Speed Isn’t Everything

China should take advantage of the approaching slowdown in its economy

China is facing an economic slowdown， which is likely to continue into the second half of the year. This is good for China’s overall economy， as its rapid growth in the past depended on an unsustainable bubble economy. The longer a bubble lasts， the worse the effect when it finally bursts. The country must prepare now for a slower growth rate， or face worse consequences in the future.

The current tightening in monetary policy will not sufficiently deflate the bubble. China’s current interest rate is too low compared to the projected inflation rate over the next five years. It should increase deposit rates by three percentage points as quickly as possible to prevent further inflation， or else it will continue to rise despite the economic downturn.

The slowdown won’t be painful， as exports， consumption， and infrastructure will likely keep growing. China has the luxury to pop its housing bubble without risk of a recession， because the dollar is weak. If， however， China loosens monetary policy again in the name of protecting growth， it will revive the housing bubble， increasing the adjustment needed in the future. Once the Fed tightens its monetary policy， the bubble will burst， this time not on China’s terms， which could lead to a severe recession.

The Slowdown has Begun

National electricity consumption dropped greatly in April， without a clear sign as to whether changing supply or demand was responsible for the fall. Meanwhile， exports in April rose by 29.9%， whereas imports were up by 21.8% compared to last year.

Many export companies have raised prices by 20% from last year. Hong Kong recently reported an 8% increase in the price of its re-exports. Given that retail sales are currently low in all OECDs， it is likely that price increases account for most of China’s export growth right now.

Furthermore， many businesses are struggling with financial problems， and local governments have been stranded in debt， unable to either sell land or acquire bank loans. At the same time， even though retail sales are seeing double digit growth， once inflation is accounted for， growth is less than that of the GDP. Considering how small and weak the household sector is compared to the government and business sectors， the former is unlikely to compensate for slowdowns in the latter. From these observations， we can logically conclude that we are facing an economic downturn.

A Healthy Slowdown

In the third quarter， the downturn may accelerate， as local governments and contractors abandon hope that the central government will loosen monetary policy again， and cut expenditures accordingly. When this happens， the growth rate of electricity consumption may drop below 10%， or even 8%. However， this should not be worrisome if economic efficiency is improving， as an 8% growth is enough to generate a 10% GDP growth.

Even though local governments will cut back on expenditures， they will still grow， only at a much slower pace. As of now， image projects account for much of local government spending. If financial constraints force governments to cancel such projects， it would greatly improve market efficiency.

The increase in export prices is also good news， as it boosts wages， which in turn increases consumption. With no competitor in the manufacturing industry at the moment， China can pass the increase in costs onto the global consumer through price hikes. This gives China time to address its inflation problem.

Meanwhile， China is welcoming a new generation of consumers with a propensity for greater consumption. As long as wages grow above the inflation rate， the consumer sector will keep growing.

Time for Change

China is in the midst of a large housing bubble. The Fed will raise interest rates above 5%， either due to inflation or to promote economic recovery. Although the timing is uncertain， this process could start in the second half of 2012. If China does not adjust accordingly before then， the dollar will rebound， causing vast amounts of hot money inside China to leave. A property crash will follow， leaving China in a very unfavorable economic state.

China can look to its neighbors for confirmation. Fifteen years ago， Southeast Asia was in a housing bubble， thanks to the weak dollar which ensured a cash flow into the market. When the dollar strengthened， the whole region fell apart because it never adjusted for the bubble， turning an economic crisis into a political crisis.

A popular argument against tightening monetary policy is that China must grow out of its problems， and that if growth slows down， many problems will arise. However， without taking action， these problems will only get bigger.

Another argument is that tightening is hurting small and medium-sized enterprises (SMEs). Without capital for growth， SMEs will take a hit in a down credit cycle， as banks gravitate towards large companies for safety. SMEs require inflows of new money to prevent them from going bankrupt. Inflation has made business difficult for SMEs the past three years. Most of them have cut capex and devoted themselves to speculation， pawning their factories to speculate in commodities， land， or stocks. If this trend continues， speculation could lead to more and more bank loans. However the struggles of the SME sector should not be an argument against tighter policies.

Tightening Is Necessary

Contrary to popular belief， a slowdown does not mean tightening should stop. Much of China’s inflation problem is due to excessive spending by the local governments and real estate sector. Without these excesses， however， inflation would be even higher， because the labor and energy markets have shifted in favor of inflation. Financial restrictions trigger necessary adjustments in the local government and real estate sectors.

China’s M2 doubled in the past four years， and its inflationary power has yet to take effect. The current M2 target of 16% is clearly above the potential growth rate of the economy. This indicates that it is still contributing to inflation， albeit less so than before.

China is entering a decade of double digit wage growth， and its energy sector is in a similar state. The price of coal is likely to rise greatly due to higher production costs and lower production increase. This means that 5% inflation in the long term is very likely. To prevent instability， deposit rates need to be raised above 5% as quickly as possible.

Controlling inflation is a long-term fight， a separate issue from adjusting the local government and real estate sectors. Tightening monetary policy should simply be seen as a means of restructuring the economy.

The Necessity of Slow Growth

Three decades ago， when China first opened up to foreign capital and trade， it was an underemployed economy. It underpriced its largely unused factors of production to increase its global market share， resulting in rapid growth.

Today， China is borrowing from the future to sustain its current production levels. It costs more than China’s foreign exchange reserves to clean up the environment. Not cleaning up， however， means sacrificing people’s health for the sake of the GDP. Then again， its only a matter of time until there is a massive health crisis， and when this happens， the government will shift its priority from growth to safety overnight. It would be better to make that change now.

Meanwhile， China’s labor market is facing a serious shortage in the blue-collar segment， and surplus in the college graduate segment. The latter can’t be solved by pushing growth， which only increases demand for blue collar workers due to the nature of growth. Only an economic rebalancing towards the service industry， and away from construction， could help unemployed college graduates.

Future growth depends mainly on productivity and raising capital. Up to now， China has experienced a total factor productivity (TFP) of 4-5% per annum. Maintaining this rate will be difficult， but by addressing the numerous inefficiencies caused by structural issues， it can be done.#8239;

China’s growth rate will likely slow from its current rate of 10% to 5% by 2020. This should not be troubling， as China does not need rapid growth anymore. Now that unemployment is low， the aim of economic growth should be to improve standards of living. When configured properly， 5% growth can bring about a big change in quality of life.

Finally， the economic slowdown could still make China the world’s largest economy between 2020 and 2022. With a 5% inflation rate， nominal GDP can still triple to USD 18 trillion by 2020， equaling that of the US. This is possible if China adopts a policy that leads to more sustainable growth.

Endurance， not speed， wins the race.