1. Impacts brought by over expansions of investment, credit, and foreign trade surplus
The above three problems in investment, credit, and foreign trade surplus are highly correlated. Below I will proceed from the investment rush to analyze the possible impacts these problems may generate.
(1) The consequence of the investment rush at present is not the pressure for inflation but the worsening of excess capacity.
Before completion of a project, investment is a demand. Generally speaking, rapid growth in investment may lead to inflation. However, the problem of excess capacity in China’s manufacturing sectors has been serious ever since 1998. As a result, even though the rapid increase in investment has resulted in quick price hike of some products relevant with investment, the prices of those products in other manufacturing sectors with excess capacity still keep dropping. Therefore, the price movement in this year will be similar to that in 2003, 2004 and 2005. The price trends of heated sectors and excessive capacity sectors will offset each other. As a result, the consumer price index and the retail price index will stay at a very low level. So the major problem brought by current investment rush is not the pressure for inflation but the deterioration of excess capacity as the investment after completion will turn into capacity.
(2) The trade imbalance reflects excess domestic capacity
This year, consumption increased very rapid in China. In the first six months, the total retail sales of consumer goods reached RMB3.65 trillion, up by 13.3% over the same period of last year, and actually increasing by 12.4% in real term after deduction of price index. At present, most sectors have excess capacities. The large trade surplus is a result of the large excess supply in domestic economy. In the first six months, foreign trade surplus increased continuously. In May and June, the current account surplus registered a record high of USD 13 billion and USD 14.5 billion, respectively.
(3) Excess trade surplus worsens domestic and foreign imbalances
By the end of this March, China accumulated USD875.1 billion of foreign reserves, overtaking Japan and becoming world No. 1. Under such circumstance, if trade surplus continues to increase, the following will be the likely consequences: (i) the pressure for RMB appreciation will increase. RMB speculation will be triggered. Some foreign direct investments, such as foreigners’ investment in real estate, are speculative. It will lead to more surpluses in capital accounts, thus increasing the amount of foreign reserves, further heightening the pressure for RMB appreciation and resulting in a vicious circle; (ii) China will meet with more international trade frictions and anti-dumping accusations. The environment of foreign trade relations will be worsened; (iii) the central bank needs to issue huge amounts of RMB to purchase the foreign exchanges in order to stabilize the exchange rate. That money supply increases the commercial banks’ funds available for investment loans. To the investment rush, such situation is as if oil poured on the flame.
(4) Macroeconomic policies are in dilemma
Under the condition of excess capacity, macroeconomic policies will face many dilemmas: (i) according to the principle of macroeconomics, the common method to control overheated investment is to raise interest rate thus increase investment cost. However, with excess capacity in the economy, the increase of deposit interest rate along with the increase of loans’ interest rate will bring down consumption, worsening the excess capacity. If the deposit interest rate does not increase, the margin between loan rate and deposit rate will be widened, thus stimulating banks to issue more loans. The results will go contrary to the original wishes of controlling investment growth. (ii) Excess capacity will stimulate exports, increase trade surplus, and intensify the pressure for RMB appreciation. Though RMB appreciation may reduce export, increase import, balance current account and lower appreciation pressure, the reduction of export and increase of import brought out by the appreciation will further worsen the problem of excess capacity.
(5) The phenomenon in real estate sector is abnormal
The over expansion of investment in fixed assets is reflected in both manufacturing and real estate sectors. Last March, the State Council issued “Eight Measures” to address the overheated investment in real estate sector. In 2005, the investment in real estate sector increased by 20.5%, down 5.3 percentage points from 2004, while it bounced back to certain extent during January and May this year, increasing by 21.8% over the same period of last year. Although investment in real estate sector has maintained high-speed growth and real estate supply is increased quickly in recent years, there appeared some abnormal phenomena: it is revealed by the China real estate climate index in May published by NBS (National Bureau of Statistics) that by the end of this May, the vacancy of housing in China reached 122 million square meters, up by 17.8% over the same period of last year and the vacancy of residential housing reached 67.28 million square meters, up by 15.9%. Normally, so much supply and so fast increase of vacancy should make the price of real estate down. However, the average sales price of housing in China rose by 8.9% during January and May over the same period of last year and that of residential housing rose by 11.3%. The price of residential housing is already very high and still keeps climbing up. Most residential properties tend to be big in size, resulting in contradiction in both structure and payment ability between the demand of ordinary urban residents for residential housing and its supply.
2. Reasons for over expansions of investment, credit, and trade surplus
The rapid expansions of investment, credit, and trade surplus on the one hand is the normal results of China’s current stage of development and on the other hand is attributable to the incomplete reforms in institutions and policies.
