How to Handle an Overheated Economy

MEMORANDUM

TO: Wen Jiabao
Premier of China
FROM: Barry Naughton
RE: Cooling the Chinese Economy

As perhaps the best-prepared Chinese leader since Deng Xiaoping, you became premier 18 months ago set to preside over an ambitious reform agenda, impressive institutional development, and a major economic boom. You and President Hu Jintao positioned the government as supportive of the weak and disadvantaged, fair to ordinary citizens, and less tolerant of the corruption that permeates the ruling elite. Yet today, a wave of problems — from resurgent inflation and electricity shortages to wasteful investment and continued corruption — has swamped your carefully prepared economic program. Moreover, you’re bogged down in an effort to impose central government administrative controls over local governments. Your political rivals are taking potshots. What went wrong? How can you fix it?

Your term certainly started off well. You initiated policies to improve living standards in rural areas and began work on the financial sector reforms essential to restoring confidence in China’s banking and corporate governance systems. You also developed some of the regulatory muscle needed to manage the economy now that China has joined the World Trade Organization (WTO). Even the SARS epidemic last year was only a minor setback, because once you took charge, you handled the crisis effectively and with as much candor as possible. In mid-2003, economic and institutional reform seemed well on its way.

Fast forward to today’s discontent. There is no question that the economy is seriously overheated. Inflation is back. In July 2004, the consumer price index surged above the 5 percent "redline" for the first time in seven years. Rippling electricity shortages cause blackouts and inflict significant economic damage. Huge investments in real estate and popular industrial sectors generate useless capacity that threatens to sap the country’s economic strength for years to come. Your financial reforms are wallowing, and some may be on hold indefinitely. The almost weekly scandals in the financial sector are making investors nervous and sinking important deals.

At the same time, you are engaged in a wrenching program to slow down investment by scrutinizing existing ventures, restricting the volume of credit that goes to certain overheated sectors, and revamping land allocation procedures. It’s no surprise that these policies generate stubborn resistance from local governments. Economic conditions are therefore deteriorating in the midst of nasty conflicts among politicians and interest groups. Here is some advice for navigating this harsh environment:

Depoliticize the Economy: This is tough advice for politicians, because they thrive on the ability to distribute goodies to their supporters. But China is more politicized than other economies, and the last two years have shown how harmful that can be. In China, almost every investment involves a government decision, political influence, or semiofficial payoff. That’s the main reason the economy deteriorated so quickly. Today’s economic bubble began in 2001, when local officials initiated a spate of construction projects to showcase their achievements and to ease the leadership transition at the 16th Communist Party Congress in 2002. This "political-business cycle" accelerated as new leaders took office and committed themselves to another round of public and private investment projects. The abuses you have uncovered — such as the Tieben steel mill in Jiangsu, built with shady funding on land expropriated from peasants — are only the worst among many ill-advised economic interventions by local officials.

It’s tempting to respond by outmaneuvering the most corrupt politicians and shutting down the worst projects. But experience shows that you won’t overcome political interference in the economy by fighting with local officials and interest groups over each project, corruption case, or regulatory decision. Even a skilled bureaucratic operator such as you will be overwhelmed by the strategies of resistance that local officials have honed for decades, even centuries. The most you can do is grab opportunities to unleash economic forces, and then sit back and let them work. Market forces can punish the types of behavior you want to discourage and force people into line with your policies. The best policies are those that work at arm’s length: permitting competition whenever possible, allowing interest rates and exchange rates to alter prices, changing incentive structures, and privatizing.

Twenty-five years of economic reform in China clearly show that government-designed and politically calibrated reforms rarely succeed. Market-driven reforms, however, often work. They force systemic change by convincing actors that prices, opportunities, and the rules of the game have changed. You and your predecessor, Zhu Rongji, seem to have recognized as much when you pushed hard for China’s WTO accession, gambling that market forces would drive reform within the country. That gamble is already paying off. Now it’s time to take another risk by creating conditions that will curb politicians and local officials from meddling in the economy.

Don’t Use Red Tape to Slow Growth: Your current policy is designed to reduce investment in real estate, steel, aluminum, and several other overheated sectors. Bureaucrats are scrutinizing the tens of thousands of investment projects in the country. They have suspended many and are only gradually reauthorizing them. In other words, the central government is in the midst of a macroeconomic adjustment program to discipline local governments and their business clients. There are good reasons to improve regulatory oversight of local government land use and investment policies. But adjusting the country’s macroeconomic trajectory is not one of them. You are using red tape as a proxy for macroeconomic tools such as currency appreciation, interest rate changes, and spending cuts.

This strategy will not work. The interests at stake are massive and complex, and it is too easy to maneuver around the administrative controls. Perhaps if you were in a more powerful political position, you could use the bureaucracy to consolidate your own power, reward supporters, and penalize opponents. But you lack a strong independent power base, and you won’t win this kind of bare-knuckles fight. As soon as possible, get macroeconomic policy instruments working in your favor and shift the focus of administrative control to pure regulatory reform. Then declare victory — and get out of the business altogether.

