6 China’s Macroeconomic Imbalances: The Liquidity Tango Mechanism

he post-1978 marketisation of China’s economy has interacted with the continued state ownership to create an inflationary “liquidity tango ” between the state-owned enterprises (SOEs) and the state-owned banks. Whenever the hard budget constraint is imposed on the SOEs, China’s dysfunctional financial system imparts a deflationary bias to the economy and renders China a capital exporting country by constraining the growth of domestic demand. Foreign economic advisers recommend that China solve its internal and external imbal-ances by raising the interest rate and appreciating the exchange rate. However, the use of price mechanisms as the only instrument for all economic problems is not appropriate for China’s transitional economy. Trade surpluses are better handled by establishing an efficient financial intermediation mechanism and by faster import liberalisation than by appreciation of the yuan; and investment expenditure of the SOEs is better curbed by administrative controls than by higher interest rates. The year 2006 could well turn out to be a year of sizzling growth. The annualised real GDP growth rate, which hovered at 10 percent in the 2003-2005 period, climbed to 10.3 percent in the first quarter of 2006 and then to 11.3 percent in the second quarter of 2006 (see Table 1). These high growth rates were driven by record high investment spending and record export performance. Investment rose to over 45 percent of ∗ I am deeply indebted to Ariel Buira, Jane D’Arista, ZdenƟk Drábek, Stephan