Albert Keidel
Cover by Benjamin Hurd
Albert Keidel, president of Rock Creek Research, was senior economist in the World Bank office in Beijing from 1997 to 2000.
Although China's government stimulus seemed to revive growth in 2000, not all signs are positive. Rural incomes and consumption must rise substantially to stimulate badly needed off-farm employment growth.
China's economy in 2000 and early 2001 is performing moderately well. But it is still not performing well enough to provide the job growth needed to facilitate fast-paced market reforms. GDP growth is decidedly positive, even if the actual rate may be several percentage points lower than the officially reported figure. Price declines of recent years appear to be moderating. Budget deficits and national debt, however defined, remain manageable, and China's overall external position in foreign trade, foreign debt, foreign investment, and foreign reserves, is excellent.
The economy's greatest asset is the government's determination to continue to promote GDP growth through a range of stimuli while pushing market reforms and economic opening to the world. China's fiscal stimulus program of budget-deficit-funded infrastructure and technology investments, begun in 1998, is continuing for a fourth straight year in 2001, and Prem ier Zhu Rongji announced, during his press conference for Chinese journalists at the close of the March 2001 National People's Congress, that it will probably continue into next year. The government is also preparing to increase urban wages yet again and has made raising rural incomes a high priority for 2001. Long-term efforts to join the World Trade Organization (WTO) are already paying off, as foreign direct investment (FDI) commitments and inflows are once again surging.
Not enough new jobs
China's economic performance, however, has fallen short in one critical area: job creation, especially in the services sector. Overall national employment growth stayed below 1 percent in 2000 for the third year in a row and even slowed slightly from 1999. This represents a significant deceleration from job-creation rates in the mid-1990s. Sector details for 2000 are not yet available, but in the 1998-99 period, employment in industry declined. Meanwhile, the share of employment in services hardly changed at all as employment in agriculture actually increased. Such a backward shift in the structure of employment is not typical of a fast-growing economy, which normally experiences the classic shift of labor out of agriculture and into manufacturing and services. China's National Bureau of Statistics (NBS) has yet to release service-sector employment data for 2000, but services GDP growth remained basically unchanged compared to 1999, and it is unlikely that employment patterns have changed much since 1999. China's macroeconomic challenge is thus to generate GDP growth based on rapid expansion of service-sector jobs.
Finding and sustaining a better growth configuration will be tricky. A potentially softening world economy could require more than the usual dose of Chinese ingenuity to stimulate exports, and weaker world financial markets could make it harder to raise cash. Agriculture's structural difficulties will also not be resolved easily. These include cropping patterns out of alignment with demand, low incomes from low crop prices (which are still above world prices), struggling rural enterprises, and problems of corruption, bad loans, and cash shortages at rural credit institutions.
If, somehow, the rural economy were to recover--leading to higher rural consumption, investment, and demand for related materials--China could start another upswing in its traditionally volatile domestic demand cycle. Judging from past trends and the still-developing state of China's macroeconomic policy apparatus, a rapid upswing has a better-than 50 percent chance of appearing. Such an upswing would likely lead to a cycle of inflation, devaluation, more inflation, and an eventual, and damaging, credit crackdown. In the face of this fragile policy environment, government officials appear to be well briefed and aware of shoals ahead if they stray off course. The current overriding priority is to throttle up growth enough to meet employment needs made more urgent by reforms.
GDP: A strong point
How is China's economy doing? The economy generated better-looking official statistics in 2000 than in the past two years, but the truth beneath the numbers is that China's economy struggled last year to maintain output and employment growth adequate to support market reforms. The main culprits are the weak rural economy and surging imports.
The strongest indicator of the economy's health is the official GDP growth rate for 2000. At 8 percent, GDP growth ended a seven-year slide (see Figure 1). The GDP deflator also moved into positive territory. This deflator is used to convert, or "deflate," GDP in current prices to GDP in constant prices from some base year, allowing for measurement of real growth undistorted by price changes. Because this deflator measures price movements averaged across all types of production, it is arguably the most robust indicator of inflation (or deflation). Rising prices likely indicate a strengthening of overall demand. The 2000 upturns in both GDP and its price deflator thus appear to signal a new expansionary period.
