Is China s Economy Overheating?

We blast the air conditioning the entire way, and we never experience overheating.

And you might remember, some of you, how the cars were back then, and it was a common problem of overheating.

For example, if evidence of future economic strength makes a government worry about economic overheating and inflation, it might try to cool domestic demand by raising taxes and lowering government spending. If the government is only partly successful in preventing economic overheating, it might nonetheless appear to casual observers that austerity actually strengthened the economy.

Unemployment is down to 5 , with no signs of overheating. The employment cost index suggests that wage increases so far have been surprisingly low.

When, in late 2009, the investment intensive economy began to show signs of overheating, the government imposed strict macroeconomic controls, forcing investors to halt ongoing projects. Growth fell immediately.

Without that exchange rate adjustment, faster export growth would expose the Chinese economy to the risk of overheating. But, with the adjustment, Chinese consumers will spend more on imports and less on domestic goods.

I'm now supporting Stewart's position, softly, from a risk management standpoint, agreeing that the risks of overheating the planet outweigh the risk of nuclear incident, which certainly is possible and is a very real problem.

Since 2004, China s government has sought to cool an overheating economy by bringing the growth rate down from 12 to a more sustainable 8 9 . It even began to tax exports in order to reduce the trade surplus.

The price fall represents a return to more normal conditions after the overheating of the market in 2004, and reflects the fact that demand growth has slowed in most parts of the world while supply has continued to increase.

Postponing structural reforms eventually constrains any economy s performance, as we saw in Japan in the 1980 s and 1990 s. China has similar problems, with the investment growth nexus threatening macroeconomic stability witness the overheating that occurred in 2003 and 2004.

Since he became president in 2003, Hu Jintao has repeatedly warned that China s economy is overheating, and his government has recently acted accordingly, raising interest rates last October, imposing a new tax on home sales in June, and revaluing the Yuan in July.

Increased currency flexibility would allow China s central bank to use monetary policy to enhance China s financial and price stability. As Premier Wen Jiabao recently emphasized, China must now undertake comprehensive measures to control mounting inflation, growing asset bubbles, and an overheating economy.

BEIJING China s real estate sector has been a source of serious concern for several years, with soaring property prices raising fears of overheating in the housing market. But, with price growth easing, it seems that the government s campaign to rein in property risk is finally taking hold.

But claims that China is overheating don t seem to be based on observations of inflation. While China s consumer price index rose 5.3 in the year ending in July 2004, this was due primarily to a spike in food prices both before and since, inflation has been negligible.

At least two of the reasons for high and rising home prices in the United States are well understood. What remains highly uncertain, however, is whether an obviously overheating market can be cooled without sending America, and its main trading partners around the world, into an economic tailspin.

Nevertheless, by the end of October, M2 money supply had increased by 18.4 growing by 1.3 faster year on year, and exceeding the 16 target. By the start of 2008, it was clear that controlling inflation and cooling an overheating economy had become the government s main economic target.

The Keynesian prescription is simple If the economy is weak, fiscal policy should be used to stimulate it if it is overheating, spending cuts or tax hikes should be used to cool it down. Public debt levels will rise and fall, but policymakers should not pay too much attention.

Following a benign period of a positive global supply shock, a positive global demand shock has led to global overheating and rising inflationary pressures. Now the worries are about a stagflationary supply shock say, a war with Iran coupled with a deflationary demand shock as housing bubbles go bust.

International agencies recently issued warnings about speculative excesses in asset markets, suggesting that we should be worried about a possible crisis. In a speech in June, International Monetary Fund Deputy Managing Director Min Zhu argued that housing markets in several countries, including in Europe, Asia, and the Americas, show signs of overheating.

Instead, those who argue that the Chinese economy is overheating cite the high rate of investment in plant and equipment and real estate, which reached 43 of GDP in 2004. On this view, China has been investing too much, building too many factories, importing too many machines, and constructing too many new homes.

For example, we had no financial crises when central banks instructed commercial banks to limit their lending to particular economic sectors that they believed were overheating, such as real estate or consumer loans. The Chinese authorities do it today, and they also set the minimum deposits banks must maintain with the central bank.

Policymakers in many emerging market countries worry that surging capital inflows will drive up the value of the local currency, destabilize financial markets, and fuel economic overheating. Their reactions range from buying up the foreign money to prevent currency appreciation to adopting capital controls, and, in extreme cases, to keeping the money out altogether.

If allowing a currency to appreciate freely is costly, the second option is unsterilized foreign exchange intervention. This is effective in stemming upward exchange rate pressure, but it feeds the beast it exacerbates overheating in already fast growing emerging markets, causing inflation and leading to excessive credit growth, which can fuel dangerous asset bubbles.

This sharp balance sheet improvement has been instrumental in enabling emerging countries to bounce back strongly from the 2008 2009 global financial crisis, whereas the West continues to hobble along. Indeed, until the recent renewed downturn in America and Europe, the emerging world s major policy concern was too much growth, mounting inflationary pressure, and economic overheating.

China can purchase more industrial machinery, transport equipment, and steelmaking material, which are among its leading imports from the US. Directing spending toward imports of capital equipment would avoid overheating China s own markets, boost the economy s productive capacity (and thus its ability to grow in the future), and support demand for US, European, and Japanese products just when such support is needed most.

But the central government enjoyed a 28 increase in revenues over the last year, and has more than 3 trillion in foreign exchange reserves. In addition, the moderation of inflationary pressure as a result of slower growth and cooling global commodity markets will allow Chinese and other Asian policymakers to shift their focus from containing economic overheating to rebalancing growth.

BAHRAIN China watchers are waiting to see whether the country has engineered a soft landing, cooling down an overheating economy and achieving a more sustainable rate of growth, or whether Asia s dragon will crash to earth, as others in the neighborhood have before it. But some, particularly American politicians in this presidential election year, focus on only one thing China s trade balance.

BEIJING Even in the best of times, it is difficult for China s small and medium size enterprises to get bank loans. But with the current regimen of credit austerity, imposed to contain economic overheating and inflationary pressure, making conditions for SMEs worse, the financial sector the least reformed sector in China now is suffocating the beating heart of the country s economic dynamism.

One major factor driving the lackluster performance of investments in emerging markets is the expectation that the Fed will begin to raise interest rates and normalize monetary policy later this year. In a recent speech, Fed Chair Janet Yellen confirmed that such steps would be appropriate if the economy continues to improve, stating that delaying action to tighten monetary policy until employment and inflation are already back to our objectives would risk overheating the economy.

The problem is that there is no certain way to explain how people will react to such a policy change, to any signs of price overheating or decline, or to other news stories that might be spun as somehow important. We simply do not have much well documented history of big financial crises to examine, leaving econometricians vulnerable to serious error, despite studying time series that are typically no more than a few decades long.

The debate over how to value the yuan is at the heart of the two year struggle by the country s policymakers to slow down China s overheating economy. One response was the decision by the People s Bank of China to increase the one year interest rate from 5.31 to 5.58 its first rate hike in over nine years in an effort to curb fixed investment growth, staunch increasing prices, and offset a worrying decline in savings.