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The International Economy program aims to explain developments in the international economy, and influence policy. It does so by undertaking independent analytical research.

The International Economy program contributes to the Lowy Institute’s core publications: policy briefs and policy analyses. For example, the program contributed the Lowy Institute Paper, John Edwards’ Beyond the Boom, which argued that Australia’s transition away from the commodities boom will be quite smooth.

 

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Trump’s tariff antics as the TPP-11 is signed

The symbolism of last Thursday for the future of the global trading system was hard to miss. In Washington, Donald Trump authorised new tariffs on steel and aluminium imports of 25% and 10% respectively in one of the clearest signs yet that he plans on following through on his protectionist agenda. In Santiago, eleven countries, including Australia, gathered to sign the Comprehensive and Progressive Partnership for Trans Pacific Partnership (CPTPP or TPP-11), voicing their support for the opposite – a desire to open markets further and work constructively to modernise the rules of international commerce.

Trump’s new tariffs were always poorly conceived (by one estimate it will destroy 146,000 American jobs on net). Ostensibly, the policy is aimed at protecting national security and curbing Chinese imports in particular. In practice, it serves neither purpose well and will instead primarily hit US allies. Canada and Mexico got exemptions and the door was left open for others with a US “security relationship” to also seek exemptions, with Australia already securing this after intense government lobbying.

Yet sighs of relief should still be tempered for now. Although we are still some way from an actual “trade war”, the risks of escalating tit-for-tat protectionism remains high.  

After Canada, the EU is the second most important source of US steel and aluminium imports, at about US$7.3 billion a year. The EU is yet to get an exemption and has already drawn up a “hit list” of some US$3.5 billion in US exports for retaliatory measures. Trump said he would retaliate to their retaliation with tariffs of 25% on EU car exports. If this actually happened, it would be a big escalation – these exports are worth some US$40 billion a year.

The EU is of course hoping its status as a close ally will eventually earn it an exemption, though America’s trade deficit with the EU could be a sticking point (the US, by contrast, runs a trade surplus with Australia).

Meanwhile China will be little affected by the latest tariffs, so is likely to be more restrained in response. But the real risk emanates from the ongoing US investigation into technology theft by China. This will soon be completed and could lead to wide-ranging protectionist measures. Risks of a more damaging protectionist cycle following such a move are much higher, especially as China is unlikely to give in easily to US demands. Compromise will need to be found on both sides.

Trump’s antics also risk undermining the ability of the World Trade Organisation to play its role in keeping a lid on protectionism. The claimed national security foundations were always flimsy and risked setting a damaging precedent. But by linking exemptions for Canada and Mexico to a favourable outcome in ongoing North America Free Trade Agreement negotiations (favourable, that is, according to the flawed logic that trade deficits are inherently bad) it is now even more obvious that national security was never anything other than a convenient loophole.

The WTO itself would also be put in a precarious position should the case be referred to it. If it finds in favour of the US, it risks opening the protectionist flood gates on similar flimsy grounds. If it finds against, the WTO risks further aggravating the US, which is already putting significant pressure on its dispute settlement body by blocking the appointment of new appellate judges. Making matters worse, the planned retaliation by the EU may also violate WTO rules.

In this context, what should we make of the signing of the TPP-11 last week?

While the TPP-11 clearly lost the battle for the headlines, it is by far the bigger deal on the pure economics (that is, as long as a full-blown trade war is avoided). Lost exports amongst those affected by Trump’s new tariffs might amount to about US$10 billion a year, compared to around US$300 billion in estimated additional annual exports by 2030 for the TPP-11. Even this comparison overstates the relative importance of Trump’s tariffs, as a large share of lost exports to the US will likely be diverted to other markets.

More important, however, will be what impact the TPP-11 can have in keeping the agenda of open markets, international cooperation and a rules-based system alive, even as Trump’s America pulls back.

At the margins, fear of losing out through trade diversion may give others an incentive to join the pact and/or catalyse “competitive liberalisation”, in particular ongoing negotiations for the Regional Comprehensive Economic Partnership. However, the latter continues to move at a snail’s pace. Meanwhile, a number of countries at various points have said they are interested to join the TPP. But the agreement has also become far less attractive now that better access to the US is not on offer, while the political cost in terms of the deep and wide-ranging reforms required to join remain largely the same.