(1) Normal factors contributing to current rapid expansions in investment and credit:
Firstly, China is still in the early stage of industrialization. Even if the capacity is excessive, there is still a large room for upgrading industrial structure and technology. Therefore, there are many opportunities for high rate-of-return investments. Moreover, in view of the experiences in Japan, South Korea, Taiwan, Singapore, Hong Kong and other economies in East Asia, both residents and enterprises have a high saving propensity during the rapid industrialization stage. When there are both investment opportunities and sufficient funds, investment will naturally increase quickly. Such investment is an important mechanism to narrow China’s gap with developed countries in industries, technology and income level.
Secondly, since China started the reform and open-door policy in 1979, it has greatly strengthened the foundation in manufacturing sectors. Particularly, the manufacturing sectors in the Pearl River Delta and the Yangtze River Delta has formed many competitive industrial clusters, making numerous overseas export-oriented companies moved their productions and export bases to China. Meanwhile, China's huge domestic market also attracted enormous foreign direct investment aiming to tap China’s domestic market. The above foreign direct investments have not only driven up the investment and economic growth rate in China, but also enhanced China’s competitiveness in exports, accelerated import substitution, and increased foreign trade surplus and the accumulation of foreign reserves.
Thirdly, quick economic growth and continuous rise of per capita income level will fuel the demand for real estate. Therefore, the quick growth of investment in real estate sector also has its rationality.
The above factors are positive to the long-term development of China's national economy. While solving current economic problems, we shouldn’t hinder the functioning of these normal and reasonable factors.
(2) Existing problems in institutions and policies
Under the presence of huge excess capacity, the rapid expansions of investment, credit and trade surplus also reflect some problems in current institutions and policies:
Firstly, the banking industry is over concentrated. China’s financial sector is dominated by banking industry, while banking business is mostly in the hand of four major commercial banks. As a result: (i) SMEs, including those in service sector, can hardly obtain loans from banks. Generally speaking, SMEs have high return on investment and can most effectively increase employment opportunities. Normally, the countries and regions with well developed SMEs will have more employment opportunities, evener income distribution and higher household consumption propensity. By contrast, in China, the development of SMEs lags behind, resulting in less employment opportunities, higher inequality of income distribution, higher household saving propensity, and more deposits in banks as households have limited investment alternatives in China; (ii) large banks are born to favor large projects. The recent IPOs of state-owned commercial banks have brought them plentiful capital. Under the pressure of market competition, they pay more attention to profits. Moreover, the interest rate margin at present is very large. All these motivate large banks’ enthusiasm at providing loans for large projects and large enterprises. Since the start of reform and opening up, a few profitable industries emerged in turn like waves in every stage of China’s development. As a result, investment often concentrates on a few industries at a time, such as: automobile, real estate, building material and energy.
Secondly, the behaviors of local governments: The importance of GDP growth rate for the performance assessment of local government officials and the current production-based VAT spur local governments to try their best to encourage investments. In addition to “exemptions the income tax for two years and reductions of income tax for three years” and other preferential tax policies, the most obvious example is the reduction of land price. In order to attract foreign investments, local governments in some areas provide land free of any charge and even provide factory buildings for the investments. For every area, the local government will benefit directly or indirectly from the investments, but for the whole national economy, many of the investments are repeated and excessive.
Thirdly, foreign capital and foreign trade policies: in the initial period of reform and opening up, China lacked both capital and foreign exchange and was a typical dual-gaps economy. In the 12 years from 1978 to 1990, there were nine years with trade deficits. In order to solve the shortage of foreign exchange, Chinese government adopted a tax-rebate policy in 1985 to encourage exports. During Asian economic crisis, Chinese government did not depreciate RMB. In order to strengthen enterprises’ competitiveness in export, China once again strengthened this policy in 1998. Now the shortage of foreign exchange no longer exists. During the 15 years from 1991 to 2005, foreign trade deficit appeared only once in 1993, while in the rest 14 years, China’s foreign trade all had surpluses. However, China continues to use the tax rebate to encourage exports. Likewise, in the early period of reform and opening up, in order to solve shortage in capital, China adopted policy encouraging FDI in early 1980s. Chinese government provided many favorable policies to foreign invested enterprises, including “Two Exemptions and Three Reductions”. Their income tax is only a half as much as that of domestic enterprises. These policies have played positive roles and made China the second largest country in attracting FDI, behind only to the USA. Since 1994, large surplus was seen in both China’s current accounts and capital accounts each year. By the end of this March, China’s foreign reserves reached USD875.1 billion, ranking first in the world. It is predicted this figure will reach USD one trillion by the end of this year.
