Key Trends in the World Economy

India and China's latest output data confirms rapid economic growth and relative global 'decoupling'

The publication by both India and China of their latest industrial production data confirms very rapid economic growth in both countries. This is not only important in itself but is against the view put forward, for example, by Stephen Roach of Morgan Stanley, Bill Emmott the former editor of The Economist, and others, that the major Asian developing economies were incapable of economically 'decoupling' from the US.

Taking first India's data, January's industrial production rose 16.7% year on year. Manufacturing output increased by by 17.9%. The output increase was heavily concentrated in the investment production sector - output of capital goods rose by 56.2%, intermediate goods by 21.3%, and consumer goods by 4.2%. The overall industrial output increase represented only a marginal slowing compared to the revised year on year increase of 17.6% in December - that figure was a revision upwards from the 16.8% initially announced. Overall the figures confirm extremely rapid Indian economic growth.

For China, February's monthly figures cannot be used for meaningful year on year calculations as the long Chinese New Year holiday fell in February this year and in January in 2009 - artificially distorting simple year on year comparisons. The appropriate measure is to compare January and February 2010 with January and February 2009. Taking this China's industrial production was up 20.7% year on year. Light industrial production was up 14.5% and heavy industrial production up 23.7%. Particularly notable advances were in production of transport equipment, up 43.7%, and telecommunications, computers and other electronic equipment - up 26.4%. The rapid increase  of production is evident - this blog has previously analysed the successful shift of China into growth driven by expansion of domestic demand and this is confirmed by the continued trend of China's falling trade surplus.

In addition to the inherent importance of the growth data for both India and China these figures throw clear light on the issue of 'decoupling' - that is whether rapidly growing Asian economies would be able to continue to grow at a fast pace under conditions of recession or economic slowdown in the US. The idea that 'decoupling' could take place was strongly argued against, for example, by Stephen Roach of Morgan Stanley and Bill Emmott  - former editor of The Economist and a long term analyst of the Asian economies.

Stephen Roach in The Next Asia argued: 'The hopes and dreams of decoupling - an overly optimistic scenario that envisaged emerging market economies have the wherewithal to stand on their own in an otherwise weakening world - are in tatters.' (p66) This represented a continuation of his argument, presented a year earlier, that: ''Dreams of decoupling danced in the air on this first official day of meeting at Davos [in January 2008].... I didn't offer much support for this view... My case is relatively simple. Developing Asia - where the growth dynamic is the strongest and the hopes of resilience are the deepest - remains very much an externally dependent economy.' (p30)

Roach argued that China was particularly vulnerable to external economic slowdowns: 'There is a second factor at work that is likely to challenge the view that hyper growth is here to stay in Asia - the region's persistent reliance on external demand as a major driver of economic growth. A slowdown in the United States - the main engine of the demand side of the global economy - can't help but work its way through the export channel and reduce externally dependent Asian growth.... China is at the top of the external vulnerability chain... As the United States economy now slows, the biggest piece of China's out-size export dynamic is at risk... the Asian growth dynamic remains highly vulnerable to an external shock.' (p302)

In the case of Stephen Roach's earlier articles no reversal of his view was expressed when they were collected together and published, after June 2009, in The Next Asia.

Bill Emmott, in his book The Rivals, similarly argued: 'The onset of a global economic slowdown, an unsurprising consequence of the financial crisis in America and Western Europe, was initially expected to leave China and India fairly unaffected... The view that Asia could "decouple" itself from the rest of the world soon proved too sanguine. It could never truly have done so, given the trading links between East and West. But even more than that, the sudden slowdown in both China and India... exposed the economic weaknesses that were already present... A property boom turned to bust in China and, combined with falling exports, produced the possibility that China's growth rate could halve during 2009 from 2007's 13%, raising the prospects of social unrest. A difficulty in overcoming inflation in India, plus the drying up of the global liquidity on which big Indian companies had depended, made that country too look vulnerable, perhaps returning it to the 4-6% annual growth rates common in the 1990s.' (pxxi)

It is possible Stephen Roach and Bill Emmott, or supporters of their analysis, may argue that the current rapid growth in India and China reflects the fact that the world economy as a whole is no longer moving downwards. But the chronology does not confirm such a view. China's economic recovery began in the second quarter of 2009, at the worst point of the dip in international financial markets and as advanced economies were continuing to contract. It did so on the basis of stimulus package that raised both domestic investment and domestic consumption. A decline in China's net imports continued through the whole latter part of 2009 but its economic growth rate accelerated. While it is correct that the US trade deficit began to expand after July 2009, China's trade surplus continued to fall - that is the increased demand sustaining economic growth was not externally driven. India's economic growth was similarly driven by internal economic stimulus. In short China and India both showed themselves capable of 'decoupling'.

