Key Trends in the World Economy

Danny Quah on the analysis of Asian and Chinese growth

Earlier this month I shared a joint platform on Asian economic growth with Danny Quah, Professor of Economics at the London School of Economics. Professor Quah I knew principally from his writings on international comparisons of growth such as Empirics for Growth and Distribution, Twin Peaks: Growth and Convergence in Models of Distribution Dynamics, and The New Empirics of Economic Growth. Recently I had also read with considerable interest his analysis of Post-1990s East Asian Economic Growth which deals extensively with Asia’s recovery from the 1997 debt crisis - and can be strongly recommended to readers of this blog.

I had, however, not personally met Professor Quah before and preparing for the discussion gave an opportunity to catch up with a number of his other writings. These include criticism of the myth that the cause of the international financial crisis is over-saving by Asian countries. He has therefore urged the need to, ‘rebalance the global economy by all means, but with an eye to fostering aggregate supply as much as aggregate demand.’

This point is crucial given that, all other things being equal, reduction in Asian savings/investment rates will necessarily lower the rate of international economic growth – which will not aid global economic recovery.

Such analysis led Professor Quah into a discussion with Martin Wolf of the Financial Times - who precisely proposes radical reduction in savings by Asian countries to eliminate their balance of payments surpluses. Danny Quah noted, against Martin Wolf: ‘the appropriate policy is not what you propose for the surplus countries to do. Instead, it is that the deficit countries need to improve their supply-side productivity - they should get workers and business back to work, through restoring confidence and making credit again available for normal business operations - thereby raising national output, and lowering the current account deficit. The surplus countries will then have their trade surplus automatically decline. World output will increase, and global balance again restored.’

Such arguments, evidently expressed from a somewhat different viewpoint, parallel a number of issues discussed on this blog. The panel was a highly interesting exchange. Since then Danny Quah has posted a piece on his blog analysing China’s 1st half 2009 GDP growth.

All highly recommended reading.

China's 1st half GDP growth should settle the dispute on the correctness of its approach to the financial crisis

On 16 July, as was widely reported, China announced very strong economic growth in the first half of 2009. GDP was up 7.1% year on year for the six months to June. Growth was 7.9% for the second quarter of 2009 compared to the same period in 2008.

Economic acceleration was evident as China's year on year growth rose from 6.1% in the first quarter to 7.9% in the second. Industrial production in June was up 10.7% year on year. In terms of annualised quarter on quarter growth, official figures for which China does not publish as it considers its data on seasonable adjustments are not yet sufficiently accurate, the Wall Street Journal notes private economist estimates of 15% annualised GDP growth in the second quarter.It therefore appears highly likely China will hit its 8% annual growth target this year.

Despite this rapid growth there was no sign of inflationary pressures in consumer or output prices due to overheating - on the contrary year on year consumer prices in June were down 1.7% and the producer prices declined by 7.8%.

These are evidently stellar figures in the context of the international financial crisis - by far the best results of any major economy. They also cast clear light on the debate that has been taking place internationally on the correctness, or otherwise, of the policies being pursued by China in dealing with the international financial crisis. Such first half GDP figures evidently indicate great success, and countries  pursuing objectively guided policies would study China to see carefully what lessons could be learned from this.

This is particularly important as China is not pursuing a course based on running a large budget deficit. Such policies, which are generally mistakenly referred to as 'Keynesian' in the US and Europe, are dominant in those countries' recovery packages - 'mistakenly' because Keynes own views were focused on monetary economics, and based on the priority to reduce interest rates by measures such as quantitative easing, not on expansion of budget deficits, as writers such as Turner and Tily rightly point out. A policy of meeting the financial crisis through large budget deficits might be correct, as Paul Krugman argues, or it may be incorrect. but it is not actually a 'Keynesian' policy in the sense of being the one advocated by Keynes.

Contrary to some mistaken claims in the financial media, China's stimulus package is, however, not based on a large budget deficit. This is clearly confirmed by the figures. China's deficit is projected to expand this year but only modestly, from balance to a deficit of 3% of GDP.

China's stimulus package is instead focused on two measures. The first is direct methods to raise, that is control, investment - thereby avoiding the precipitate fall in investment which is the driving force of an economic downturn.