Quarterly data make this conclusion less convincing, however. China does not publish GDP data for individual quarters, but calculations from year-to-date quarterly data and official commentary indicate that GDP growth slowed to 7.4 percent in the fourth quarter after surging to over 8 percent in the first three quarters (see Figure 2).
Industrial output growth also decelerated moderately at the end of 2000. It averaged 11.4 percent for the year as a whole but slowed to 10.5 percent in November-December and 10.2 percent in January-February 2001. In other words, output for the year showed a recovery, but more recent quarterly and monthly trends indicate that growth early in 2000 was probably in response to deficit spending and export promotion. When both of these programs tailed off in the fourth quarter, so did output growth.
Investment, retail sales: Strange brew
Investment and retail sales present a more complicated picture. On the face of it, investment in 2000 grew 9.2 percent and then accelerated to a surprising 16.7 percent in January-February 2001. The 2000 data show a good recovery from a relatively weak performance in 1999, but the early 2001 performance is curious.
It is less curious if one remembers that annual and monthly investment data have different statistical foundations. Monthly data are based only on a subset of enterprises, excluding urban and rural cooperatives and all sole proprietorships. These monthly data for 2000 show investment during most of 2000 at rates much higher than the annual average, and then stagnation in December 2000 (at -1.3 percent growth). One strong possibility is that public funds for investment credit subsidies and other public projects ran out by year's end, forcing the postponement of reporting on formal spending until January-February, but not of the actual work in progress. That is, investment activity may have been stronger than reported for all of 2000 and less remarkable in the first months of this year.
Such statistical conundrums have no easy explanation, though the complete record for 2001 may help provide some answers. In the meantime, however, one reasonable supposition is that investment trends have been heavily dependent on public spending, with less of a boost from overall consumer demand and related investment in consumer goods capacity.
Similarly, it is difficult to know what to make of retail sales trends. China does not publish a demand-side GDP figure for consumption, and retail sales data are frequently taken as an imperfect proxy for consumption. The 2000 annual data revealed a 9.7 percent increase, but then January-February 2001 data revealed a surprising 10.6 percent growth figure over the year-earlier period. This was higher than many analysts expected based on an apparent sales slowdown at the end of 2000. It is true that January-February is a heavy spending period because of the Chinese New Year holiday, but that happens every year and shouldn't affect year-on-year growth rates. Monthly data in 2000 reveal that retail sales tailed off in November-December to levels below the 9-11 percent rates earlier in the year. One reason retail sales are an imperfect proxy for consumption spending is that significant investment spending takes the form of retail purchases. It is likely that the same investment spending mentioned above, delayed from late 2000 to early 2001, also stimulated a parallel shift in reported retail sales growth.
Inflation: In check, for now
In another critical economic dimension--inflation--China appears to be solving its recent problem of generally declining prices. However, overheating has appeared quickly during past cyclical upswings, and many policy positions responsible for inflation in the past are emerging again in 2001. Thus, the current trend is promising but deserves careful attention. China's consumer price index (CPI) has been below or close to zero for more than two years. Again, the main cause has been in the rural economy--falling prices for farm products, which is the root cause of weak rural consumption demand.
Declining retail prices for manufactures, foods, and other consumer goods (with the exceptions of medicines and books) have allowed the government to make important upward adjustments in administratively determined prices--most significantly for housing, healthcare, transportation, and education (see Figure 3). Other price trends have been complicated by the suddenly higher oil prices of last year and by much higher cotton prices, the result of cotton planting policy shifts in 1998-99. Overall, price movements are good for city residents, especially since substantial wage increases compensate for more market-based housing and service-sector price trends. For farmers, however, price changes have yet to bring relief.
