China Raises Reserve Requirements to Fight Growth

The NYT reports that China finds itself in the rather enviable position of fighting to keep its already phenomenal growth rate from becoming excessive. So for the second time in just one month, the People's Bank of China has raised the requirement for how much of the deposits kept in major banks must be held in reserve. And changing the reserve requirements is not the only tool that China has been using to slow growth. China raised interest rates three times in the last year.

The problem China faces is that even with these adjustments, growth is unlikely to slow. China has a $46 billion trade surplus that doubled since just last year. And foreign investors have been pouring money in China's currency as they speculate that the government will have to let the currency strengthen. The stock market has been exploding, rising 130% in 2006 and about 40% so far this year.

Many intelligent people the world over have come to the conclusion that China's rise as a major economic power to rival and even surpass the United States is now a given. In this environment, the huge investments in China are justified, but they have bid down the expected rate of return well below the original potential of the market. The world is facing a level of capital liquidity that is completely unparalleled in history. This liquidity is ultimately a force for good, but a panic could turn this capital influx into an exodus.

The real question that most people are probably asking themselves is: "What's wrong with an economy that grows faster than 10% a year?" The straight answer is that there is nothing magical about growing that quickly that ensures the growth is the result of speculation and not underlying macroeconomic change. But growth of this magnitude has never been sustained before in human history. Economies that have been growing significantly more slowly have been gripped by speculative bubbles that sparked worldwide financial collapse. China treats 10% as the growth rate above which it chooses to be concerned, and with good reason. China's political structure is set up in such a way that continued economic growth is critical to social stability. If the economy stopped growing or even worse began to crash, the Communist Party would face troubles from the countryside that could loosen its grip on power.

Too much growth is actually more likely to cause economic woes for China rather than too little. A speculative bubble popping is the most likely bad scenario and China's steps are a reasonable movement to prevent that. Unfortunately for China, only a slowing world economy is likely to hold back China's export driven growth and outside of the United States, the economies of the world are doing better than they have in years. For once, America's housing bust might do something good for the world economy.

US Economic Downturn Possible, but Improbable

Reuters reports that the President of San Francisco's Federal Reserve suggested that a downturn in the US that ripples around the world is possible. Of course, she qualified that statement to make it significantly less meaningful than the article suggests. Her analysis appears to consist of noting that the US represents 25% of world production and that the US economy hasn't been doing well recently. She goes on to say that her own opinion is that growth picks up instead of slowing into a recession, but that wouldn't make for exciting headlines.

Except for the fact that most Federal Reserve Presidents talk in the most purposefully bland, obtuse language in order to avoid spooking the markets, this would be a prime example of editorial overstretch. Yet the case for a coming economic downturn needs to be considered on its merits.

The problem with the pro-recession storyline is that it lacks a promising catalyst. One could argue that interest rates are choking growth, but does anyone really believe sub 6% rates that haven't moved upward in a while are causing a slowdown? Macroeconomic instability could be blamed for a slowdown, but what exactly is the hold up? Trade is accelerating around the world, and important markets in Asia and Europe are doing better than they have in years. US relative prominence is clearly shrinking, but that has been happening every year since the end of World War II. Absolute levels of production have been steadily rising and even the increasing costs of inputs doesn't seem to have slowed the economy. Oil could certainly be a lot cheaper, but it could also be a lot more expensive. Gas prices in excess of $3 a gallon are painful, but consumers haven't cut their consumption at all.

The most promising source of weakness is obviously the housing market. The value of housing in many areas around the country has clearly been in the midst of a speculative bubble for years and is now in the early stages of a correction. The question then becomes if the securitization of home mortgages as opposed to traditional government-backed lending has caused a structural fault to develop that will continue to suck the growth out of the economy. It's impossible to say at this point, but it seems like investor's demands for tighter lending standards has already squeezed out a lot of the risky loans that caused the trouble this time around.

The President of San Francisco's Federal Reserve thinks that a worldwide economic contagion could spiral out for the US in the event of a downturn, but she doesn't think that downturn is going to materialize. Looking at the underlying problems the economy faces, slow to moderate growth looks significantly more likely than a recession.