Home' Trinidad and Tobago Guardian : April 3rd 2014 Contents BG26 | THE ECONOMIST
BUSINESS GUARDIAN www.guardian.co.tt APRIL 2014 • WEEK ONE
Some economic journalists are like storm-
birds, coming alive when financial clouds
gather and the thunder rolls. My career has
been different. I have migrated away from
trouble, escaping crisis-struck Britain for
booming India in 2007, then leaving that coun-
try before it sank into its sad, stagflationary
funk. This will be my last week covering
China s economy; which may be a good thing,
given the whiff of ozone in the air.
This month China s corporate-bond market
suffered its first default since it began in its
present form, a widely watched manufacturing
index fell for the fifth month in a row and
officials in one eastern county rushed to placate
worried depositors lining up to withdraw
money from two small banks. It would seem
a good time for a fair-weather bird to fly away.
China remains a resilient economy, however.
It still has substantial room for error and a
great deal of room to grow. Although it is
already a vast economy---its US$9 trillion GDP
is bigger than 154 other economies combined---
it is not yet a rich one. Its income per head,
at market-exchange rates, is only 13 per cent
of America s and ranks below those of more
than 80 other economies.
Because China is already the world s sec-
ond-biggest economy, it attracts scrutiny that
smaller economies escaped when they were
at a similar stage of maturity. Observers expect
it to pass financial thresholds that other catch-
up economies did not cross until much later
in their development.
This month s bond default, for example,
represents a painful but necessary step toward
maturity for China s capital markets. Most
commentators saw it as a woefully belated
coming-of-age. Japan did not record its first
bond default until the late 1990s, however,
when its standard of living was 3.7 times
China s today. Likewise, back when South
Korea had the same income per person as
China enjoys now, foreigners paid little atten-
tion to its monthly manufacturing wobbles.
The heft of China s GDP, combined with
the modesty of its GDP per person, is one of
the curiosities of China s economy, but it is
not the only one. Another example is China s
"financial repression." Its central bank caps
the interest rate that banks can pay depositors,
imposing an implicit tax on their savings. In
China, however, unlike other countries, this
repression does not discourage saving. In fact,
it appears to do the opposite. The country s
households are "target savers," squirreling away
money to meet a fixed financial goal, such as
the down payment on a home. If their thrift
is poorly rewarded, they simply do more to
reach their target.
China s financial repression therefore has
proven surprisingly sustainable, although rest-
less depositors have sought higher returns
from online funds and wealth-management
products. It has contributed to China s remark-
ably high rate of saving, which reached more
than 50 per cent of GDP in 2012. This is more
than China can invest at home, obliging it to
export some of its saving, typically two per
cent to three per cent of GDP.
This incurs the wrath of its trading partners,
but therein lies a paradox. Even as China is
frequently lambasted for excess saving, the
same critics also accuse it of excess borrowing.
Worrywarts point out that credit in China has
increased from about 100 per cent of GDP
five years ago to about 135 per cent of GDP
today. The central bank s broader measure of
financing, which includes the bond market
and some areas of shadow banking among
other items, is 180 per cent.
How can an economy suffer from both
excess saving and excess borrowing?
This riddle is best answered with a textbook
parable. Consider a one-farm economy, which
yields a GDP of 100 ears of corn. The farmer
gives half to a field hand as wages and keeps
the rest for himself. The field hand eats half
of his wages and lends the remaining 25 ears
to the farmer. The farmer now has 75 ears of
corn. He eats 25 of them, plows 48 back into
the field as seed corn for next year s harvest
and lends two to a neighboring farm.
To an economist, saving means anything
not consumed. Therefore this economy, like
China s, has a remarkably high saving rate,
the 50 per cent of corn not eaten. This high
saving is combined with heavy domestic bor-
rowing, however: The farmer has added 25
per cent of GDP to outstanding debt. If, instead
of lending corn to the farmer, the field hand
ate it, saving would fall---because more corn
would be being consumed---and so would bor-
rowing, because the farmhand would be con-
suming his own earnings, rather than lending
half of them out.
Last year China s economy harvested more
than US$9 trillion worth of goods and services.
Almost half of that output consisted of new
capital goods such as infrastructure, housing,
factories and machinery. This investment rate
of about 48 per cent of GDP is among the
highest ever recorded. Some of this frantic
accumulation has been wasteful, building cities
without citizens and bridges without desti-
nations. It is as if the farmer scattered some
seed corn on stony ground, where it could
never take root.
This "malinvestment" is a pity, but it is not
enough to undermine China s economic future.
