Former People’s Bank of China adviser warns on China imbalances
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Former People’s Bank of China adviser warns on China imbalances

Former monetary policy official Yu Yongding calls on the Chinese government to turbo-charge its economic reform agenda, including financial market liberalization, in order to nurture a consumption-led economy.

In a wide-ranging interview with Euromoney, former Chinese monetary policy official Yu Yongding argues China’s export-led economy is rebalancing at a faster pace – from a still-low base – than the IMF, and the market, recognizes. However, “the longer the delay in the correction, the more serious will be the final reckoning”, he warns. In other comments, he argues China should speed up financial market reform and renminbi internationalization.

Recent data paint a mixed picture on China’s imbalances. Nevertheless, the share of national income going to households appears to have risen in 2012, compared with the relative weakness of household spending in recent years. Do you think this is a cyclical or structural rebalancing process and do you think the pace of adjustment is encouraging?

Yes, indeed, China’s imbalances have improved in recent years. However, it is far from satisfactory and no one is quite sure to what extent these improvements are structural and permanent. China’s imbalances include two aspects: internal and external. The former refers mainly to China’s extremely high investment rate and irrational investment structure. The latter refers to China’s large current account surplus.

However, for Chinese economists, external imbalances mean co-existence of current account surplus and capital account surplus. China has run the ‘twin surpluses’ persistently for more than two decade, which lead to China’s accumulation of more than $3.3 trillion foreign exchange reserves.

Compared with other components of aggregate demand, household consumption is most stable and the increase in household consumption tends to lag behind the increase in household deposable incomes. The changes in the share of household consumption in GDP are attributable to changes in consumption propensity and/or that in the share of household incomes in GDP. Though there is still a lack of firm evidence on the rise in household consumption propensity, evidence for rapid increase in wages and salaries is abundant.

According to the 12th five-year plan, from 2010 to 2015, the growth in minimum wages should be higher than 13%, significantly faster than the targeted economic growth of 7%. The progress in China’s reform of the social security system is also significant. The universal coverage of basic old-age insurance for rural as well as urban residents has been basically achieved. A medical insurance system that covers the whole population is emerging. Hence, it is very likely that household consumption propensity has also risen.

China’s falling current account surplus-to-GDP ratio also supports the proposition that structural progress has been made in China’s internal rebalancing. China’s current account surplus-to-GDP ratio has fallen from more than 10% in 2007 to 2.8% in 2011. Current account surplus implies excess savings, and vice versa, although the direction of causality is a debatable question. The 30%-plus of real appreciation since 2005 and factors such as rapid increasing in labour costs in exporting sector must have a serious impact on China’s rebalancing. The bankruptcy and upgrading of many enterprises in coastal areas are cases in point.

Though the market shares of Chinese exports seem to have held up quite well, this is attributable to Chinese exporters’ price-cutting in foreign markets and cannot be sustainable. As the largest manufacturer in the world, accounting for more than 40% of manufacturing products in the world, it is difficult to see how China can maintain the momentum of its export drive. It is expected that China’s growth rate of exports would be 7.2% in 2012. It is unimaginable that China’s surplus-to-GDP ratio will be able to rebound to the pre-crisis level in 2013.

In short, while not ruling out the cyclical elements, China’s rebalancing is more genuine – and more fundamental than IMF and many foreign observers recognized – though the pace of rebalancing, in my view, is still too slow.

Recent IMF data state that over-investment in China is equivalent to about 10% of GDP, with a large cost to households and SMEs, since the financial system favours large companies. The IMF says China’s over-investment gives it a one-in-five probability of an economic crisis, based on a cross-country regression. Do you agree with this assessment?

Yu Yongding was president of the China Society of World Economics. Source: World Economic Forum

I do not know how the IMF has reached this conclusion, but China’s over-investment is serious. There are lots of conceptual confusions in recent discussions on China’s investment. Many argue that China’s capital stock is low and hence over-investment is not a problem for it. This argument confuses three different concepts: capital stock, investment, and the growth rate of investment. This is equivalent of confusing distance, speed and accelerator in physics. Capital stock in China is certainly very low in comparison with developed countries. The contrast is even more striking when compared with capital stock per capita. The issue is not the level of capital stock and capital intensity, or the level of investment. The issue is the growth rate of investment that is persistently higher than that of GDP.

The investment rate now is about 50%. It cannot increase forever. The stabilization of the investment rate means the high growth rate of investment (14% to 15%) must fall to the level of growth rate of GDP (7% to 8%). Because the very high share of investment in GDP, the stabilization of the investment rate means a dramatic fall of the growth rate of GDP, unless other components of demand can increase more dramatically to offset the impact of the fall in investment growth, which is not very likely. Now over-capacity is prevalent. To eliminate over-capacity, the common practice in China is to create more capacity.

However, you cannot build more steel mills to absorb over-capacity of steel production forever. The longer the delay in the correction, the more serious will be the final reckoning. The rapid increase in investment also causes lots of problems in the supply side of the economy – the prevalence in waste, repetitive constructions and declining efficiency are cases in point. The very high leverage ratio of enterprises is becoming very worrying.

The consensus is that during the longer term China’s potential growth is set to moderate over the next decade as the economy matures, while inflation is likely to be structurally higher. What’s your view on China’s trend growth/inflation rate?

The consensus in China is that China’s potential growth rate will be lower in the next few years. For example, China’s 12th five-year plan set an indicative target for an annual average growth rate of 7%. In my view, the difficulty lies in how to slow the growth rate to something like 7%-plus, so that breathing space can be left for structural adjustment.

If China can accomplish the structural adjustment in a period of five years or so, its growth rate can pick up again, until its per capita income becomes comparable with developed countries. China should always vigilant about inflation, but in 2013, inflation should not be a big problem for China.

China’s new leadership has raised expectations for economic policy reform in 2013 but it’s not clear whether the administration will embark on new initiatives. Some analysts were left disappointed by the Central Economic Work Conference, since it lacked specific policy goals and a timetable for action. What are your views on the administration’s reform agenda?

We have to wait until after March 2013. By then, we may be able to see something specific and comment on it.

What are the priorities for financial market reform and in which order: a focus on interest rate liberalization; corporate access to financing; further progress on currency reform; and RMB internationalization?

The easiest task is the further liberalization of the exchange-rate regime. It seems that this is what China’s monetary authority is doing. China has made great progress in interest-rate liberalization via disintermediation and securitization. How to regulate and supervise the process of interest-rate liberalization is a very serious challenge to the PBoC and China’s various regulatory authorities.

RMB internationalization essentially is about capital-account liberalization. Hence the right question should be how China will pursue capital-account liberalization. My view is that capital-account liberalization should be conducted on a case-by-case basis. There is no point in pushing wholesale capital-account liberalization, no matter under what names. And RMB internationalization will be a natural result of the liberalization.

Do you think fiscal reforms are required to address income distribution problems?

Certainly. For example, property tax and inheritance tax should be levied. Capital gains tax should be introduced more widely. Tax codes for personal income tax and corporate income tax should adjusted. But because the shares of personal income tax and corporate income tax in GDP are small, the result of such reform cannot be very large. More work should be done in the expenditure side. The government should take more responsibility in providing decent public goods. The improvement in the social security system, medical care, education and so on will help to reduce the problem of inequity greatly.

When do you think full RMB internationalization will take place?

After the RMB has become fully convertible, but even this is just a necessary condition. By then, whether foreigners will be willing to use the RMB for invoicing, settlement and reserve currency is another question.

Yu Yongding was president of the China Society of World Economics, and a former member of the monetary policy committee of the People’s Bank of China.

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