Without expanding membership and eventually bringing the US back into the fold, it will be difficult for the TPP to fulfil its other strategic objectives. Hopes of using the TPP to write the rules of international commerce for the region and using this to influence broader negotiations at the WTO are, for now, significantly diminished.

There is also little the TPP-11 can do to anchor US economic engagement in Asia and reassure Asian partners of American reliability, key overarching objectives of the original TPP. For that, Washington would need to rethink its protectionist and unilateralist agenda.

No urgency in cutting Australian corporate tax

Prime Minister Malcolm Turnbull returned from Washington last month even more convinced of the need for deep cuts in Australia’s 30% corporate tax rate, which is well above that in the US. Given the numbers in the Australian Senate, however, it is unlikely the proposed tax cut will pass.

How serious an issue is this for the future of the Australian economy? How long can any middle-sized economy hold out against a trend to lower corporate rates among its competitors?

As my Lowy Institute colleague Steven Grenville recently reminded us, because of the imputation system, corporate taxation functions very differently in Australia than in all other countries, except New Zealand.

The relevant issue is the impact company tax cuts will have on foreign investment in Australia. This is readily conceded in Treasury modelling, and has been pointed out several times by the Reserve Bank.

Somewhat surprisingly, given the rhetoric of the Australian Government and the Business Council of Australia (BCA), the numbers show that the relatively high nominal tax rate appears to have had no discernible impact on foreign direct investment in Australia. In the 12 months to the September quarter of 2017, the most recent quarter for which we have data, the flow of foreign direct investment into Australia was higher than it had ever been, and by a considerable margin.

At $79 billion, the inward flow was more than a tenth higher than the next highest 12-month rolling total, back in 2012. This is transactions data and comes closest to measuring the inward flow.

The stock of foreign direct investment in Australia has been similarly firm. At just short of $900 billion, in the September quarter 2017 the stock of foreign direct investment was 50% higher than it had been five years earlier, at a time widely regarded as the peak of the mining investment boom.

Throughout the period in which Australia has been discussing cuts to the corporate tax rate, and the government and the BCA have been warning of a sharp loss of international competitiveness, foreign direct investment in Australia has boomed.

If the corporate tax rate was such a disincentive to investment, one might expect Australian businesses to be eagerly putting their money into other economies with lower tax rates. Attracting foreign investment is, after all, said to be the motive for lowering corporate tax rates. But recently, outward direct investment has been unusually feeble.

The stock of Australian direct investment abroad in the September quarter 2017 was much the same as it had been two years earlier, and would have been markedly less were it not for the valuation effect of the cheaper Australian dollar. The flow of outward direct investment in the same period was $5 billion, or one sixteenth of the inward flow of direct investment.

It may be that Australia’s corporate tax rate is not as uncompetitive for foreign investors as the headline rate suggests. What really matters are the provisions for capital depreciation and other deductions. These account for a large part of the difference between the nominal tax rate and the effective rate, which is the actual rate paid.

In his Interpreter article, Grenville used Congressional Budget Office estimates of comparative rates to show that Australia’s effective rate is more competitive than the nominal rate suggests. Finance Minister Mathias Cormann prefers the corporate tax database of the Oxford University Centre for Business Taxation. In this database, Australia’s effective average corporate tax rate was 26.6% in 2017.

Of advanced economies, Japan, Germany, Spain, Belgium, and a number of others have somewhat higher corporate tax rates than Australia. New Zealand’s was a little more than one percentage point lower, and Canada three percentage points lower. The US effective rate was an enormous seven percentage points higher, but is now lower. The UK effective tax rate was far lower, at 18.5%.

On these numbers, the effective rate facing a foreign investor in Australia is a little higher than in New Zealand, Canada, and the UK, and a little lower than in a number of other countries.

