China’s administrative approach to fiscal tightening is not working and it must now use more traditional tools to fight inflation and hasten its transition to a consumption-led economic model, says Morgan Stanley’s non-executive Asia chairman Stephen Roach.
Addressing the media in Hong Kong, Roach suggests inflation is the biggest single risk to the country’s successful implementation of its 12th five-year plan.
He notes that consumer price inflation in China has jumped from zero a year ago to 5%, adding that administrative tightening measures are proving ineffective as a means to stem this rise.
“The policy is not working because it is too administrative, matching credit and increasing bank reserve ratios,” says Roach. “Traditionally we attack inflation by counter-cyclical policies such as a sharp appreciation of the currency or a sharp increase in interest rates.”
Roach reckons that the 6% short-term benchmark lending rate is too low, against inflation of 5%. He agrees that a one-time renminbi appreciation is not in the best interests of China or, in fact, the rest of the world.
But he adds: “By ruling out currency inflation, there is only one instrument left, which is monetary policy. The PBoC [People’s Bank of China] has raised interest rates three times in the last four-and-a-half months, but the rates are still not high enough. The real interest rate needs to go up to 2-3%, from the current 1%.”
He suggests that China’s annual GDP growth of 10% provides it with an ample cushion to risk the adverse impact that higher interest rates would have on economic growth. Once inflation is under control, China will be able to carry out its 12th five-year plan with greater ease.
But Roach urges China to implement this plan quickly, given the strong likelihood that external demand from the US, Europe and Japan is going to remain weak in the post financial crisis era.
“China is restructuring its economic model [from investments, exports and manufacturing] to one driven by the services industry and internal private consumption,” says Roach. “It could well be the greatest consumer story that the world has ever seen.”
The strategy to build such an economic model needs to be built on “job creation in the services sector, wages in rural China, and a social safety net to reduce the excessive precautionary savings”, adds Roach.
He also points out that if China reorientates its economic growth model from manufacturing to services, it does not need to grow as fast as it did in the past.
From 2000 to 2008, China recorded a double-digit GDP growth rate that was envied the world over, but its growth in employment was just 0.5% over the same period.
China has substituted labour, which was needed to boost productivity and drive its old manufacturing economic model, with capital. “You don’t generate more jobs per unit of GDP, you need more units of GDP to absorb surplus labour to maintain social stability,” says Roach. “This is not sustainable.”
According to Morgan Stanley research, the number of jobs per Rmb1 million of GDP generated by the services sector is 19.6, compared with 14.2 for the manufacturing sector.
“The new service model is a totally different approach in which you don’t need so many GDP units to absorb surplus labour,” Roach notes. “This is the answer for China: more balance, more services and more labour-intensive economic growth.”
The 12th five-year-plan heavily endorses the services sector, including wholesale and retail trade, distribution, supply chain and logistics, domestic transportation, hospitality and leisure.
“China’s footprint in all these areas is tiny and it has to build these industries quickly now,” stresses Roach. “This is a big boost for job creation, to absorb surplus labour that comes in through rural-to-urban migration.”