*[This article was originally published by Knowledge@Wharton on March 28, 2012].
Analysis on China’s economic growth and the reforms that will be needed to keep its economy out of trouble.
As China's high-octane economy shifts into lower gear, virtually everyone agrees that the double-digit, super-charged boom years are drawing to a close. Speculation over the possibility of a so-called "hard landing" for the country flourishes with each boom and bust cycle, only to die down as China's growth revs up again. This time, however, both external and internal factors — including global conditions, domestic politics and financial trends — are reinforcing the downturn. Many experts warn that without some painful reforms, there will be worse trouble to come.
Still, economists' opinions about just how far China's economy will fall range widely. Also, exactly what constitutes a "hard landing" for a country that has until now been viewed as an almost unstoppable economic powerhouse varies from analyst to analyst, although most point to China's growth rate as a key defining factor. "People give different definitions," notes Wharton finance professor Franklin Allen. "Mine would be growth below 5%."
China's growth slowed to 8.9% in the final quarter of last year, after months of attempts by the government to cool inflation through curbs on bank lending, interest rate hikes and stringent increases in banks' reserve requirements. The government has said all along that it expects growth to slow: In his "State of the People's Republic" address to China's legislature on March 5, Premier Wen Jiabao set the annual growth target for 2012 at 7.5% — the first time the official benchmark has been set below the 8% level long viewed as the minimum needed to create enough jobs and ensure social stability. And in the current five-year plan, the government has set the annual growth rate at 7%.
Despite the fact that China is one of the few countries that routinely surpasses growth projections, this time reality might come closer to the government's target. Wei Yao, a Hong Kong-based economist at Societe Generale Cross Asset Research, forecasts that China's economy will grow at an 8.1% pace in 2012, slowing to 7.7% growth in 2013 and 7% in 2016. "I do not think that China will have a hard landing this year, but what will happen by 2014 really depends on what the government does in the next few years," she says. Given the many issues the country's leadership is juggling — including the property bubble, local government debts, income gaps between rich and poor and rampant corruption — "it will be a challenging task to avoid a hard landing."
Patrick Chovanec, a professor at Tsinghua University's School of Economics and Management, sees China heading for a "bumpy landing," with ups and downs in the next few years. The country's leaders, preoccupied with the upcoming shift to a new generation of Communist officials and distracted by the global financial crisis, have put off several tough but crucial structural reforms, he notes. These include liberalizing exchange rates and interest rates, improving the distribution of wealth, carrying out tax reforms and shifting away from the increasing dominance of state-owned industries. The worst thing China could do, Chovanec and other economists say, is to unleash another flood of stimulus to counter weaknesses in exports and investment. "That would be … kicking the can down the road for another year, presuming they could. All it would do is set up the economy for an even bigger fall later," Chovanec notes. "China needs corrections in the property market and broader economy to refocus growth on activities that earn genuine returns. The longer you put them off, the more painful it will be."
China's handling of those challenges matters more now than ever. Political stability will hinge on overhauling the economy to ensure that growth is more sustainable and equitable, suggests a report issued in late February by the World Bank. "This is not the time just for muddling through. It is time to go ahead of events and to adapt to major changes in the world and national economies," World Bank President Robert Zoellick said during a news conference for the report's launch in Beijing. "As China's leaders know, the country's current growth model is not sustainable."
The Next Middle East?
China's transition to an era of lower growth in some ways parallels Japan's abrupt shift in the early 1990s. Both countries allowed excessively cheap, often politically influenced use of credit to create a massive bubble in their property sectors.
But there is one key difference that could lead to ugly consequences in case of a hard landing, notes Wharton management professor Marshall W. Meyer. "You still have a lot of poor people in China, many more than Japan in the 1990s. Japan was essentially middle class, with all [citizens] having medical insurance and social security. That is where the political trouble is," Meyer says. Dissatisfaction over lagging incomes and inadequate social services could spiral if the growth that has underpinned Communist Party rule were to stall: "Neither China nor the world would like to see turmoil [in China] like [what we saw last spring] in the Middle East." Indeed, in mid-March, Premier Wen noted that if the country doesn't initiate key reforms, it could experience enough social unrest to precipitate another Cultural Revolution like the one that shook the country between 1966 and 1976.
Chief among the World Bank's recommendations is a call for China to ensure that growth is more reliant on consumer demand than on the heavy investment in construction and capital equipment that has been the main source of dynamism in recent years. Even if the structural changes outlined in the report are carried out, the World Bank said growth is destined to slow from an annual average of 8.6% in 2011-2015 to 7% in 2016-2020, 5.9% in 2021-2025 and 5% in 2026-2030.
