China, it seems, has avoided the much-feared “hard landing” following a period of overheating in 2003-04. This may be partially due to continued local enthusiasm for infrastructure investment and GDP expansion, which prevented demand from falling sharply when growth finally slowed down. But today’s soft landing is also due to the simple fact that the bubble never became too big in the first place.
Compared to the previous episode of overheating in the early 90s, when the official growth rate jumped to over 14% and inflation reached 22% in 1994, this time government reacted much more quickly and effectively to contain the heat. As a result, the overcapacity created in the investment boom was minimal, so the clean-up job was straightforward. What this shows is that, for policy-makers, the imperative is always to act swiftly to avoid time lags after making the right diagnosis.
While we may all agree on that point, the second lesson from China’s recent experience of macroeconomic management is more controversial: China still has to rely on some direct quantity controls (such as lending ceilings) and some administrative management (such as “industrial policies” and land-use approval policies). This might seem contradictory to market-oriented reforms, and could also lead to some negative consequences for economic efficiency.
China is on the way to market-oriented transformation. But the institutional change is a long-term effort, and the transition may take decades. Over this inevitably long period when institutions do not yet function fully as a market system, and many big players in the economy such as state-owned enterprises and local governments are still insensitive to market-based policies, measures especially designed for this situation need to be employed.
The deeper point is that what seems effective in the “objective” textbook (or developed) world may not be effective in the emerging market reality. For instance, when there are still some major players in the economy who contribute to the overheating and even fail to repay their debt principals, the effectiveness of interest rate adjustment must be limited.
Short-run macroeconomic management policy is predicated on institutional fundamentals, although all developing countries should make long-term efforts to reform their institutions (including privatization, financial liberalization, development of the rule of law, etc.) in order to lay down the conditions that would allow market-based policies to work properly and effectively.
Some may argue that the mechanism of business cycles would resolve all problems and
eventually create a market system. This may be true. But what kind of cycles are we talking about, and how long and how many cycles do we need to realize those ultimate goals? With an inefficient state sector, a fragile financial system, and minimal capacity of a first generation of private enterprises, it is so easy for China to run into all kinds of crises and to be marginalized in this era of globalization.
A 10-year recession in China without job creation and income growth, as happened in some other developing countries, could lock the country into an era of poverty, instability and backwardness for another two centuries. As a latecomer to the market, why shouldn’t a developing country like China harness the knowledge of the business cycle reaped from centuries of world history to avoid its pitfalls and therefore not repeat the same crises as developed countries experienced in the past?
Developing countries do not have many advantages aside from their backwardness as latecomers.
The use of administrative controls may slow down reforms or strengthen the unreformed old regimes. Such side effects are not insignificant, and are rightly thought of as additional costs of economic instability in a transition economy. But if the opportunity cost, i.e. the probability of economic crisis, is high, it is still worthwhile.
The real issue here is not whether a country like China should still use the non-textbook (market economy) means of macroeconomic management, but if it is making enough effort to reform during both the boom and bust periods, in order to create conditions for stability and the effectiveness of market-based policies. From this perspective, two major problems can be observed in China: first, reforms slow down during the boom time, as people often lose the sense of urgency when profitability improves; second, while non-market measures appear to work, particularly in times of emergency, people often forget or ignore the demands of price adjustments as a parallel measure to manage the dual economy.
China’s is still not a full market economy, but the market has been developing, and some economic agents in the economy, such as private businesses and private households, have become sensitive to the policy variables. That sensitivity is becoming an increasingly important factor for the economy as the private sector grows fast. But the Chinese government has been too slow to “allow” the policy variables (interest rate, exchange rates, tax rates, etc.) to vary.
Unchanged variables created distortions in a changed world and then led to protracted instabilities. This even created problems for the next phase of macroeconomic management. For instance, because the central bank failed to increase the interest rate during the boom, it will be short of means to boost the economy when it turns into recession, because it lacks the room to cut the rate.
The worrisome sign of overheating again reared its head in the first half of 2006. But the good news is that there is now more flexibility in key economic variables. For example, foreign exchange rate regimes reverted to a managed float, and two interest rate hikes occurred within four months (compared to once in two years during the 2003-04 period).
More reforms have also been on the way – the securities market finally started reflecting the changes in the macroeconomic climate after two years of efforts to make non-tradable shares tradable; and banking sector reforms are gaining momentum with first-stage outcomes.
All this may improve China’s economic performance in the next stages of development and reduce reliance on old policy instruments. But still, a dual-track policy operation should be and will be with us for quite a while, as China’s is likely to remain a dual economy for a long time to come.
For developing countries, vulnerability is sometimes associated with being too eager to adopt all the good things that have been created and seem wonderful in developed countries (not only the macroeconomic policies, but other things like social policies and the welfare system, for instance). These are goods that should be pursued as a long-term goal, but they may not yet be beneficial for China as the conditions for their success are still not yet in place.
Fan Gang is professor of economics at Peking University and Chinese Academy of Social Sciences, and director of the National Economic Research Institute, China Reform Foundation