The largest part of China's $585 billion stimulus package is going into urban fixed investment which rose 33.5% year on year in the first half of 2009 and 35.3% in the year to June. As, in the same period, producer prices were falling sharply it is likely that the real increase in investment in fixed assets approached 40%. China is able to achieve this due to its large state company sector which can be issued with 'administrative' instructions to increase investment, thereby countering any downturn.

The second part of the stimulus package is expansion of bank lending. M2 was up in China by 28.5% year on year in June with bank lending rising by RMB 1.5 trillion ($220 billion) in June and RMB 7.37 trillion ($1.1 trillion) in the first half of 2009. The fact that China's banks are state owned allows them to be instructed to increase lending - whereas in the US and Europe only indirect, so far relatively ineffective, methods can be used to attempt to persuade banks to counter-cyclically expand their lending.

This combination of direct measures to expand investment and rapid increase in bank lending explains the success of the stimulus package and therefore China's rapid economic growth in the first half of the year. This model is evidently quite different to, and far more successful, than the policies based on large scale budget deficits being pursued in the US and Europe.

A number of non-Chinese commentators have accurately judged that the Chinese stimulus package will be successful - the most prominent probably being Jim O'Neill, Goldman Sach's chief economist. In contrast theorists that China is 'oversaving', and must change its economic model, who are given frequent extensive coverage in sections of the the media, such as Martin Wolf of the Financial Times and Michael Pettis, have been proved inaccurate.

It would be hoped that as economic theory has not led writers such as Wolf and Pettis to change their analysis facts might now lead to an acknowledgement their analysis is wrong. As, however, they have maintained views which are false from the point of view of economic analysis, and from the point of view of economic facts, for many years it is probably unlikely there will be any change in light of the latest data. Indeed Pettis in his latest post, commenting on China's GDP figures bizarrely, in the light of the facts, claims: 'I think China will be among the last countries to escape from the effects of the global crisis,'  This is roughly the economic equivalent of continuing to believe that the world is flat despite the fact that all evidence shows it is round.

Fortunately for the health both of China's and the world economies the Chinese authorities have continued to pursue their own policies and ignore such advice from outside. The latest GDP data confirms just how right they were to do so.

China's rapidly shrinking trade surplus

One of the areas where most media commentary is lagging behind events is regarding China’s trade surplus. Articles dealing with China’s surplus, one the key international trade trends, have been a regular feature of economic analysis ever since it first appeared in 2005-6. What has not received equal commentary are the signs of a very rapid drop in China’s surplus this year.

This trend is so recent and so strong that the usual year on year comparisons do not capture it adequately. Figure 1 therefore shows China’s monthly trade surplus since 1992 up to the latest available figures for June 2009. Figure 2 shows the same data calculated as a three monthly moving average in order to avoid any purely short term distortions.

Figure 1

Figure 2

The trend is clear and striking. China’s trade surplus rose steadily from 2005 onwards and then temporarily rose even further under the impact of the onset of the international financial crisis in September 2008. The peak was reached in January 2009 with a monthly surplus of $42.1 billion. Since then China’s surplus has fallen steadily and rapidly. The surplus for June was $8.25 billion.

Expressed in terms of 3 monthly moving averages China’s monthly trade surplus was $22.5 in August 2008, immediately before the onset of the financial crisis and the collapse of Lehman brothers, rose to $38.1 billion January 2009, and has since dropped to $12.5 billion.

The trends behind China’s shrinking trade surplus are clear. Under the impact of the financial crisis both China’s exports and imports have declined. But its imports have declined far less than its exports. Since the peak month of August 2008 China’s exports have fallen by 28.0% but its imports have only declined by 18.5%. China’s net trade position is therefore acting as a locomotive for the rest of the world economy.

Indeed this change in China’s trade position, if the trend continues, is a significant stimulus. The net turn around in China's trade for the latest month, compared to August 2008, is $18.5 billion – its monthly trade surplus having shrunk from $26.7 to $8.3 billion. This is equivalent to an annualised $220.9 billion.

This trend in China’s exports and imports would be by itself insufficient to offset the depressive effect on world trade of the fall in demand from the US. Between August 2008 and May 2009, the latest available figure, the US trade deficit fell by $34.9 billion a month, declining from $60.9 billion to $26.0 billion - equivalent to a net negative shock for other countries' trade of $418.8 billion. Nevertheless it does mean that, if this trend continues, China is capable of taking up about half the slack in world trade created by the downturn in the US – a far from negligible effect. This trend in China’s trade must therefore be watched carefully if world trade begins to recover.