But it is quite difficult to link the corporate tax rate with investment – either foreign or domestic. On World Bank data for the year 2016, Australia’s investment as a share of GDP was 25.5%, compared to 17% for the UK. Investment in Canada and New Zealand as a share of GDP was also below Australia’s, though both countries have somewhat lower effective corporate tax rates. The US, with a stellar effective corporate tax rate of 34%, nearly twice the UK’s effective rate, also had higher investment as a share of GDP than the UK in 2016.

It is true that tax rates are one of the issues affecting the level of foreign investment, and if corporate tax rates in competing economies continue to erode, Australia may someday have to cut its rates as well. But foreign direct investment, as well as overall investment, in Australia is actually very strong compared to economies with lower corporate tax rates. And we are yet to see the long-term consequences of financing corporate tax cuts by adding to fiscal deficits, which is what the US is doing.

At the very least, the strength of inward flows suggests there is no urgency in cutting Australian corporate tax. We could well wait and see, and in the meantime repair the Federal Government budget faster than we could otherwise. This might also give Australian policymakers time to think up cleverer and more discriminating ways to attract mobile foreign capital in its most useful forms.

Multilateral trade versus self-interest

How should countries respond to President Donald Trump’s tariffs on steel and aluminium? One response would be to retaliate. Another would be to emphasise the damage done to the global multilateral trade framework. Yet another would be to negotiate a side deal to avoid, and perhaps even benefit from, the distortion.

All three approaches have been evident since Trump’s announcement.

The European Union has taken the first course, with EU president Jean-Claude Juncker threatening to put tariffs on Harley-Davidson motorcycles and American bourbon imported into Europe. Of course, Trump fired back with a swift tweet threatening further measures (“we will simply apply a tax on their cars which freely pour into the US”). This tit for tat can escalate into a trade war, which Trump says is “easy to win”.

Germany, the UK, and Japan have taken the second course – reacting critically, but more in sorrow than in anger. They register disappointment but seek to calm matters, sometimes with an explicit renunciation of retaliation. The tariffs “raise deep concerns”, but “there is too much at stake”. A “proportional” response is needed. Playing for time by “seeking clarification” may allow the situation to calm.

China (the long-time target of Trump’s trade wrath) falls into this second group. Vice–foreign minister Zhang Yesui said that “China will not sit idly by”, but added explicitly that “China does not want a trade war with the US”.

Canada and Australia fall into the third group: critical of the tariffs’ multilateral harm, but mainly concerned about domestic damage and focused on obtaining a bilateral exemption. Canada has the most to lose, being the top exporter of both steel and aluminium to the US (the two economies are so closely integrated that America exports almost as much steel to Canada). Prime Minister of Canada Justin Trudeau said the tariffs “are absolutely unacceptable” and “make no sense”. As a close neighbour and security partner of the US, Canada is seeking an exemption.  

It’s said that all politics is local. Sticking to the second script is hard for politicians when there’s pressure to protect local industry by doing a special deal which would bring personal kudos and perhaps large advantages to the domestic industry. Australian Minister for Trade Steve Ciobo’s mention of multilateral trade was lost among the special pleadings for exception (here and here), based on earlier promises made by Trump. But it looks as though exemptions will be scarce.

To be torn between principle and practice is a familiar dilemma for Australia. In principle we are in favour of multilateral free trade, but in practice we eagerly pursue so-called Free Trade Agreements (FTAs), with their preferential arrangements.

Harvard economist Dani Rodrik’s recent paper, “What Do Trade Agreements Really Do?”, sets out what is wrong with FTAs. Why, then, do we put so much effort into these agreements? The answer is simple: when others are distorting the multilateral system with FTAs, a country can minimise the distortion (and perhaps even benefit) by climbing aboard the distorting FTA bandwagon.

Australia might have chosen a different balance of principle and practice here, making a strong public pro-multilaterist argument against the Trump tariffs while keeping our self-interested lobbying on a private track. That would avoid any suggestion of unseemly kowtowing to seek special favours. It would also minimise the political damage if the approach fails to obtain an exemption.

The long road back for the US to rejoin the Trans-Pacific Partnership

Tentative signs the US may have been adopting a more sensible view on trade have been dashed by President Donald Trump’s recent decision to impose tariffs of 25% on steel imports and 10% on aluminium imports.

