Sunday, September 25, 2005
Myths and realities as the dragon's roar gets louder
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

All roads, it seems, lead to China, except the ones that go to India. Tony Blair told the cabinet last week that his visit to the two countries earlier this month had convinced him of the magnitude of the challenge Britain faces from these emerging giants. There will be a lot more of this from the prime minister and Gordon Brown at the Labour party conference in Brighton this week.

In Washington this weekend, China in particular is also hard to ignore. The International Monetary Fund, in its twice-yearly world economic outlook, revised up its growth forecast for China for both this year and next, to 9% and 8.2% respectively, while it revised growth down for euroland and, even more dramatically, Britain (now put at just 1.9% and 2.2%). The way China is growing, the IMF’s numbers look a little cautious.

China has been growing at an average rate of 9.5% a year for more than two decades. It is only recently, however, that its economy has been big enough to acquire critical mass — accounting for roughly a third of global economic growth over the past two to three years.

And it is only in the past 12 to 18 months that China has begun to contribute significantly to the global economic imbalances the IMF frets about. The “bra wars” trade dispute between the European Union and China was just the tip of the iceberg. Its trade surplus this year will be roughly three times last year’s figure of $32 billion (£18 billion).

China’s might is not in doubt. The Organisation for Economic Co- operation and Development says her economy is already bigger than two of the G7 countries, Canada and Italy, and will soon overhaul Britain and France. By 2010, only America, Japan and Germany will have bigger levels of gross domestic product — and in the case of Japan and Germany, not for long. By then China will have taken its place as the world’s biggest exporter.

If these projections do not convey the full story of China’s progress, how about these statistics? Since the mid-1980s the percentage of Chinese households with colour televisions has increased from 1% to 94%, the length of the country’s paved roads has risen from 38,000 kilometres to 208,000 kilometres (and is planned to treble over the next three decades), and the number of students in higher education has gone up from 2m to at least 15m.

There are more than 360m mobile- phone subscribers and there will be many more in the not-too-distant future. Yuwa Hedrick-Wong, economic adviser to Mastercard International, predicts a rise from 65m to 650m in the number of middle-class Chinese over the next 15 years.

China raises many questions. Let me deal with one of them: that sudden surge in her external surplus this year. China accounts for a quarter of America’s trade deficit. If Chinese-EU trade tensions have been evident in recent weeks, they are as nothing compared with the potential for trouble arising from China’s growing surplus and America’s seemingly intractable deficit. Add in political undercurrents — Washington is more protectionist than Brussels — and serious dangers loom.

But China’s growing surplus also exposes some enduring myths. The first is that China’s gargantuan appetite for oil, along with the hurricanes battering America, has been the prime factor driving crude prices higher, and explains why we should look forward to an era of permanently high energy prices.

In fact, what is notable about China this year is her limited appetite for imported oil. The Paris-based International Energy Agency expects Chinese oil imports to rise by 220,000 barrels a day this year, compared with a rise of 860,000 barrels a day in 2004. China’s oil companies, unable to pass on higher crude costs because of domestic price controls, have been restricting their purchases. Indeed, the trade surplus has been helped by exports of refined products from China to other countries.

Myth Number 2 is that China’s exports are all T-shirts, trainers and other low-tech (with apologies to Nike) products. Lehman Brothers points out that while textiles have been one of the drivers of the trade surplus, so increasingly have high-tech goods such as telecommunications equipment and computers. A fifth of the trade surplus is accounted for by such items, a reminder to the world of the competitive threat China represents up and down the value chain.

The third myth is perhaps the most enduring. It is that China is essentially just a low-cost location for assembling products for the rest of the world’s consumers. The trade surplus is therefore the logical result of this. In fact, as Hedrick-Wong points out, China is neither particularly dependent on exports nor on foreign direct investment. While exports are large, about 36% of gross domestic product, so are imports, 34%. The difference puts China in a very different position to, say, Japan during its phase of dramatic export-led growth two to three decades ago.

Foreign direct investment is important, because of the technology and practices it brings to China, the world’s biggest magnet for such investment. But only an eighth of all investment in China comes from abroad. China’s growth is mainly internally generated. A study by Professor Robert Lucas of the University of Chicago found that under the extreme assumption that China was cut off from foreign trade and investment, its growth rate would be reduced by only 1%-2%. not much of a worry for an economy expanding at a rate of 9.5%.

That, of course, is not going to happen. China will remain integrated in the global economy, despite protectionist pressures. That raises the question, in turn, about who is benefiting from this expansion. George Osborne, the shadow chancellor — following in the footsteps of Blair and ahead of a visit next month by Brown — has just been to Shanghai. He said that, despite the government’s rhetoric, Britain is being left badly behind in China by our European competitors. Food for thought.

