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Green is fairly pessimistic, it seems to me, about the likelihood that China will take the necessary policy steps to shift its economy towards a more sustainable model.  That shouldn’t come as a surprise.  It is always difficult to make major necessary adjustments when external conditions are bad, and yet it seems unnecessary to do so when external conditions are good.  I have mentioned before in this blog the difficult experience of the US in the early 19th Century when the US economy shifted from being driven primarily by exports to the UK, Europe and the Caribbean to being driven primarily by the development of its own internal market. 

This shift did not occur in a gradual way and according to the best thought-out plans of businessmen and government leaders.  The change was forced onto the US and happened mainly because beginning in 1797 the Napoleonic wars and an especially vicious spread of smallpox along the coastal cities decimated the US export business, ushering in a very long depression.  It took the ensuing financial crisis and depression to reorient the economy towards its domestic market, and not without a great deal of difficulty

The “silver lining” in the current global slowdown for China may very well be that China is also forced kicking and screaming into doing what it should have done much earlier, although I suspect Green is right that in the early stages it will actually try to strengthen the export and investment orientation of its economy as a way of slowing job loss. This would be a mistake in the long run, but may be a natural reaction for a government that greatly fears the short-term political consequences of rising unemployment.

As the first of the two charts below shows, both government revenues and spending have increased sharply in recent years. Beijing did indeed run a surplus in 2007, but only because revenue growth fractionally outstripped the rise in expenditure at the very peak of the cycle. Unfortunately for finance ministry officials, history tells us that when the economic cycle turns down, revenues tend to fall rapidly, while spending proves a lot more "sticky". As a result, fiscal positions quickly deteriorate and budget surpluses soon turn into deficits.

There are ominous signs that this is happening in China. As the second chart shows, government revenue in August was just 10 per cent higher than in the same month in 2007. That compares with a rise of 32 per cent for 2007 as a whole.  And there are signals China's fiscal position will get a great deal worse before it gets better. Tax reform earlier this year has already damped corporate tax revenue from domestic companies. Now with profit growth slowing abruptly - the country's biggest listed aluminium producer warned yesterday that third-quarter profits would be down 50 per cent from last year - revenue from corporate taxes is set to fall steeply.

That's not all. The property market is cooling. Home sales in Beijing and Shanghai were down around 80 per cent in September compared with the previous year. As a result, government revenues from property taxes and land sales are also likely to head south.

Rising domestic consumption may help shield China's
manufacturers from weaker exports. Retail sales grew 23.2 percent
in August from a year earlier, close to the fastest pace in at
least nine years. Fixed-asset investment in Chinese urban areas
jumped 27.4 percent in the first eight months of 2008, up from
26.7 percent in the same period last year.

``China is not just sitting around, waiting for orders for
Christmas toys and mobile phones from U.S. retailers,'' said Carl
Weinberg, chief economist at High Frequency Economics Ltd. in New
York. ``The boom in China's trade has been nice icing, but
China's economic cake is baked at home.''

To contact the reporters on this story:
Luo Jun in Shanghai at
jluo6@bloomberg.net;