IMF’s Latest Growth Forecasts for China Look Overly Rosy

The overriding consensus is that China is investing at an unsustainably fast pace. The symptoms include empty malls, shoddily built railways and ghost cities. This investment-led growth model can’t continue indefinitely. The debate for most analysts is not if China will slow, but when and by how much.

As a result, I was surprised by the IMF’s latest forecast that shows growth remaining quite robust over the next five years. China’s economy is expected to grow by over 9% annually in 2012-16, as shown below.

Figure 1:  The IMF sees real GDP growing at an average annual rate of 9.4% over the next five years

Source: IMF World Economic Outlook Database, September 2011

At the same time, the IMF envisages investment falling only slightly as a share of GDP to 46.2% in 2016 from an estimated peak of 48.7% this year. That implies investment will continue to grow strongly (at an average annual rate of roughly 8%) through 2016, even though most analysts agree that China is already over-investing, such that capital is being directed toward activities (eg. ‘white elephant’ construction projects) that are doing nothing to enhance the country’s productive capacity and long-term growth potential.

Figure 2: China’s investment to GDP ratio is far and away the highest among the big EMs, highlighting the economy’s reliance on investment-led growth

Source: IMF World Economic Outlook Database, September 2011

Figure 3: The IMF does not expect any significant shift from the investment-led growth model over the next five years

Source: IMF World Economic Outlook Database, September 2011

I can appreciate the challenges the IMF faces in developing its forecasts. In the same way that it was hard to put a date on when the US housing bubble would pop, it’s also hard to time China’s slowdown and its severity. Nevertheless, a forecast of steady, above-9% GDP growth through 2016 appears overly rosy, especially considering a recent IMF report where the institution acknowledges the risk that over-investment poses to sustainable economic growth.

“[C]ontinued high investment could, down the road and absent sufficient progress in rebalancing, create excess capacity, given uncertain demand prospects in advanced economies, thus risking a hard landing that reverberates beyond China.” (See IMF Country Report, July 2011, pages 5-6) In effect, the IMF appears close to contradicting itself. Very little movement is expected in the investment-to-GDP ratio over the next five years, meaning the IMF does not expect any significant rebalancing toward consumption. At the same time, the institution foresees growth holding steady over the period.

What is interesting is that even the 12th draft of China’s five year plan for 2011-15 stands in sharp contrast to the IMF forecast. The plan foresees GDP growth slowing to an average of 7% annually and targets a rise in domestic consumption.

What Do Analysts Think?

Most China watchers believe some sort of correction is unavoidable, although they do not necessarily see a slowdown as imminent. A number seem to think  the breaking point could come soon after 2013 – a year of transition in the Communist Party leadership.

Patrick Chovanec – an economics professor at Tsinghua University – sees a slowdown as inevitable. “China will have a correction, China needs a correction.” He notes, “There is a tug-of-war between those who say keep lending and let growth continue, versus those who are more concerned about inflation and want to rein it in.” This sounds like the typical battle of words before a bubble pops.

Michael Pettis – a Wall Street veteran and finance professor at Peking University – also sees a slowdown in the offing, but not this year or next: “[A]s long as the Chinese government retains its capacity to raise debt we are not going to see a sharp slowdown in economic growth – at least until 2013.  Any indication that the economy is slowing too quickly will be met with a relaxation of credit controls, and the concomitant rise in investment will spur growth. “

Nouriel Roubini – the New York-based economist who correctly predicted the popping of the US housing bubble – is one of the brave souls to put a date (at least sort of) on China’s slowdown. He sees the bubble bursting after 2013, which is when the change in political leadership is due. “Once increasing fixed investment becomes impossible – most likely after 2013 – China is poised for a sharp slowdown.”

Chile: Latin America’s Wunderkind

Chile’s finance minister, Felipe Larraín, swung through London this week with a contingent of business people in tow to celebrate ‘Chile Day’ on June 27. The event was aimed at promoting the country as an investment destination. Given Chile’s strong institutions and envy-inducing macroeconomic performance, they certainly have a lot to celebrate. Mr. Larraín stopped by the London School of Economics for a public airing of his marketing pitch and managed to impress your resident blogger.

Why is Chile the economic envy of the region?

Highest sovereign credit rating in Latin America

• Fitch upgraded Chile’s rating to A+ in February 2011, citing the country’s ‘structural strengths’ and ‘very strong institutional framework.’

• Moody’s upgraded Chile’s rating to Aa3, the fourth highest investment grade, in June 2010, around the same time that it cut Greece’s rating to junk.

• Ratings agencies are notoriously behind the curve, but Moody’s move came as a positive surprise in the wake of Chile’s ‘financial resilience’ to the devastating February 2010 earthquake.

First South American member of the OECD

• Chile became the 31^st member of the OECD’s club of advanced economies in January 2010.

• In welcoming Chile, the organisation noted Chile’s  ‘prudent tax policies’ that gave it the leeway for stimulus measures to weather the global financial crisis as well as the country’s ‘groundbreaking’ pension reforms in the early 1980s.

Solid public finances

• The country has one of the lowest public debt levels in the world at less than 10% of GDP at the end of 2010. This is a sharp contrast from the lofty levels in most advanced economies.

• Chile needed $8.4bn in financing for reconstruction efforts after the earthquake. Officials showed an admirable political willingness to raise taxes – something the far-more-indebted US has shown no stomach for – as well as issue debt, rather than tap its sovereign wealth fund.

• The government issued a global peso bond for the first time in history in July 2010: US$520Mn in 10-years at a yield of 5.5%.

• Chile has a fiscal rule to help maintain fiscal discipline by insulating public spending from short-term copper price fluctuations and the business cycle. See this recent IMF paper on the rule.

Strong institutions

• Chile has the strongest institutional quality in Latin America and ranked 28^th out of the 139 countries surveyed globally in this category, according to the latest Global Competitiveness Index, due to transparent policymaking and low levels of corruption.

Balanced growth

• For a small open economy, Chile has surprisingly strong domestic demand. The ratio of consumption (private + government) to GDP in 2010 was 70%, which is in line with that in many advanced economies as well as with bigger emerging markets, such as Turkey.

• Consumption showed considerable resilience during the global financial crisis. As seen in the graph below, consumption is the only GDP component that has positively contributed to growth every year in the 2007-10 period.

Source: Banco Central de Chile

• Export-led economies, such as the Czech Republic and Hungary, where export-to-GDP ratios exceed 70% of GDP, are more vulnerable to downturns in world trade and contracted more sharply than Chile during the global financial crisis.

No impending danger of overheating or a sudden stop in capital flows

• Gross capital inflows are strong, at 16% of GDP in Q1 2011, but are driven by FDI, making the economy less vulnerable to a sudden stop in capital inflows. FDI is generally considered less prone to reversal than foreign inflows into equities and debt securities.

• Bank lending to the private sector – at around 10% y/y – is growing at a measured pace, much slower than in many other countries in the region (eg. Brazil, Colombia, Peru).

BUT….

Fate is largely tied to China

• Those who think a hard landing is on the way in China should be wary about Chile.

• Asked what an abrupt China slowdown would mean for Chile, Mr. Larrain artfully dodged the question and simply said he doesn’t expect such a scenario.

• China bought about a quarter of Chile’s exports in 2010 and Asia as whole accounts for about half of exports, a higher percentage than in Argentina or Brazil.

Source: Lecture by Felipe Larraín at LSE on June 29, 2011

Chile is still copper country

• The country’s exports are not very diversified and copper continues to dominate, leaving the economy vulnerable to any downturn in global demand for the metal.

Source: Lecture by Felipe Larraín at LSE on June 29, 2011