Naturally such a process of 'decoupling' cannot be absolute in the sense that China and India will be unaffected by developments in the US economy. But the emphasis of Roach's and Emmott's arguments, which stressed the limits of India and China's relative autonomy rather than its possibilities, and suggested that their growth would slow dramatically under the impact of a recession in the US, has been shown not to be correct.

StephenRoach has a justified reputation as one of the world's most most systematic economists -  I read every word of his I can get hold of. Emmott's The Rivals is similarly a highly interesting book - as are his other writings. But on the 'decoupling' their arguments have been shown to be wrong.

China's inflation threat - detailed data show price rises still primarily bunched in food and housing and parallels with India

Considerable international media coverage was given to China's 2.7% consumer price index (CPI) rise in February. This was justified. The trend in China's inflation rate has moved upwards from 1.5% in January and is being met by monetary tightening. As China is at present the world's most rapidly growing economy, with its increasing imports being a key driver of Asia's economic recovery, tightening in China will have international consequences. The inflationary pressures, as this blog has analysed earlier, are real.

Before any hint of exaggeration sets in however it is necessary to look at the detail of February's CPI figures. This shows that inflation is primarily being driven by increases in the price of food and, in second place, by housing costs. Most other elements of inflation in China remain subdued. This parallels a process taking place in India where higher inflation is also primarily being driven by higher food prices.

Looking at the detail of China's February CPI data the price of foodstuffs rose by 6.2% - undoubtedly a severe effect in a country where a far higher proportion of household expenditure goes on food than in a developed economy. Housing costs also rose by 3.0%. Both the need to avoid social discontent and those of economic rationality clearly require urgent government attention to be addressed to food and housing costs - which is undoubtedly a primary reason why the current meeting of the National People's Congress, China's highest legislative body, is chiefly focused on domestic issues.

However China's non-food prices rose by only 1.0% in February - clothing prices actually fell by -1.3% and transport and communication costs rose by only 0.1%.

Inflation also clearly did not cut into retail sales - which increased by 17.9% in January and February 2010 compared to same period in 2009. Purchases of consumer durables in particular soared - sales of building and decorating materials were up 30.5% year on year, household appliances up 31.7%, furniture up 36.3% and automobiles up 41.7%.

What conclusions follow from this situation?

First, evidently, that the fight against inflation requires serious action in the spheres of food and housing. It is necessary to take measures to squeeze inflation in these sectors and prevent inflationary trends spreading to others.The Chinese government is clearly well aware of this. It is arguable that its overall 3% inflation target for 2010 is too tight, the IMF recently released a paper suggesting an international norm of 4% and rates of 3-5% have historically not been unusual in rapidly developing economies, but clearly food inflation is too high and housing has significant upward momentum.

Second, it confirms again how correct China was to increase domestic demand in 2009 by expanding both investment and consumption. If China had followed the advice of some analysts and only raised  domestic consumption, without the greater capacity and efficiency produced by increased investment, it would face more widespread capacity constraints and therefore greater inflationary pressures.

Third, this pattern of inflation gives a further reason why both China and India are stepping up the priority given to investment in rural areas. In China the economic stimulus package gave preferential treatment to household purchases in rural areas and government officials from President Hu Jintao and Prime Minister Wen Jiabao downwards have been stressing the need for increasing investment in rural areas. On a recent trip to India the crucial priority to investment in rural areas was stressed to me by Amir Ullah Khan, dean of the Bangalore Management Academy, and other Indian experts. This is undoubtedly required by wider considerations but is reinforced by the inflation pattern in both countries.

The pattern of inflation in China and India, the abandonment of reliance on 'trickle down' as an approach in both, and the emphasis being given to rural investment shows important parallels in both economies.

