China Right to Set Lower Growth Target

By JOHN ROSS

THE reduction of China's 2012 growth target to 7.5 percent from the eight percent of recent years headlined the international media coverage of Premier Wen Jiabao's report to the National People's Congress. The announcement was greeted with falls on international stock markets – simultaneously reflecting China's economic weight and a misanalysis by international markets. But the lowered target, which is justified by the global economic situation, is only the tip of the iceberg of complex short- and long-term challenges China is facing in its economic policy.

Wen's report used the general formula – "to follow a proactive fiscal policy and a prudent monetary policy." In other words, the government will steer the economy through budgetary policy but will not launch major monetary expansions of the type used to deal with the 2008 international financial crisis.

This policy is explained by considering the weight of short-term economic risks. Currently all major developed economies are attempting to counter the aftermath of the financial crisis by electronically creating huge quantities of money. The Federal Reserve used quantitative easing and "Operation Twist;" the European Central Bank is issuing unlimited three-year low-interest loans to European banks to try to prevent the euro zone debt crisis from turning into a new banking crisis, and Japan's central bank is intervening to try to drive down the yen's exchange rate. Not all this "liquidity tsunami" – a term coined by Brazil's President Dilma Rousseff – will remain within the developed economies; it will spill into developing countries as well.

Some results of these huge monetary injections have already surfaced. Driven by the money flood, share prices in developed markets have risen, while simultaneously international commodity prices stopped their eight-month slide in December 2011. Even though commodity prices again dropped slightly towards the end of February – probably due to the economic downturn in the euro zone and slower growth in major developing economies such as Brazil – this may only be temporary. China's consumer price index, however, is closely tied to commodity prices. The high liquidity generated in the world's advanced economies creates international inflationary risks which, if they develop further, could undermine China's success so far in its attempt to lower inflation.

Meanwhile, China is bringing down housing prices, whose rise was an undesirable side effect of money spilling into the property market from the country's overall successful 2008 stimulus program. Large-scale monetary emission by China could reignite property inflation.

For China's general public, as in other developing countries, inflation is one of their worst problems. And against the backdrop of current global conditions, China would clearly be risking inflation with a new monetary stimulus to promote marginally higher growth. Instead, the right choice, taking the balance of risks, is the government's combination of accepting a slightly lower growth target and avoiding actions that would stoke inflationary pressures.

China's new growth mark also illustrates the fundamental relationship between its economy and the international business cycle. The superiority of China's economic policy is that when the global economy grows fast China expands even more rapidly; contrarily, when the global economy decelerates, China slows down less than others. But it is utopian to believe that China can be entirely exempt from fluctuations in the international economy.

If major monetary expansion is ruled out, any significant economic stimulus must be budgetary, i.e. fiscal – hence the formula: "a proactive fiscal policy and a prudent monetary policy." From the international economic viewpoint, these short- term policies appear well judged.

The difficulties arise in longer-term economic measures, not primarily in Wen's report but in some commentary and lack of numbers on some key issues.

There is a resurgence in disguised form in some commentary of the fallacy that "prosperity can be achieved by sharing out poverty." But this time this error is being promoted not by the "leftist" circles – of the type that supported this fallacy prior to China's 1978 economic reforms – but by certain pro-market economy currents. In economic terms the view is that the key to increasing Chinese people's living standards is increasing the proportion of consumption in GDP.

The fallacy of this argument can be simply shown. International studies show GDP growth is by far the most important factor in consumption growth – 90 percent of consumption increases are explained by increases in GDP. China's per capita GDP is approximately one tenth of the U.S.'s. Therefore, if China's share of consumption in GDP were raised to the same level as the U.S., the average income in China today would also be merely one tenth that of people in the U.S – which is definitely not prosperity! Only by a prolonged period of more rapid economic growth than advanced economies can China achieve the living standards of developed economies.

But econometrics shows that the most important factor in economic growth, and therefore consumption growth, is investment. As an economy develops, its growth relies more – not less – on investment. The reason China has the world's fastest-growing GDP, and therefore the fastest growth in consumption, is because it has the highest level of investment. While short-term consumption boosts can be correct, reducing China's rate of investment to the global average would lead to its growth rate of both GDP and consumption falling to the average. If that is the case, China's consumption will never achieve that of developed economies. The goal, therefore, must be the most rapid sustainable increase in consumption, not the highest percentage of consumption in GDP.

Sustainability also relates to the key issue of environmental protection. This also requires high investment. A non-polluting, non-carbon emitting power plant is more expensive than a polluting one, reforestation requires extensive investment, etc. The focus of investment must certainly be shifted away from heavy polluting industries, but radically reducing China's overall level of investment will lead to less, not more, consumption growth and reduced environmental protection.

But the latter are crucial medium-term matters. China must first address short-term issues for its economy, and the immediate growth target of the government is in line with not only domestic but international economic conditions.

John Ross is a visiting professor at Antai College of Shanghai Jiao Tong University. From 2000 to 2008 he was director of economic and business policy in the administration of Mayor of London Ken Livingstone. He previously served as adviser to several major international mining, finance and equipment manufacturing companies.