Chinese authorities have been employing a whole range of policy instruments in their attempt at cooling off the economy but have not been successful. However, we expect that this challenging task will be accomplished in 2008, reflecting ‘external aid’ – in the form of a mild US recession — rather than skillful macroeconomic management.
A great dichotomy. One day after our US economists Dick Berner and David Greenlaw called for a mild US recession, China posted the highest reading of CPI inflation in a decade: the headline CPI inflation reached 6.9%YoY in November. These latest developments highlight the great dichotomy for the Chinese economy entering into 2008: while China’s external environment is set to deteriorate significantly, the risks of out-of-control inflation and general economic overheating in the domestic economy is on the rise.
Four seasons in 2008. In view of the tremendous uncertainties about the outlook for China’s external demand and the domestic policy stance, we characterize potential scenarios for 2008 as four seasons of the year.
Autumn scenario for 2008 (60% probability) — an imported soft landing. We expect the Chinese economy to achieve a soft landing in 2008, aided primarily by a significant moderation in China’s export growth due to weak external demand. We therefore call it “an imported soft landing”.
First, concerns about the risk of overheating in 2008 are not unwarranted. Investment and exports have been the main drivers for growth in China. Since interest rates are still largely controlled at below market-clearing levels and the renminbi exchange rate remains substantially undervalued, these price signals tend not to constitute effective binding constraints for investment decisions in China. In this context, the investment cycle tends to reflect the macro policy stances, which are influenced heavily by the political cycle in China. Since the early 1990s, FAI growth rates have reached a peak every five years, and the year of peak growth rates happened to be the year of change of government. The next change of government is due to take place in March 2008. An acceleration of investment from the current levels — which are already deemed high — could easily drive the economy into overheating territory, in my view.
Second, moderation in China’s export growth due to weak external demand in 2008 should be a welcome development that would help the economy to achieve a soft landing. In my opinion, it is very challenging — if ever possible — to realize a policy-induced soft landing of the economy at the current juncture, given that Chinese authorities are pursuing multiple objectives but with limited policy tools. In particular, the effectiveness of both interest rate and exchange rate policies is seriously compromised by some objectives that do not have direct bearing on the macro-economy. In this context, a weakening external demand should serve as a healthy headwind and thus help slow the economy that is constantly on the verge of overheating.
Under the ‘imported soft landing’ scenario, we forecast China’s GDP growth to decline from 11.5% in 2007 to 10% in 2008 and CPI inflation from 4.5% to 4.0%. Our forecasts envisage a modest rebalancing in growth drivers in 2008: relatively weak exports to be offset by sustained strong domestic demand. Consequently, the current account surplus (in percent of GDP) will narrow, as import growth outpaces export growth, albeit both at lower levels.
Under the ‘imported soft landing’ in 2008, the policy outlook will likely feature a continued muddling through. The authorities’ current policy priorities are addressing the risks of overheating in general and entrenched inflation in particular. However, they may have to increasingly resort to administrative measures to achieve the intended policy effect. The welcome downturn in external demand and its attendant cooking-off effect should be able to provide a breathing period for the authorities and ease the urgency to take aggressive policy actions with blunt policy tools. We therefore expect a continued muddling through approach in policy implementation in 2008 featuring “three No’s”: no campaign-style administrative tightening, no large one-off revaluation of the Renminbi exchange rate, and no aggressive rate hikes.
Summer scenario (25% probability): Overheating. What if there is no meaningful external slowdown to import in the first place? If this is the case, the risk of overheating would, in my view, rise substantially. Under this scenario, we would expect China’s economic growth to remain robust, with exports still the main growth driver. The authorities are expected to continue muddling through in policy implementation with no major policy direction shift. In this context, investment growth will likely accelerate from the current high levels, as the political- cycle-driven investment cycle plays out fully.
Spring scenario (10% probability): Policy-induced soft landing. Here, we envisage that the authorities would seize the opportunity when the global economy is still delivering robust performance and take proactive measures to address the imbalances in the economy and cool off the economy from a position of strength. A much faster appreciation of the renminbi exchange rate should be the most important element of the policy package that could potentially bring about a soft landing when the global economic environment remains favorable. We estimate that a 20% appreciation of the renminbi under the Spring scenario, together with the secular softening in export growth, should be able to produce roughly the same magnitude of export growth decline as under the Autumn scenario. However, we attach a very low probability to this scenario. The Chinese authorities – known for their hallmark gradualist approach in implementing reform programs – are very unlikely to make such a bold move as 20% appreciation in 2008.
Winter scenario (5% probability): Outright hard landing. The winter scenario features a double-whammy impact on the Chinese economy: aggressive policy tightening chokes off domestic demand, exacerbating the impact of a global synchronized downturn and resulting in an outright hard landing of the economy. At first look, it appears the most likely scenario at the current juncture: while the risk of a US recession is looming large, the Chinese authorities have been very vocal lately in warning against the risk of overheating and inflation and vowed to take tough tightening measures to control rapid investment growth. We, however, attach the smallest probability, of only 5%, to this winter scenario. This is essentially a ‘gigantic policy mistake’ scenario.
By Qing Wang Hong Kong
Morgan Stanley
December 17, 2007
Monday, December 17, 2007
China: A Recession in US Is Welcome
Posted by Nigel at 11:01 PM
Labels: World Economy
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