Hopes that Trump’s protectionist views were mellowing were kindled at Davos in January when he hinted that the US might consider rejoining the Trans-Pacific Partnership (TPP) trade agreement. In February, US Treasury Secretary Steve Mnuchin said the US had held talks with TPP members about what it would take for the US to rejoin the deal. This statement followed a letter to the President, signed by 25 Republican senators, urging the US to rejoin the trade agreement.

Another positive sign that the US may have been moving away from protectionist rhetoric was the annual Economic Report to the President, prepared by the Council of Economic Advisers. Released on 21 February, the report stated, “trade and economic growth are strongly and positively correlated”. Notwithstanding Trump’s scepticism about the World Trade Organization (WTO), the report also stated:

The United States gets better outcomes via formal WTO adjudication than negotiation, increasing the probability that the complaint will be resolved and decreasing the time it takes to remove the barrier in question.

Even on the North America Free Trade Agreement (NAFTA), which Trump described as “the worst trade deal ever made”, the Council of Economic Advisers said, “Studies suggest the existence of net positive gains from NAFTA for US GDP and employment”. As Matthew Goodman from the CSIS observed, there was hope that views on trade in the White House were evolving in a positive direction.

Yet Trump’s decision to place levies on steel and aluminium imports has squashed such expectations. In contrast to the pro-trade comments in the report from his Council of Economic Advisers, after imposing the tariff on steel and aluminium imports Trump tweeted:

When a country (USA) is losing many billions of dollars on trade with virtually every country it does business with, trade wars are good, and easy to win.

As one commentator later rightly observed:

There’s a lot to unpack in Trump’s tweet, but the overall message is pretty clear: The president doesn’t seem to have a full grasp of what’s going on here.

When Mnuchin said the US had begun talks with other countries about rejoining the TPP, Australia’s Trade Minister Steve Ciobo cautiously welcomed the news. His caution was wise because, even before Trump’s imposition of tariffs on steel and aluminium, it would have been a hard slog for the US to rejoin the TPP.  After Trump’s announcement, the prospect is very unlikely under this administration.

As the largest market economy in the world, the US was the driving force behind the original TPP agreement. But following Trump’s decision to withdraw from it, and efforts of the remaining members to continue as “TPP-11”, the US is no longer in the driving seat in any negotiations. The remaining 11 members will have to agree to the US rejoining.

The qualification in Trump’s comments at Davos was that the TPP would have to be renegotiated, and the US achieve a “significantly better deal”. The irony is that the US drove the original TPP negotiations, pushing for provisions only reluctantly agreed to by many other members who would say the original TPP was a “good deal” for the US.

Following the US withdrawal from the TPP, the immediate reaction was that the agreement was dead. However, the eleven members remaining, led by Japan and with strong support by Australia, were able to keep most of the TPP agreement in place under a new name, the Progressive Comprehensive Trans-Pacific Partnership (PCTPP), and with a number of provisions suspended. The suspended provisions were mainly those driven by the US, including rules governing copyright, patents, and pharmaceuticals – issues very close to the heart of US business, but controversial for many other TPP members. The PCTPP was described as the “Trans-Pacific Partnership with fewer bad bits”.

While the suspended provisions can be unsuspended if the PCTPP members agree by consensus, this would not be sufficient to entice the US to rejoin. Trump said the original TPP, which included the suspended provisions in the PCTPP, was a “potential disaster”, clearly suggesting he wants to renegotiate the whole agreement.

After a decade of difficult negotiations, it is unlikely the PCTPP members would be willing to accommodate a better deal for the US. The Chilean President, Michelle Bachelet, said the TPP cannot be redone to please the US; and Japan’s chief negotiator on the TPP, Kazuyoshi Umemoto, said renegotiating the agreement would be difficult given that it took months of intensive talks to revise the pact after Trump pulled out.

But it is very unlikely that Trump has any idea of what a significantly better TPP outcome for the US would look like. As we have seen on numerous occasions, Trump’s musings on policy issues are not the outcome of well-considered deliberations. The immediate issue facing the PCTPP members is not what it would take to entice the US back into the TPP, but how to avoid a disastrous trade war.