The country, as its critics suggest, should have
consumed these resources rather than squan-
dering them on ill-conceived ventures. If it
had done so, its people would be happier. It
is important to realize, however, that they
would not be any wealthier. Consumption,
like malinvestment, leaves no useful assets
behind. If the farmhand had eaten the wheat
his boss scattered on stony ground, he would
be better fed but next year s harvest would be
China s high investment has been financed
with plentiful credit. One further puzzle is
why this surge in credit has not resulted in
higher inflation. Investment adds to an econ-
omy s productive capacity, which eventually
will depress prices. To build the extra capacity,
however, firms must first hire workers and
buy materials. If carried too far, this will push
up wages and prices, adding to inflation.
China has escaped this fate partly because
a growing portion of its credit has been spent
on existing assets, including land and property.
Because these assets already exist, their pur-
chase does not make any fresh demands on
the economy s productive capacity. Buying
them does not add to GDP, which measures
only the production of new goods and services.
Nor does it push up wages or consumer prices.
It will, however, drive up asset prices. These
higher valuations can, in turn, raise people s
willingness and ability to borrow. In this way
credit and asset prices can chase each other
upward, without any immediate limit. It is as
if two farmers were to compete to buy the
same storehouse of grain, each offering ever-
Deflating this credit bubble is the trickiest
task China now faces. Stormbirds squawk
incessantly about a "Lehman moment," but
that disaster was only the second of three acts
in America s financial tragedy. The first was
an inevitable fall in house prices. The second
was a seizure in the financial system after
Lehman s bankruptcy, as financial interme-
diaries lost confidence in each other, and the
interminable third act consisted of a prolonged
shortfall in spending, as chastened banks and
bloodied borrowers licked their wounds.
China will suffer the first of these stages.
People will discover that they were not as
wealthy as they thought. China should escape
the second and third stages, though. Rather
than allowing banks to fail, the central gov-
ernment -- or even the central bank -- can
step in and take bad loans off their balance
sheets. Credit will stop growing as quickly,
but, since China s credit excesses added little
to GDP, unwinding them need not subtract
greatly from GDP. If a lack of lending or spend-
ing does threaten to drive output below its
full potential, the government can oblige banks
to lend and state-owned enterprises to spend.
This may seem too good to be true, but it
reflects the peculiar nature of China s excesses.
Asset prices may need to fall, but production
does not. China suffers from neither inflation
nor a big trade deficit. It is not living beyond
its means. It does not need to spend less, it
needs to spend differently.
For every sunset industry---steel, solar energy,
baroque apartments---that must contract, a
sunrise industry such as health care, logistics
or spartan apartments should expand. Oth-
erwise the country will fall short of its potential.
It must consume more of its harvest and invest
less of it, but it should still reap that harvest
Of course, it is not always easy to reallocate
labor and capital from oversupplied industries
to underserved ones. This is not a challenge
unique to China, however, nor is it unique to
this period in its history. The composition of
China s output, like every other economy s,
is always changing. In the past six years alone,
exports have fallen from 38 per cent of GDP
to about 25 per cent, and services have grown
from 42 per cent to 46 per cent.
China s excesses should also be kept in per-
spective. It has indeed accumulated more cap-
ital per worker than other fast-growing coun-
tries had at a similar stage of development,
but it also has many stages of development
ahead of it. Its capital stock per worker is only
about a quarter of South Korea s, for exam-
ple.As the economy grows, big problems tend
to diminish in its rearview mirror. In 1998 as
many as 40 per cent of China s loans turned
sour. Cleaning up the mess cost 5 trillion yuan,
or 58 per cent of China s 1998 GDP. China s
growth makes molehills out of mountains,
though: 5 trillion yuan now represents less
than nine per cent of its GDP. New production
quickly eclipses the old. Indeed, of all the
goods and services ever produced by the Peo-
ple s Republic of China, more than 30 per cent
were churned out in the four years since I
arrived in 2010.
On a prior visit to Shanghai, I enjoyed a
drink at Cloud 9, a bar at the top of the city s
then-tallest building. I recommended the same
bar to my wife a few years later, only to realise,
too late, that the tallest tower was no longer
the same one. Now Shanghai is conjuring a
third tower to overshadow the other two.
This new peak recently was scaled by two
foreign trespassers, who posted a video of the
climb online. The pair looked woefully ill-
equipped, but the view from the top was
breathtaking and a little gut-wrenching.
This feeling of being overawed, under-
equipped but well-rewarded is familiar to any-
one lucky enough to write about China s ver-
@2014 The Economist Newspaper Ltd. Distrib-
uted by the New York Times Syndicate
On cloud 9 trillion
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