PS Professor Steve Nickell of the Bank of England’s monetary policy committee had some fun last week with the house-price doomsters, resurrecting some of their 2002 and 2003 crash predictions. I won’t name names. He, like me, didn’t expect a crash then, and doesn’t now. Indeed, there have been tentative signs of a housing pick-up, although I wouldn’t read too much into them.

Nickell, delivering the Keynes lecture at the British Academy, gave four reasons why house prices have risen and why the market may not be overvalued. Some will be familiar. The first three were: the rise in the number of double-income households; reduced levels of housebuilding relative to demand; and low interest rates and inflation. The last allows larger loans relative to income, known in the jargon as solving the problem of front-end loading.

More important, however, has been the fall in long-term real (after-inflation) interest rates. Since 1997, real rates have dropped from 4% to under 2%. Other things being equal, he argued, this could justify an increase of up to 70% in the ratio of house prices to incomes.

Nickell examined what the Bank would have had to do to prevent the housing boom’s final phase, and concludes the MPC would have had to raise rates in 2002 by three percentage points. Instead of 4%, the rate would have had to be 7% and kept there. I have no quarrel with that. What I do doubt is his assertion that this would have cut economic growth by a mere 0.5 percentage points the following year. If that’s what the Bank’s economic model shows, no wonder it has been overestimating growth. Such a rate rise — bigger than since the early 1990s — would surely have tipped us into recession.

From The Sunday Times, September 25 2005


Dear David
re Nickell ribbing house-price doomsters, I recall the fate of those who called the bursting of the tech bubble too soon.... and the 1980's Japanese stock market and house-price bubbles. In each case, some folk had managed to come up with new-paradigm-why-it's-different-this-time rationalisations by the time the bubbles burst. What all this illustrates is that bubbles in financial markets can be identified with quite high confidence. The hard (if not impossible) job is to say exactly when the bubble will burst. Experience shows you can lose a lot of money (and your job too) by calling it too early or too late. All the best, Laurence Copeland

Posted by: Laurence Copeland at September 25, 2005 12:06 PM

Gordon’s “but wait, there’s more” speech was stirring stuff.

Well what he actually said was “And this year let us do more.” but the whole speech did come across rather like an infomercial.

He also said “last year a house price bubble ... In any other decade, a house price bubble would have pushed Britain from boom to bust”.

So it’s official then – it’s a bubble.

He went on, “And we will respond in the pre-budget report to the dream of young couples to own their own homes with our plan for 1 million new affordable homes … striving for Britain to be a home-owning, share-owning, asset-owning, wealth-owning democracy, not just for some but for all.”

A million is such a nice number. Gordon liked the word so much he used it fourteen times during his speech. Unfortunately, prudence didn’t get a single mention.

As for the million new homes, re-reading shows he’s only promising a plan rather than actual homes. But if by some incredible he manages to overcome the vested interests of the land-owning builders and councils he would then probably be thrown out of office by middle-class voters who know only too well what a million new affordable homes would do to existing house prices.

Good luck, Gordon. It’s a good trick if you can do it.

Posted by: David Sandiford at September 27, 2005 08:45 AM

For the answers to these questions and more:

1. Why did the US current account deficit start to widen sharply after 1997, reach such a high percentage of GDP, and yet has been relatively easily financed?
2. Why has Asia run such large current account surpluses and built up such a high level of international reserves?
3. Why did the world's central banks push short-term interest rates to their lowest level for a century, and why has this apparently easy monetary policy not led to an appreciable pick-up in inflation?
4. Why have bond yields been so low, and why have they stayed low even when short-term interest rates have been raised?
5. Against this background of wide payments imbalances, why have the margins for risk in corporate and emerging market debt been so exceptionally low?

See RBA Governor, Ian Macfarlane's speech to the Economic Society of Australia:

Posted by: David Sandiford at September 28, 2005 11:35 AM

If you take a look at per capita GDP in developed countries you will find that during last 55 years it was about $400 (2002 dollars) per year. This means that there was no any change of this value with time. Accordingly, relative per capita GDP growth was inversely proportional to the absolute value of per capita GDP itself => g=A/G, where g is the relative growth rate of GDP per capita, G is the per capita GDP, A is $400. Extrapolating this relationship one can find that the per capita GDP growth rate is decaying and has an asymptotic value of 0.
Now about so called China incredible growth rate. If to convert these fabulous relative values in absolute one can obtain a value of $350 achieved by China last year. Before it was much lower. It is a long time necessary for China to catch up European countries in the mean per capita GDP absolute growth.
There is no danger for Europe in China economic growth before they can manage to increase this value to $500 or $600. In the long run no one big country could manage to do this in past. Exception is small and dependent economies.
Even in the case if China will achieve this elevated absolute growth is future, Europe will have its $400 average annual increase as before. No signs of any influence of the global economic development on this invariant (fudamental) value are seen so far.
Can provide a more comprehensive paper on this issue.

Posted by: I.Kitov at September 30, 2005 10:42 AM