Trump’s tariffs: not a trade war, yet

Although widely portrayed as the opening shots in a trade war between the US and China, new US tariffs on steel and aluminium imports confirmed by President Donald Trump on Thursday clearly are not.

China’s steel exports to the US account for barely more than 2% of total US steel imports, and barely one eighth of Canada’s steel exports to the US. All up, China accounts for around 0.5% of the US steel market.

Nor is China a big exporter of basic aluminium products to the US. It has taken a one-fifth share of the US aluminium foil market, but the US Commerce Department is already taking action under anti-dumping rules quite separate from, and far more draconian than, the 10% aluminium tariff announced by the President.

China is moving to cut back on aluminium production, which is often inefficient, expensive, and polluting. As pointed out in an earlier article, China exports were also little affected by US actions against solar panels and washing machines announced in January.

It is not the trade war, yet. But the threat of one has been sufficiently real for China to this week send its top economic negotiator, Liu He, to the White House. On Wednesday, the Office of the US Trade Representative sent its annual report to Congress, and reminded us the Commerce Department has for many months been putting together a case against China’s treatment of corporate intellectual property. Whatever form the result takes, be it a proposal for sanctions against China or a US law making intellectual property transfers by US businesses to Chinese businesses difficult, the intent will be to slow down China’s race up the production chain into market-leading technologies.

That will not be easy. If the US hinders technology transfers, competitors such as Japan, Germany, the UK, and France will seize what opportunities they can to profit from US reluctance. After all, China these days is not only a big exporter of manufactures but also a vast and increasingly wealthy market. China is itself an increasingly successful innovator and is building the domestic capacity to become a technological leader.

As interesting and complicated as a discussion of intellectual property protections may be, it will not begin to address what Trump says is the big trade issue between China and the US: the size of the bilateral trade deficit. If the US wants to approach that through tariffs, it would be recklessly damaging to the US as well as China.

Unlike steel tariffs, which will only gradually find a way into higher US steel prices and higher product prices, punitive tariffs on China’s manufacturing exports would be immediately evident in every Walmart and Home Depot store in the US. This would be very unwelcome to the people who put Trump into office. China would respond in ways that hurt the US farming sector, another important Republican constituency.

Liu He’s assignment in White House discussions this week is to draw the US back into the bilateral economic consultations suspended by the Trump administration late last year. Australia is not the only country hoping he succeeds.

Central banks changing of the guard

Breaking tradition, President Donald Trump has not reappointed Janet Yellen to another term as chair of the US Federal Reserve. Elsewhere, central bank leadership is also in transition. What does this mean for central bank independence?

In America, where political appointments of senior bureaucrats are the norm, it is a well-established tradition that the Fed chair is reappointed for a second term, even when political affiliations differ. Ronald Reagan reappointed Democrat Paul Volcker; Bill Clinton reappointed Republican Alan Greenspan; and Barack Obama reappointed Republican Ben Bernanke.

The case for reappointing Yellen was strong. She is generally acknowledged to have done an excellent job, especially in restraining interest rate increases even as the economic recovery strengthened and unemployment fell below what is often regarded as “full employment”. It would suit Trump’s economic growth objectives for Yellen to be seen as a “dove”. Her deep experience would have been valuable as America negotiates the forthcoming “normalisation” (raising) of interest rates and unwinding of quantitative easing.

Thus, the failure to reappoint Yellen is taken by some as an indication that Trump will assert stronger control over the Fed. In discussing candidates before the appointment, the President said: “You like to make your own mark, which maybe is one of the things which is a little bit against her.” The fact that Trump’s appointee, Jerome Powell, is a lawyer is seen by some as leaving more room for politics, at the expense of economic analysis.

Central bank independence is a subtle issue in which personality is as important as technical expertise. Arthur F. Burns, well-qualified as an economist, is routinely cited as a malleable Fed chair ready to do the electorally motivated bidding of Richard Nixon. George H. W. Bush clearly expected partisan loyalty from his Fed chairman when he blamed Alan Greenspan for his election loss: “I reappointed him, and he disappointed me.”