Foreign trade: A drag on output
China's international economic performance has been strong. Exports have surged remarkably, although imports have grown even more quickly. Consequently, in spite of this strong export performance, the trade surplus has declined over two straight years. This means that foreign trade has actually been a drag on output rather than a stimulus, falling 17 percent for all of 2000 and 18 percent in January-February 2001 (see Figure 4).
On balance, however, China's international financial position strengthened in 2000, as foreign reserves increased to $166 billion. Gross FDI inflows increased 1 percent, the first increase in four years, to $41 billion, and companies raised over $20 billion on foreign stock markets, a sevenfold increase. Foreign funds raised on foreign markets are doubly sweet, because they bring with them no foreign exchange outflow risks. In 2001, FDI inflows accelerated markedly in January-February, increasing by 24 percent. However, portfolio inflows in 2001 may not come close to last year's record, as large-scale overseas initial public offerings (IPOs) may be postponed until market conditions improve.
The weakest link: Rural spending
The reasons China has done as well as it has in recent years are the deficit-funded fiscal stimulus program begun in 1998 and the promotion of exports through tax rebates and other stimuli. This combination fits a pattern seen over and over during the past 20-odd years: When domestic demand has weakened--usually because of successful anti-inflation programs--export promotion and fiscal stimulus have helped make up the difference. When domestic demand has been strong, promotion of an external surplus has relaxed. Thus, the truly critical variables affecting China's natural macroeconomic health seem to be the strength and structure of domestic demand.
Indeed, the single most important macroeconomic problem facing China this year is within the rural economy. Stagnant rural household expenditures have taken the wind out of China's economic sails for four straight years, and all of China's successful efforts to promote urban spending have not made up for this weakness. Food prices, on average, continued to fall throughout 2000 and into 2001. While urban incomes rose 6.4 percent in real terms, rural incomes increased only 2.1 percent, the smallest increase since the troubled years of 1988 and 1989. Rural incomes only increased at all because of a growing dependency on off-farm work.
Ironically, the solution to rural demand problems is higher rural incomes from higher prices for rural products, which in turn poses a whole different set of macroeconomic concerns. Several years of low inflation have allowed bank deposit interest rates to settle at low nominal levels (2.25 percent for one-year deposits). If food prices and other non-service components of the CPI show even moderate increases, real deposit interest rates will become significantly negative. In the past, Chinese households and firms alike have shown themselves sensitive to real deposit rates . Negative rates have quickly led to increases in circulating cash, stronger retail sales, accelerated investment, and pressures on prices all the way around.
Monetary statistics in 2000 and early 2001 show, if anything, a slowdown in growth of circulating cash (M0), which was up only 9 percent at year's end. M1, which includes cash and short-term or demand deposits, increased 16 percent and M2, the measure of cash and all bank deposits, 12 percent. These statistics are difficult to interpret, however, because Y2K concerns a year ago led to wild swings in M0. Monthly data now, one year later, are based on comparisons with those unusual trends. Furthermore, high levels of stock market activity have increased M1 in unusual ways, since households and enterprises want their funds in the more liquid M1 forms, which are convenient for rapid buy-and-sell activity. M1's high growth rate relative to M2 for two years in a row still indicates increased liquidity in the economy, however, since potential spenders have purchasing power more readily at hand than if their funds were tied up in the long-term savings deposits characteristic of M2.
In the past, an inflationary surge has accompanied policies promoting rural and financial-sector liberalization, policies originally meant to solve problems of slow growth and low rural incomes. This was the pattern in 1985, 1988, and 1992. Once again, in 2000-01, Chinese pol icies are promoting both financial and rural liberalization programs. An important but as-yet-unanswered question is whether policymakers and their institutions can be sophisticated enough to regulate liberalization adequately and nimble enough to raise nominal deposit rates at the right time. In the past they have failed to achieve this balance.