The structural imbalance of payments increases pressure for RMB speculation. As China is yet to liberalize its capital accounts, RMB can't be converted freely. In order to speculate the appreciation of RMB, the enterprises engaging foreign trade may legally speculate the appreciation by over pricing reports and under pricing imports and convert the over-reported trade surplus into RMB. This might be a key reason why China registered USD102 billion of surplus in current accounts last year and USD61.4 billion from January to June this year.
Fourthly, speculative demand for real estate: the investment in Chinese real estate sector has maintained a growth rate of 20~30% for years. This sector features a quick increase in supply, large vacancy rate, fast-rising price and dominance of large flats which are unaffordable to ordinary citizens. The overheated real estate investment has something to do with the practice that some local governments regard real estate sector as a pillar industry and reduce land price to attract developers. Normally, however, if supply increases rapidly, real estate price won’t go up continuously. This abnormal phenomenon has to do with the speculative demands of domestic and overseas investors: (i) for the rich Chinese people, if they make money in a county, they will buy houses in a city; if they make money in a city, they will buy houses in the provincial capital; if they make money in a provincial capital, they will buy houses in Beijing and Shanghai. Such purchase habit reflects that the level of development, culture and infrastructure is proportionate to political power in China. Among these non-local people, many of them regard house purchase as a kind of investment. Buying house and leaving them unoccupied is an element of speculative demand; (ii) China might be the only developing country without any restriction on foreigner’s purchase of real estate properties in China. Before 1998, China classified real estate properties into those sold to Chinese citizens and those sold to foreigners. After 1998, due to excess capacity and deflation, this classification was removed. Foreigner’s investment in real estate becomes a loophole before the opening of capital accounts. Some foreign investors speculate RMB appreciation, so they convert foreign currency into RMB and legally invest it in real estates. Such conducts on the one hand increased China’s foreign reserves and the pressure for RMB appreciation and on the other hand pushed up real estate prices. When RMB appreciates, the investors will cash in the speculative gains from real estate and convert the earnings into foreign currency. Both domestic and foreign speculators certainly prefer large houses and apartments. For this reason, real estate price hiked up continuously and developers are unwilling to build small flats that are affordable to ordinary people but have a small profit margin.
3. Policy Options
At present, China’s domestic production, finance and foreign trade are all in a relatively relaxing environment. China should make use of this good opportunity to solve some structural and institutional problems. However, it takes time to resolve long-standing problems. Therefore, in addition to long-term measures, it is necessary to take some short-term ones to maintain fast and steady economic growth.
(1) Control the heated growth of investment and credit
In a normal market economy, the government mainly relies on the policy of interest rate to adjust the growth of investment and credits. The preconditions for such a policy are a good credit culture of banking sector and the equilibrium in supply and demand in the economy. At present, the micro foundation for good credit culture of Chinese banks needs to be strengthened and most industries have excess capacity. In order to contain the heated growth of investment and credit, the central bank issued targeted central-bank bonds to commercial banks and increased commercial banks’ reserve ratio to lower bank's over-sufficient liquidity. Meanwhile, through window guidance, effort is made to strengthen examination of borrowing enterprises’ fulfillments of industrial entry policies and loan preconditions. These are necessary short-term control measures under the current circumstance and can be reinforced as per the actual situation.
(3) Alleviate the over concentration of bank loans on large enterprises
In a short term, the government should require commercial banks to observe relevant policies and strengthen supports to SMEs in loans. In a long term, the key is to develop regional small and medium-size banks to reduce bank concentration. Regional small and medium-size banks can more effectively support the development of regional SMEs, facilitate diversified investments, increase employment opportunities, reduce the propensity of savings and expand domestic demand. The “the 11th Five-Year Plan” passed by the NPC this March and the “No. 1 Documents” issued by CPC Central Committee and the State Council in recent years all have explicitly called for the development of regional small and medium-size financial institutions, including small and medium-size banks. The main task at present is to put this policy into practice by starting from pilot work.
(4) Reduce local government’s investment impulse
In a short term, the best approach is: (i) to control the supply of land for development; (ii) to strengthen the policy of “tender, auction and listing” to increase transparency in land transactions and to allow land price be set by market. In a long term, necessary policies and measures include: (i) transform production-based VAT to consumption-based VAT to reduce local government’s excessive investment enthusiasm for the purpose of tax revenues; (ii) forbid local governments to create unfair environment for market competition by means of tax exemption and reduction or attract investment through any policy against the principle of treating any enterprises equally; (iii) revise the performance indicators of local government officials, spurn GDP worship and redefine the evaluation and promotion system for local government officials according to the central government’s newly proposed scientific view of development.