Paul Volcker laid the foundations of US Fed independence with his 1980 “Volcker shock”, a stellar example of determination to put economics ahead of politics in setting monetary policy. To build on this independence, Greenspan was active across politics, holding weekly breakfasts with the Secretary of the Treasury and tirelessly socialising with members of Congress and the financial press. But if this reinforced the power of his position, it created another problem – Greenspan the infallible maestro, overconfident in his opinions.

Ben Bernanke and Janet Yellen have established a more modest, more inclusive independence based on demonstrated competence. Jerome Powell, who has been a member of the Fed board since 2012, can continue the tradition.

The Fed chair is powerful, but the composition of the board matters also matters. There are four vacancies (including the key vice-chair position, recently vacated by top economist Stanley Fischer). Marvin Goodfriend, Trump’s only nomination so far, would bring deep technical expertise to the position without any doctrinal baggage.

Perhaps the concern is less for monetary policy and more for financial stability. Trump’s appointment of Randal Quarles is a clear return to a less-regulated approach to prudential supervision. Some speculate that Yellen’s support for the post-2008 financial stability regulatory reforms was the main factor in Trump’s decision not to reappoint her.

The complexity of the seemingly simple idea of central bank independence is demonstrated elsewhere. Appointments to the European Central Bank board seem mired in politics, with national entitlements more important than competence or independence. This issue will become more acute next year, when Mario Draghi’s term as president concludes.

Again, the arguments of technical competence versus political shrewdness are illustrated by recent history. Jean-Claude Trichet was undoubtedly well-qualified technically (he had been governor of the Bank of France), but his misreading of the post-2007 crisis period is widely seen as a serious error, while Draghi’s astute call of “whatever it takes” to save the euro in 2012 was politically brilliant.

In the UK, the perception that the Bank of England (BoE) failed miserably in the financial stability challenges of 2007–08 saw an outsider, indeed a foreigner, brought to the governorship. But Canadian Mark Carney (and the BoE under his leadership) does enjoy a high degree of independence.

In Japan, Haruhiko Kuroda is expected to be reappointed as Governor of the Bank of Japan (BoJ). Kuroda’s closeness to Prime Minister Shinzo Abe has never been in doubt: he was appointed in order to implement the monetary policy element of Abe’s “three arrows reforms. If this seems contrary to accepted ideas of independence, its success neutralises any criticism. The BoJ’s pre-2012 policy of studied inaction provides the contrast: the bank might have demonstrated its independence, but at the cost of creating a reputation for being ineffectual.

Elsewhere in Asia, the separation of politics from policymaking depends, again, on personalities. In China, Zhou Xiaochuan is seen as an outstanding governor of the People’s Bank who has trimmed back inflation, reined in the current account surplus, and advanced the cause of economic openness at a good pace, with only a few missteps made along the way. All this within an institutional framework that gave him little room to manoeuvre.

Indonesia illustrates the same ambivalence about independence. After the disaster of the 1997–98 crisis, Bank Indonesia was granted autonomy modelled on the strict separation of the German central bank. This degree of assertive independence was a poor fit with post-1998 politics and one of the factors which led to prudential supervision being shifted from the central bank to a separate agency, in an unhappy outcome for overall financial stability.

What are the lessons learnt from these diverse experiences? Appointing the top central bankers is the legitimate prerogative of governments everywhere, and this presents a potential threat for independent monetary policy. While the tradition of central bank independence is relatively new, the idea has held firm, despite the disruptions to monetary policy since the 2008 financial crisis

China’s economic gloom merchants

Markedly slower growth and imminent financial crisis have been the common dual predictions for China over the past decade. China’s growth has indeed slowed from its unsustainable breakneck pace in the two decades before the 2007–08 global crisis, but since then has settled down to a steady 6–7% per year, two or three times as fast as advanced economies.

Keeping growth going through and since the downturn has, however, required a big increase in domestic credit, raising the risk of a financial crisis. Can China continue to confound the pundits?

This depends on the intertwined but distinct issues of growth and financial stability.

