crisis may be regarded as one of the greatest challenges since World War II, and its far reaching implications are present in every corner of the world. The current crisis, however, is not the result of a traditional cycle-fluctuation. More correct, it is due to structural imbalances in the global economy. Saving rates has been too low and consumption too high in the United States and Europe, while China has provided both the saving to finance that consumption and the products themselves. This has not only led to huge trade-imbalances, but also a structural miss-match in the Chinese economy, i.e., too much focus on export-oriented manufacturing. It is true that China’s export-led growth model has generated enormous increases in output, higher incomes and new job opportunities. But it has also stalled the necessary re-balancing of the economy to one geared more at private and public consumption.

The toxic debts caused by the sub-prime mortgages in the United States, which in essence was the failure to properly price risk, was rapidly spread amongst western countries leading to an immediate financial crisis. Today, western countries are mired in low growth and the global economy is likely to enter recession in 2009 with the United States, Europe and Japan posting negative or very slow rates of economic growth. As the global demand for Chinese export goods diminish there is little doubt that China will suffer.

So far China has been able to avoid the worst problems due to its strict controls on capital flows, the relative conservatism of its banks and its large trade surplus. The real economy still remains reasonably strong and from this perspective China has powerful tools to maintain stability in its own financial system and to stimulate the domestic economy.

Signs are, however, already emerging that the global financial crisis is having an impact on China. In the third quarter of 2008, China’s annual gross domestic product growth slowed to 9 percent from 10.1 percent in the second. Inflation has slowed to an annual 4.6 percent in September from a peak of 8.7 percent in February. There is a sharp slowdown in industrial profit growth and fiscal income, China’s stock market has recorded its worst ever month and tens-of-thousands of workers risk losing their jobs in a near future. The uncertainties in the world’s currency markets have exposed the Chinese banking sector to higher foreign asset risks, and earnings growth is rapidly declining. It is serious to the extent that the central bank is devising a plan for providing emergency liquidity to banks in case they need it in the future.

The fundamental issue for the Chinese government today is to change its growth model and to re-balance the economy. This is the most important issue – together with the environment – and there is very little time. In this respect, the current crisis presents China with an opportunity to analyze its own problems, reflect about its weaknesses and in which areas they should focus their efforts.

In order for China to confront the many destabilizing and uncertain factors that exists it is necessary for them to strengthen the awareness of the difficulties and proactively deal with the challenges. The Chinese leaders are, however, caught in an ideological battle over the future direction of the country’s economy. Some view the problems that western financial institutions are experiencing as proof both of the superiority of China’s economic policies and its political system, while others argue in favor of continued market reforms. Indeed, the western-style democracy has recently been attacked, while lauding the Chinese one-party system and its tight control over the economy. From this perspective, pressure to act in a less optimal direction may be irresistible for Chinese leaders and as a result we are likely to see much of the macro-economic adjustment policies to be short-sighted rather than focusing more on the long-run development issues.

In the short-run domestic demand may be stimulated through massive investment in infrastructure. The government has already implemented a handful of monetary and fiscal measures, including cuts in interest rates and banks required reserves, to stimulate growth. The central bank will continue to reform interest rates to make them more market orientated and improve exchange rate flexibility while keeping the stability of the Yuan in check. In addition, the bank will keep a close eye on the real estate sector and improve the financial services related to it.

Stimulating the domestic economy may help in the short-run, but will only be effective if the government pays careful attention to its stimulating policies so as to avoid future problems. Critics argue strongly that it may be dangerous to increase debts levels rather than fighting the core of the problem – lack of a social safety net and private consumption.

In the longer-run household consumption must increase, with the main target being the rural population. Increasing private consumption is, however, a slow process and it will take at least a decade to reach sufficient consumption levels. On the other hand, increasing public consumption may help speed up this process. Creating both a new health care system and welfare system is seen as the key to rapidly increase private consumption among the poorest households. The plan is ambitious and the intentions are definitely good. The big question mark is the large distance between households and the central government and in this respect the political administrative layer will likely be a drag on development. The fact is that local governments do not have the ability to implement the needed reforms at a satisfactory level.

The fact remains that China finds itself in a very sensitive political and economic situation in which the uncertainty of what will happen over the coming two years are significant.