US trade deficit - trend to widening continues

The official press release on the publication of US trade data for January concentrated on the shrinking of the monthly deficit between December 2009 and January 2010.(1) Coverage in the Wall Street Journal similarly referred to 'the narrowing trade gap.'

This analysis shows that it is misleading to use single month's figures without looking at wider data. It is clear that the trend of the US trade deficit is widening again significantly and January's figures were a normal fluctuation within this. This is shown in Figure 1, which charts monthly data for the US trade deficit, and Figure 2 which shows the monthly data calculated as a three month moving average in order to remove the effect of purely short term fluctuations. Both show that since May 2009 a clear and significant trend of widening of the US trade deficit has occurred - reversing the earlier improvement that took place after July 2008.

Figure 1

Figure 2

Taking figures the monthly US trade deficit reached its narrowest point at $25.8 billion in May 2009. It widened to $37.2 billion by January 2010.Taking a three monthly moving average the monthly US trade deficit reached its narrowest point at $27,0 billion in June 2009. By January 2010 it had widened to $37.8 billion.

The fundamental trend to widening of the US trade gap is therefore clear.

Notes

1. Its first sentence read: 'The U.S. Census Bureau and the U.S. Bureau of Economic Analysis, through the Department of Commerce, announced today that total January exports of $142.7 billion and imports of $180.0 billion resulted in a goods and services deficit of $37.3 billion, down from $39.9 billion in December.'

China's trade surplus continues to shrink - confounding critics of the 'Asian growth model'

China's February trade statistics confirmed the continued shrinking of the country's trade surplus.

Even more significant than the monthly data, which received wide press coverage, was the longer term trend. Figure 1 therefore shows the development of China's monthly trade balance, while Figure 2 shows the monthly data graphed as a three monthly moving average in order to remove the effect of purely short term fluctuations. Both measures clearly show the downward trend of China's trade surplus which this blog has been analysing since last July.

Figure 1

Figure 2

In terms of numbers China’s trade surplus in February was $7.6 billion. However as the long Chinese New Year holiday fell in February in 2010, but in January in 2009, which significantly distorts monthly figures, it is better to take the combined January and February figures for yearly comparisons. This year the combined January and February trade surplus was $21.8 billion. This compares to $44.0 for the same months in 2009 – a drop of 51%.

Calculating the monthly trade figure as a three monthly moving average, which automatically removes the distortion produced by the difference in the Chinese New Year holiday, the February 2010 surplus was $13.4 billion compared to $27.6 billion in 2009 - also a 51% fall.

These facts of the shrinking of China's trade surplus combined with simultaneous rapid GDP growth refute the analysis of writers, such a Professor Michael Pettis of Beijing University and others, who argued China was dominated by the wrong paradigm of an 'Asian growth model' in which recovery could only take place on the basis of a surge in net exports. China in 2009 and so far this year has been able to switch into an economic mode primarily powered by domestic investment and consumption growth. In this model rapid  economic growth can be combined with a shrinking trade surplus.

'Win-win' and 'lose-lose' policies on China's trade

In late February China's Ministry of Commerce held a press conference notable for its coherent outline of current thinking on key parts of China's economic strategy. The press conference dealt with trade issues more systematically and in accord with the facts than a number of foreign critics of China's economic policy.

The Ministry of Commerce explained why it is opposed to an early increase in the RMB's exchange rate. There are arguments for revaluation that other sections of the Chinese government may be considering. One is the struggle against inflation – which revaluation could help by cutting import prices. Since foreigners are not privy to how the Chinese government resolves issues of economic policy, Jim O'Neill of Goldman Sachs may be right that "something is brewing" regarding the exchange rate. But if there are arguments for revaluation, they are unrelated to trade.

China's exporters have not fully recovered from the international financial crisis. Taking a three month moving average, China's monthly exports peaked at $136 billion in September 2008. In January 2010 they were still 13 percent down at $118 billion.

The statement by the Ministry spokesman that exports "cannot reach pre-crisis levels for two to three years" may be pessimistic – it will probably take two to three years from the previous peak, rather than from today, for exports to recover. But the exporters are clearly facing unused capacity, inability to spread fixed costs resulting in pressure on profitability, and other problems.