Let’s start with growth. Michael Pettis, a professor at Peking University, has been perhaps the most vocal and persistent pessimist. In 2012, when China’s growth had already slowed to around its current pace, he bet with The Economist magazine that China’s annual GDP growth this decade would “barely break 3%”. The decade is not quite over yet, but it’s looking like a clear win for The Economist.

If you are at risk of losing a bet, try changing the terms. Pettis has an impressively ingenious take on GDP. Unlike many others, he doesn’t dispute China’s GDP data as such. Instead, he notes that this only records “national output”. He says that much of this output growth has been wasted on unproductive investment, which should be written off. Pettis says that in market economies this happens, reducing GDP growth through lower profits.

This, however, exaggerates the difference between Chinese and Western GDP. China is hardly alone in unproductive investment and tardy recognition of poor investment. And if we mark to market for poor assets, consistency requires that we revalue assets whose price has risen: housing booms would produce spectacular growth in GDP. 

In practice, the imperfect answer is that good projects boost GDP over time through higher output and stronger profits, while bad projects erode GDP. Pettis’s argument is only one more reason why GDP is an imperfect measure of living standards. That acknowledged, it’s hard to offer a much better measure. It’s harder still to see how his estimate of current (corrected) growth of 1–2% could reflect China’s reality.

Pessimism about China’s financial sector probably peaked more than two years ago, with Tyler Cowens confident prediction of an imminent and massive financial collapse, resulting in a long recession. Although he’s a smart and innovative economist, this was a miscall.

Since then, bank lending to the non-finance commercial sector has levelled out, but the more comprehensive “total social financing”, including non-bank intermediation and government debt, is now approaching 250% of GDP and still rising. This is not unusually high by general international comparison, but is high for a developing economy and has grown much too fast.

 

Thus the IMF remains pessimistic: “International experience suggests that China’s credit growth is on a dangerous trajectory, with increasing risks of a disruptive adjustment and/or a marked growth slowdown”.

But China’s credit situation is different from other countries. It has little external debt, big foreign exchange reserves, and capital controls, so won’t have a crisis like the 1997 Asian crisis. The main overextended borrowers are state-owned enterprises (SOEs) which have mainly borrowed from state-owned banks, so the situation’s “in-house”, and hence easier to restructure. Government debt is modest, allowing fiscal space to soften a crisis. Unlike the 1997 Asian and 2008 global crises, Chinese authorities know in advance that there is a problem and are taking action. China could (and probably will) have a period of painful adjustment as policy stabilises the high debt levels, but a major meltdown seems unlikely.

What does all this mean for policy? The thrust of the Pettis’s argument is that China is saving too much. His answer is to encourage consumption. This makes sense and shouldn’t be too hard: most governments have to wrestle with the opposite and more intractable problem of keeping the public happy while restraining consumption.

Pettis is surely too pessimistic about investment opportunities, recalling China’s low per capita capital stock. One of the characteristics of heavy infrastructure is that it is sensible to build excess capacity initially: think of the Sydney Harbour Bridge, which reached capacity thirty years after construction. New Yorkers wish the Second Avenue Subway had been built ahead of demand when it was first proposed in 1919.

China has an opportunity to restrain credit without harming growth by limiting SOE borrowing, which was responsible for 60% of the rise in corporate debt from 2008 to 2016. The SOEs produce only 15–20% of industrial output. The special focus should be on the “zombie” SOEs, which account for nearly 15% of corporate debt. The often-mentioned rise in the ratio of credit-to-growth should be read as a positive rather than a negative: cutting back credit growth shouldn’t damage growth much.

Of course, restructuring SOEs and reining in local governments present vexed political challenges. The IMF’s suggestion that China should accept lower growth rates in order to limit debt growth seems to be mistaken logic. If a key reform is to restructure SOEs, slower growth will make this more painful, and therefore less likely. Fiscal expansion could soften the restructure. China should be able to maintain the 6–7% growth of recent years as it deepens capital and moves towards the technological frontier.

At some stage, probably a decade or more away, China will run into the same growth-constraining factors that slowed Japan and South Korea. But not yet.

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