Recently Newsweek's Duncan Hewitt spoke to Nicholas Lardy, a leading commentator on the Chinese economy at the Peterson Institution for International Economics in Washington D.C., about the global financial crisis and its implications for China. As export growth slows, China faces renewed pressure to boost domestic consumption, and stimulate its service sector.  Several prominent Chinese economists at a recent conference organized by the Shanghai Academy of Social Sciences emphasized that China had relied too heavily on manufacturing in recent years.  Lardy went further by explaining how the export boom of the past few years, and the resulting over-investment in manufacturing, had had a significant negative impact on the service sector. He said low interest rates and an undervalued currency were two of the main culprits. Excerpts:

Hewitt: How serious is the imbalance between manufacturing and services in China, in your view?

Lardy: There’s increasing evidence that China’s whole growth pattern has been distorted over the past five years: the share of investment going into manufacturing has doubled – and that’s just official data. There are several complementary reasons for this: one is recovery from the last slowdown in late 90s, when the share of narrow manufacturing declined to just 15 per cent which is really low – now it’s up to 30%.  Also the undervalued exchange rate has increased the profitability of tradable goods.  More recently there’s also been the under-pricing of energy, which is significant.  We’ve also had an under-pricing of capital: if you can get a bank loan, the cost of capital is zero in the current environment - and that obviously favors capital intensive things over less capital intensive things, so it helps manufacturing.  For service industry the availability of cheap capital is not so important, but if you’re adding ten million tons to your steel capacity it’s very important.

But the Chinese government has talked a lot about reining in bank lending to cool the economy in the past couple of years – do you not believe that that was serious?

They have done some things, but the big state owned companies still seem to be at the head of the queue [for loans], so they’re still getting a disproportionate share of funds.

How serious an impact has this had on the service sector?

It grew from 21 per cent of GDP in about 1980 to about 42% by 2000-01 – but since then there’s been no growth of its share of GDP, in fact by last year it was actually down 1% from its peak.  In other words the economy as a whole has been growing at ten per cent or so, but services have grown at, say, eight per cent.  If you look at other [developing] countries with a GDP of US$2,000 to 5,000 per capita, and which are growing at a reasonable rate, they all have a service sector which is going up --though some, like India, have a service sector which is way too big in my opinion.

The government has talked a lot about boosting the service sector – but is it lacking in policies?

The State Council [China’s cabinet] has now put out two huge white papers about the importance of developing the services sector in the past couple of years, and they have targets for what they want to achieve.  Personally I don’t believe in ideal levels – I’m very strongly of the view that this is a market economy, and if you adopt [credit] policies that affect profitability rates you’ll see a big effect on investment flows and the structure of output.  So it should be market-determined, but that only works if you don’t have distorted prices or interest rates. It should depend on the structure of demand. 

But the way interest rates have been set means that interest income is going down: household savings have gone way up over the past decade, but the interest income they’re earning has gone down as a share of GDP.  I’ve estimated how much households would be earning if they were getting the same real interest rates they were getting in 2002: it’s not fabulous but at least positive, as opposed to the highly negative rates now.  We’re talking about between four and five per cent of GDP – so there’s effectively a huge tax on the household sector.  So disposable income is rising slowly and so is consumption demand - and a big chunk of that is services, so the demand for services isn’t there.

What’s the impact of all this?

It is a drag on the economy. They’d be much better off if they hadn’t built up these huge trade surpluses; if they had more consumption, welfare would be higher.  The problem hasn’t been so evident in the past five years as economic growth has been accelerating, so what’s not to like?  But my view is they have invested massive amounts in manufacturing that’s not going to be viable at an equilibrium exchange rate.  People on the economic panels at this conference say “We can’t have any appreciation of the RMB, firms are going bankrupt…”  Well of course firms are going bankrupt, because you over-invested in manufacturing.  The question is how do you get rid of this excessive manufacturing capacity as your currency appreciates and you get closer to something that’s sustainable?   A lot of firms that were making money at 8.28 RMB to the dollar are not making money at six point whatever. [note: currently the RMB is trading at around 6.8 to USD 1].

And they’ll make even less money when it gets to 5.5 or whatever the equilibrium rate is.  And the longer they put it off, the more resources are misallocated, and the bigger the adjustment costs will be.  But there are just so many people here [at this conference] who think you have to set your exchange rate to make sure that the least efficient firm is viable.  I think they’re making a huge mistake.  Manufacturing rose from 15 to 30% from the late 90s on; during that time the currency appreciated 30% and they did just fine. The problem was they left it fixed nominally to the dollar. In February 2002 the dollar started to depreciate, the RMB started too and they became fabulously competitive  - a surplus of 11.3% of GDP is absolutely unprecedented for a large trading country not focused on petroleum or diamond exports!

So you think China must bite the bullet on exchange rates if it’s to enter a new phase?

Yes.  Those of us who argue that they should allow more appreciation have to point out – and we don’t always – that this will not be painless: there are frictions in moving resources out of manufacturing into services, and a lot of the capital that was invested will not have a return, so it will affect the banking sector for example.

Would a currency appreciation have a positive impact on the service sector?

Yes, because when it’s undervalued it depresses profitability in non-tradable goods, in other words services.  The share of investment in services – including construction – is down 10% over recent years.  But I don’t expect much move this year on the exchange rate – and maybe they shouldn’t move so much now, because they’re losing external demand.  But one has to remember that exchange rates affect trade patterns a year or year and a half out – and at some point global growth will converge back towards long term potential and if China has not appreciated the exchange rate more a year in advance of that, they’ll face problems.  And also, what are they gaining by having two trillion dollars in foreign exchange reserves?  They’re losing massively, as the dollar depreciates. 

What’s your view of the outlook for the Chinese economy, and the challenges it faces?

My view is economic growth is likely to slow quite a bit this year: it’s already down 2.5%. Roughly half of that is due to the decline in external demand and the contribution of net exports.  It’s a little hard to figure out what the rest is due to, but I think it’s mostly a slowdown in domestic investment.  If you look at the numbers: the amount of new floor space put under construction in July declined by 3 percentage points, which is a gigantic turnaround, the first negative month in years. Normally it’s going up by 15 or 20 per cent.  So I think there’s a big policy challenge. 

A lot of people are saying we’ll just have an easing of monetary policy and everything will be fine, but I think that’s very naïve – I think when people’s expectations about housing prices change they’re going to sit on their hands rather than buy, it doesn’t matter what the banks say.  It’s what we’ve seen in the US for a year or more: increased availability of money for mortgages does not solve the problem, or is only a small factor if people’s expectations are that prices are going significantly lower.  And given the amount of ‘buy to let’ that’s gone on in China, they could have a very big adjustment. 

       And it’s not so clear what the government can do to offset this if there’s a further deterioration in investment. People say they can build more infrastructure - but if you talk to some people in Beijing they’ll tell you we’ve spent so much on infrastructure, and we’ve got excess capacity in electric power; rail still needs more investment, but they’ve built a lot of roads and electric power systems.  And the other thing you have to remember is that property investment is 10 per cent of China’s GDP – it’s huge, it’s bigger than in any [other] Asian country. And investment in infrastructure the last few years has been running at about 6-7% of GDP, so if the property sector falls off there’s no way that infrastructure can offset it.  If property investment goes down by a fifth, that’s two percentage points off GDP.  That’s the risk: a coordinated downturn in house prices across a wide array of cities, rather than just the kind of adjustment we’ve seen in places like Shenzhen that started earlier.