An increase in the RMB exchange rate would slow the recovery of exports. From China's viewpoint, therefore, avoiding a premature revaluation is justified – particularly as the dollar, to which the RMB is pegged, has risen recently under the impact of the Greek crisis and other factors.

Of course other countries cannot be expected simply to judge issues from China's viewpoint. If there is to be a "win-win" outcome, to use a favoured Chinese government phrase, others must also gain. And on this point, of how to reduce China's trade surplus and how this is benefitting other economies, the Commerce Ministry outlined its position very coherently.

Ministry spokesman Yao Jian noted that China's trade surplus has shrunk significantly – by 35 percent in 2009. Taking a three month moving average, the monthly surplus fell to $17.2 billion in January 2010 from $39.4 billion in January 2009. The 2009 surplus was $190 billion compared to $290 billion in 2008 – transmitting a $100 billion increase in net demand to other economies.

Asia's rapid recovery from the crisis compared to other regions is in significant part due to the stimulus provided by the net rise in China's imports. It will strongly aid the international recovery if China's trade surplus continues to decline.

RMB revaluation would clearly, in the short term, have the opposite effect. While there is disagreement among economists regarding the long term consequences of revaluation for China's trade surplus, there is little doubt that the short term effect would be to increase the surplus.

This is because revaluation means export prices increase and import prices fall. As it takes time for demand to adjust, the initial effect would increase China's trade surplus – this is a mirror image of the well known "J curve effect" whereby if a country devalues, its trade deficit initially widens as import prices rise and export prices fall. In the present international recession, even a short term increase in China's trade surplus, the recent shrinking of which has been a significant source of world demand, is among the least useful things imaginable.

If China's exports continue to recover, and an RMB revaluation would increase the trade surplus in the short term, the only way to continue reducing China's surplus, as Yao Jian says, is to take "measures to stimulate imports." This however requires rapid economic growth.

China's imports rose faster than exports in 2009 because its economy grew more rapidly than others. While other markets stagnated or declined, China grew at 8.7 percent, and sucked in imports. The most effective way to maintain the import surge is rapid growth.

Here trade intersects with domestic economic policy. The most immediate threat to growth in China is inflation. Inflationary capacity constraints, of physical plant and labour have already emerged – and public concern about inflation led Premier Wen Jiabao to devote part of a recent internet Q & A to it.

Fortunately China's 2009 growth pattern puts it in better shape to deal with inflation than if it had followed some of the advice it was offered. Many commentators who called for revaluation also favoured expanding domestic consumption, but not investment – citing the threat of "overcapacity". If this policy had been pursued, China would be facing much greater inflationary capacity constraints – threatening economic growth and imports. Happily, China expanded both domestic consumption and investment. The increased capacity that resulted will allow faster growth than would otherwise have been the case, increasing demand for imports.

So a coherent strategy both from China's point of view and for creating a "win-win" situation means avoiding an early RMB revaluation. This will allow China's exporters to recover and avoid a short term increase in China's trade surplus. Rapid growth is not just good for China but also boosts imports. And to make rapid growth possible without inflation China needs to boost domestic investment as well as consumption. Investment, in turn, boosts imports of machinery and equipment. Foreign countries should argue for China to maintain the existing RMB exchange rate in the short run, maintain rapid growth, and, to underpin growth, undertake high levels of domestic investment. This is the combination that will create a "win-win" situation.

By contrast, an early RMB revaluation would create a "lose-lose" scenario. It would hit China's exporters, lead to a short term increase in China's trade surplus, withdraw an economic stimulus in a recessionary international economic situation and, linked to reducing investment, would exacerbate inflationary capacity constraints.

It may be that other economic considerations, notably the fight against inflation, will force China into a premature increase in the RMB's exchange rate, but from the trade point of view, and that of international economic recovery, this would be undesirable. Not for the first time the Ministry of Commerce is notably more coherent than some of its foreign critics

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This article originally appeared on the website www.china.org.cn.

'Win-win' and 'lose-lose' policies on China's trade

I have a new article in my column on www.china.org.cn analysing China's current economic policy in particular in regard to exchange rates, growth and investment. Entitled '"Win-win" and "lose-lose" policies on China's trade' it analyses why China's current policy is more coherent, both from its own point of view from that of the international economy, than a number of its foreign critics who call for early RMB revaluation and cuts in China's economic growth and investment rates.