Revalue Your Currency: Last year, a parade of visitors from the United States told you to let your currency appreciate, mostly for the wrong reasons. Appreciation of the yuan won’t reduce the U.S. trade deficit, and it is not your responsibility to make policy that benefits the United States. It is perfectly understandable that you resisted U.S. pressure, but it actually would have been better for the Chinese economy if the yuan had appreciated. Many of your problems are worse today because the yuan has been fixed to the dollar. A stronger currency would reduce inflationary pressures by making imported raw materials and foods cheaper. It would cool fevered investment in some dubious projects and sectors, as the reality of international competition becomes more apparent. In a highly open economy such as China’s, currency appreciation is an effective way to slow the economy.

Because Asian competitors would quickly imitate a revaluation of the yuan, your booming exports will probably not suffer as much as you fear. When you cut the yuan loose from its fixed dollar value, all the other East Asian economies — Japan, Taiwan, South Korea, and many others — will allow their currencies to float up as well. You will essentially allow the U.S. dollar to depreciate. You can use your significant foreign reserves (about $470 billion at last count) to intervene in the currency markets and ease the inevitable fluctuations.

A stronger currency would, of course, have some negative effects. It will make life tougher for farmers, because imported food will be cheaper. The western and northeastern regions of China will feel the pain most acutely. Regional inequality is one of your most tenacious problems, and you’ve staked a lot on improving conditions in depressed areas. If China had one currency for the coastal areas and a different one for the inland regions, the country’s policy choice would be easy: Allow the currency of the booming coastal regions to appreciate, forcing them to restructure, while keeping the inland currency fixed, allowing its population to benefit from lower costs.

Unfortunately, you don’t have enough policy instruments to achieve all of your objectives. Your limited flexibility is all the more reason to let yourself manipulate exchange rates. In truth, you can’t afford not to let the exchange rate cool the economy.

Cut Spending and Increase Interest Rates: Although you have only a few tools to achieve many goals, you are fortunate that right now all the major macroeconomic instruments can be — and must be — used to cool down the economy. Because all these settings should move simultaneously in the same direction, the magnitude of change in each policy can be modest. Government spending in China has grown dramatically for several years, and deficits have been running at 3 percent of gross domestic product annually. Interest rates are very low. The yuan is set at a level that is reasonable but tending toward undervaluation. A combination of small tax increases and spending cuts can quickly slice the deficit. Raising interest rates by less than a percentage point should also have an effect on overheated growth. Deficit cuts, modest interest rate increases, and yuan appreciation will combine to provide the macroeconomic impact you desire.

Privatize the Banks: For a decade, there have been worries about an impending financial crisis in China. In many ways, the crisis is already upon you. The government pumps hundreds of billions of dollars into the financial system, large companies and banks fail on an almost weekly basis, and the system remains far from secure. Bank privatization is your best option. You’ve started the process of selling stakes in the strongest state-owned banks: the Bank of China and the Construction Bank. They will be listed on the stock market, perhaps as early as the end of the year. It cost a lot to make them presentable to potential suitors, and it’s still not certain that they’ll land appropriate partners. But foreign banks are willing to pay a premium for access to the Chinese market, and many other investors are willing to put money into the financial future of the Chinese economy.

Permitting independent financial groups would be a momentous step for a system that the Communist Party has always controlled. Partially or fully privatized banks, with foreign participation, will bring new skills and resources to bear on China’s financial mess and create powerful constituencies for further reform. For this reason, independent financial groups make a lot of people nervous. And the privatization effort has not yet touched the worst problem: state and cooperative banks in rural areas. Those banks will require billions more to fix. But you cannot do everything. If enough of the financial sector can be made healthy, it can grow around the diseased parts. Don’t look back.

Expose Official Corruption (Even in the Family): You understand very well that resentment of official corruption is one of the most explosive elements of public opinion. Thus far, it has worked in your favor because of your clean image. So it is not surprising that your opponents started a whispering campaign against one of your family members, who is accused of improperly profiting from a recent financial transaction.

The rumor reflects the deterioration in the political climate into a nasty struggle over power and money. You cannot afford to let this situation fester. If there is any truth to the rumor, you must fix things immediately. If the rumors are false, aggressively confront them and put them to rest. Full disclosure should be your policy. Let the chips fall where they may. This approach will accrue to your political benefit in the long term. Greater transparency strengthens the forces pushing the Chinese economy in the direction it needs to go: toward more secure property rights, better regulation, and less government interference in economic decision making.

Count Your Blessings: The growth potential of the Chinese economy is extraordinary. Your gamble on China’s WTO membership is already paying off. The country is absorbing technology, know-how, and capital from the world at an unprecedented rate. China’s economic environment will tolerate many policy mistakes. Moreover, once you start using the economic instruments at your disposal, you will find you have more leeway, even if you will never be able to solve the problems in the poorest areas of the country. With all these advantages, you may be well positioned to complete two full terms as premier, preside over a successful economy, and even begin to make progress on a broader social agenda as well.