(5) Reform the foreign capital and trade policies
In the initial stage of reform and opening up, the policies of attracting foreign capital and encouraging export played a very positive role in China’s development. However now it is the high time to reform them: (i) implement “the unification of taxes for domestic and foreign enterprises” to eliminate foreign invested enterprises’ preferential tax treatments; (ii) reduce, even cancel export rebates. The export rebate is a policy permissible under the WTO framework and widely adopted by developed countries, but in China, the trade surplus is too large and RMB is not over-valued. China can temporarily reduce or even eliminate the rebate according to the actual situation of each industry and in the future resume the policy if necessary.
(6) Damping the real estate speculation
Following rapid economic development, increase of people’s income level and increase of business activities, the demand for living and office spaces for residence and business will rise greatly. So, from the perspective of “use demand” for real estate, real estate industry should be supported to become a pillar industry of China’s national economy. However if the speculative demand for real estate is not checked, not only the normal “use demand” of majority residents and enterprises can’t be satisfied due to unaffordable price but also there is a risk of real estate bubble and financial crisis. In order to contain speculative demand, in addition to the “Eight Measures of the State Council”, the “Six Measures of the State Council” and the “Fifteen Measures” formulated by 9 departments including Ministry of Construction in which it is required to increase supply of small flats, raise the proportion of down payment and pay sales tax if a house is resold within 5 years, the following measures can be considered, too: (i) levy property tax. Owners of housing properties pay it by area annually; (ii) levy capital gain tax when a property is sold. The levy of capital gain tax helps inhibit real estate speculation. Besides, the rise of real estate’s price is the result of economic development in a society but owners’ efforts. Therefore, to return most of the benefit from the price rise of real estate to the society and use it to support local public undertakings is a policy of "one stone kills several birds”.
4. Reflection on macroeconomic theory under the condition of excess capacity
According to the neo-classical macroeconomic theories, including rational expectation theory, when investment increases too fast and foreign trade surplus is too large, the effective policy measures are to raise interest rate and to appreciate exchange rate and allow market forces to restore the balances of investment and foreign trade. This is the view held by many foreign macroeconomists and supported by many Chinese scholars. The precondition for this theory to work is that the economy is basically in equilibrium. Under an equilibrium economy, the fast growth in investment will result in an overheated economy. The rise of loan interest rate will increase investment cost and damp investments. The rise of deposit interest rate will reduce consumption. When investment and consumption are damped, economy will be cooled down and the equilibrium will be restored. Likewise, if trade surplus is too large and consequently the central bank increase too much money supply to pile up foreign reserves, bank’s liquidity will increase, interest rate will drop, investment and consumption will rise and economy will become overheated. Under such circumstance, if exchange rate is appreciated, export will decrease, import will increase, foreign trade surplus will drop and economy will resume equilibrium. The effects of such interest rate and exchange rate policies are realized through the marginal adjustments in investment, consumption and import and export brought by the policies.
However, if the economy suffers serious structural imbalance, the above marginal adjustment mechanism is unlikely to function. Taking China for an example, due to excess capacity as discussed before, the intention of controlling investment and reducing trade surplus through raising interest rate and appreciating exchange rate will make the excess capacity even worse. Similarly, in a developed country when there is a serious excess capacity and the economy is in a depression, the reduction of loan interest rate may not stimulate investment due to the lack of good investment opportunities. Meanwhile owing to the excess capacity, enterprises will either go bankruptcy or have poor performance and the employment condition will be bad. Under such a labor market situation, the reduction of deposit interest rate may not stimulate consumption. In fact, Keynesian macroeconomic theory was born in the Great Depression in 1930s, an era with serious structural imbalance characterized by enormous excess capacity.
From the Keynesianism, we learn that when the national economy suffers a serious structural imbalance, in order to resume its equilibrium, the government's direct intervention in the market is necessary. However even the Keynesianism is not completely suitable for China’s current situation. The precondition of Keynesian macroeconomic theory is a structural imbalance caused by seriously shortages in investment and consumption demands. The policy option in Keynesian theory is to use government’s financial policy to stimulate investment and consumption demand, thus drive the growth of national economy and the resumption of economic equilibrium. In China, the truth is that the investment rush in the past causes the current seriously excess capacity. However, even with serious excess capacity in the economy, neither the investment nor the consumption demands are weak. The challenges for the Chinese government are to control overheated investment, avoid the deterioration of excess capacity and stimulate domestic demand to restore the equilibrium of national economy.
Economic theories come from economic phenomena. China’s current macro phenomenon of excess capacity alongside with investment rush is unprecedented, so there isn’t any established theory that suits China's situation and can be used as a reference for macro policy. But all economic phenomena can be explained by economic theories. If there is no applicable theory at present, it means it’s a high time for theoretical innovation. To study macro-policy issues according to the characteristics of China’s current stage of development and the behaviors of local governments, banks, and enterprises in the transition process to a market economy can make contribution not only to China’s economic transformation and development but also to the development of macroeconomic theories.
