The Illusion of a Chinese Bubble

Shortly before that, China’s government acted to stop over-borrowing by local governments (through local state investment corporations), and to cool feverish regional housing markets by raising the down-payment ratio for second house buyers and the capital-adequacy ratio for developers.

This latest round of monetary tightening in China reflects the authorities’ growing concern over liquidity. In 2009, M2 money supply (a key indicator used to forecast inflation) increased by 27% year on year, and credit expanded by 34%. In January 2010, despite strict “administrative control” of financial credit lines (the PBC actually imposed credit ceilings on commercial banks), bank lending grew at an annual rate of 29%, on top of already strong expansion in the same period a year earlier. While inflation remains low, at 1.5%, it has been rising in recent months. Housing prices have also soared in most major cities.

These factors have inspired some China watchers to regard the country’s economy as a bubble, if not to predict a hard landing in 2010. But that judgment seems premature, at best.

To be sure, China may have a strong tendency to create bubbles, partly because people in a fast-growing economy become less risk-averse. Thirty years of stable growth without serious crises have made people less aware of the negative consequences of overheating and bubbles. Instead, they are so confident that they often blame the government for not allowing the economy to grow even faster.

There are also several special factors that may make China vulnerable to bubbles. China’s large state sector (which accounts for more than 30% of GDP) is usually careless about losses, owing to the soft budget constraints under which they operate. Local governments are equally careless, often failing to service their debts. In addition, various structural problems – including large and growing income disparities – are causing serious disequilibrium in the economy.

But a tendency toward a bubble need not become a reality. The good news is that Chinese policymakers are vigilant and prepared to bear down on incipient bubbles – sometimes with unpopular interventions such as the recent monetary moves.

Whatever one thinks of those measures, taking counter-cyclical policy action is almost always better than doing nothing when an economy is overheating. Whereas some policies may be criticized for being too “administrative” and failing to allow market forces to play a sufficient role, they may be the only effective way to deal with China’s “administrative entities.”

In any case, the new policies should reassure those who feared that China’s central government either would simply watch the bubble inflate or that it lacked a sufficiently independent macroeconomic policy to intervene. The consequences of burst bubbles in Japan in the 1980’s and in the United States last year are powerful reasons why China’s government has acted with such determination, while the legacy of a functioning centralized system may explain why it has proven capable of doing so decisively. After all, although modern market economics provides a sound framework for policymaking – as Chinese bureaucrats are eagerly learning – the idea of a planned economy emerged in the nineteenth century as a counter-orthodoxy to address market failures.

Some people would prefer China to move to a totally free market without regulation and management, but the recent crises have reminded everyone that free-market fundamentalism has its drawbacks, too. No one has proven able to eliminate bubbles in economies where markets are allowed to function. But if the fluctuations can be “ironed out,” as John Maynard Keynes put it, total economic efficiency can be improved.

Government investment, which represents the major part of China’s anti-crisis stimulus package, should help in this regard. Roughly 80% of the total is going to public infrastructure such as subways, railways, and urban projects, which to a great extent should be counted as long-term public goods. As such, they will not fuel a bubble by leading to immediate over-capacity in industry.

Moreover, roughly 40% of the increase in bank credit in 2009 accommodated the fiscal expansion, as projects were started prior to the budget allocations needed to finance them. Over-borrowing by local government did pose risks to the banking system and the economy as a whole, but, given China’s currently low public-debt/GDP ratio (just 24% even after the anti-crisis stimulus), non-performing loans are not a dangerous problem. Indeed, they may be easily absorbed as long as annual GDP growth remains at 8-9% and, most importantly, as long as local government borrowings are now contained.

Finally, the leverage of financial investments remains very low compared to other countries. Using bank credits to speculate in equity and housing markets is still mostly forbidden. There may be leaks and loopholes in these rules, but firewalls are in place – and are more stringently guarded than ever before.

So is a Chinese bubble still possible? Perhaps. But it has not appeared yet, and it may be adequately contained if it does.

The author is Professor of Economics at Beijing University and the Chinese Academy of Social Sciences, Director of China’s National Economic Research Institute, Secretary-General of the China Reform Foundation, and a member of the Monetary Policy Committee of the People’s Bank of China.

Copyright: Project Syndicate, 2010.
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