In the rural sector, results of policy shifts are already obvious. Grain output fell dramatically in 2000, a result of relaxed planting requirements and drought in northern China. Farmers make more money per hectare by growing crops other than grain, so if given the chance, they generally shift out of grain production, especially near urban areas. In 2000, per capita output of grain fell to levels that, in the past, have led to official concern and policy reversals, especially after poor harvests in 1985, 1988-89, and 1994 (see Figure 5). China's large stores of grain from bumper crops between 1996 and 1999 provide some buffer, but with less land allocated to grain and lower grain output, prices of grain will eventually follow past patterns and start to rise again. The result of such a pattern has been cyclical booms and inflationary overheating.
After China becomes a WTO member, with all negotiations completed, it will have the option to import significantly more grain than it has been willing to import in the past. Though the information on China's WTO bilateral and multilateral negotiations is incomplete and unofficial, pending the conclusion of negotiations, the information released to date indicates that China has agreed to phase in grain imports at reduced tariffs, but only up to a certain quota, after which higher tariffs will be triggered. The suggestion here is that China, when strategically necessary, could ignore the negotiated trigger quota and continue to import grain in quantities above the quota at lower tariff rates (see The CBR, January-February 2000, and July-August 2000).
Thus, China could ignore negotiated limits and import grain in amounts significant enough to blunt the price rises usually triggered by falling grain output. Such a policy of strategic grain imports would allow both higher rural incomes and lower levels of urban inflation. The transport and other infrastructure investment needs of accelerated strategic grain imports are not trivial, but the rewards in terms of macroeconomic stability and reduced rural poverty could be significant. Naturally, domestic political difficulties face any decision favoring strategic grain imports for macroeconomic stability purposes, making chances for this route small. Nevertheless, with WTO negotiations concluded, policy makers will have greater flexibility to move in this direction.
Inflation's inevitability
China's economy needs to create more jobs than it has in recent years, and stronger domestic demand is the key to meeting this need. Even though official GDP growth rates in recent years have been relatively high by international standards, since 1998 employment growth has faltered in critical ways. Enterprise reform layoffs accounted for some of this pattern, but not all. Somehow, in recent years, employment growth patterns have become disconnected from officially reported economic growth. High productivity gains are one contributing factor, and exaggerated GDP growth statistics are another. Whatever the reason, officially reported growth of between 7 and 8 percent has not been high enough to meet China's needs.
The only reasonable conclusion is that even faster growth, at least as reported using current methods, is needed to lubricate Beijing's state-enterprise reform efforts and meet the demands of new job-seekers coming off the farm. It is possible for China to meet this challenge with lower official growth rates like those expected in 2001, but only if more accurate growth reporting lowers official rates while actual growth accelerates. Such trends will be nearly impossible to verify. The only true test will be in employment data.
The need for jobs will be even greater in 2001 than in previous years. Government projections promise an increase in the scale of urban layoffs, even as the status of laid-off workers is being downgraded. Beginning in January 2001 workers let go from state enterprises have only received unemployment compensation rather than the earlier, more generous, furloughed-worker (xiagang) benefits. This move will increase the potential for urban worker unrest; the only real solution is more jobs.
For all of these reasons, economic stimulus is central to China's economic strategy, and as rural incomes rise in 2001 and beyond, demand pressures will almost certainly generate midrange, single-digit inflation. Whether the economy overheats beyond this range depends on the skills of government policymakers and the adequacy of recent improvements in financial regulatory systems.
Even without serious overheating, the combination of recovered domestic consumer demand and WTO accession could easily lead to a deteriorating current account balance. If balance of payments deterioration is serious, devaluation might be one part of a policy response package, leading to more inflation. Policymakers will have to be ready for quick action as one or more of these economic scenarios unfold.
In spite of all of these uncertainties and potential pitfalls, China's economy as of early 2001 is doing moderately well. But if market reforms and economic opening to the world are to succeed, it must do better still.
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