The old trick of relying on heavy government-directed investment financed by state-run banks is no longer working, notes Chovanec. "The underlying reality indicates that a big chunk of what was driving GDP growth in China" — fixed asset investment — "is now flat-lining." China's fixed asset investment growth fell 0.14% in December from November's total, which fell 0.4% from October. When fixed asset investment slackens, the result is a sharp decline in GDP, he adds. "Now, whether that is reflected in the official GDP numbers, I cannot say. GDP is a very political number in China."
Economists, wary of trusting the usual statistics, have racked their brains for ways to corroborate trends, citing measures such as construction equipment orders, demand for cement and electricity generation. There is no tried and true method, while distrust of China's statistics remains nearly universal. Even if they have improved from earlier decades, the temptation for padding or distortions is intense for local party bosses, whose career prospects depend on what they report to higher levels. Andy Xie, an independent Shanghai-based economist who travels extensively in China, believes that the real situation is much closer to a "hard landing" scenario than statistics show. "There is no reliable data to verify whether it is a hard landing or not," he says. "The GDP statistics are not meaningful at all…. They are not just incorrect, but way off."
Even taking the Statistics Bureau's data at face value, the signs are not encouraging. Its figures show that out of the 9.2% GDP growth for 2011, 5.0 percentage points came from increases in fixed asset investment. Fixed asset investment (FAI) grew 23.8% in 2011, down from 24.5% growth in 2010. But investment growth slowed through the year, to an 18.5% year-on-year increase in December, after 21.2% in November and 25% in October. "If everything remained constant, and FAI [this year] merely matched last year's absolute amount … we'd be looking at 4.2% GDP growth," Chovanec notes. So far this year, fixed asset investment in the first two months rose 21.5% from the same period a year earlier, against market expectations of slower year-on-year growth for all of 2012.
The Weakest Link
Although construction also has been slowed by shortages of financing for various infrastructure projects, Pieter Bottelier, professor of China studies at the School of Advanced International Studies at Johns Hopkins University, views the real estate sector as the weak link in the economy. The risk is not so much a residential market meltdown like those seen in the US and Europe in recent years, since Chinese homeowners rely much less on borrowing than their counterparts in those markets. The greater threat is in the massive, unsustainable borrowing by property developers whose projects are unlikely to pay the originally anticipated returns due to a downturn in prices. "If we get a sudden dip, say a 10% to 20% plunge in prices in the big cities, then we will have a new situation that could become very dangerous," Bottelier says. China has more than 10,000 real estate developers who are highly leveraged and may have to default on their bank loans if prices fall far enough.
Apart from the damage to banks, which would receive state support if necessary, the spillover into the construction, construction materials and other related sectors would likewise be damaging. Construction activity accounts for about 15% of GDP and a large share of jobs for the unskilled rural workforce. "The construction industry is such a big part of the Chinese economy, it could trigger more serious problems. This could lead to a hard landing," Bottelier notes.
So far, housing prices have fallen only marginally, although there are anecdotal reports of double-digit declines for some projects in the biggest cities as well as in provincial ones. Overall, prices in China's largest 100 cities fell 0.3% in February from a month earlier — the sixth consecutive month of decline, according to the China Real Estate Index System. Property prices in 72 cities dropped in February compared with January, while they rose in 27 cities and were flat in one city. In Xie's view, the property bubble has already burst, though the results are less dramatic than in other major economies, partly because Chinese banks are constrained by political influences and generally do not foreclose on bad loans. "Instead, you see a lot of empty buildings. China has built too many buildings," he says.
The government holds the power, still, to open the taps and allow faster growth in the property sector if it chooses to do so, Bottelier notes, but it has to act with caution. "If [the government does this] too quickly, the bubble will return." But China's leaders are insisting that they intend to keep firm curbs in place until prices come down to more affordable, less politically risky levels.
At the same time, with the US and European economies still frail, the export manufacturing sector is no longer providing the momentum it once did. China's export growth declined to 20.4% in 2011 from 31.4% in 2010, and economists are predicting from zero to 10% growth this year. Crisis-stricken Europe accounts for 20% of China's overall exports. Wharton's Allen views the risk of a hard landing as only one-in-five — unless things in Europe blow up. "If things in the US and Europe stay as they are at the moment, then [a hard landing] is much more unlikely," he says. According to the IMF, a deepening of the European debt crisis could pull China's GDP growth down to 4%.
Beijing's Balancing Act
Despite the myriad internal and external constraints confronting China's leaders, Beijing has various options for helping to shift the economy from an investment driven model to one fueled by consumer demand.
First, China needs to improve its allocation of resources to better balance the economy — a step that only can follow reforms in interest rates and other pricing mechanisms. "China has all the wrong prices — including exchange rates, interest rates, gasoline prices and land prices. Those prices are all controlled and managed by the government. If you have the wrong prices, you will have wrong allocations," notes Yao of Societe Generale. Mispricing of credit makes investment costs cheap for state-owned companies and local governments, encouraging excess construction and waste on projects that yield little or no returns and do not necessarily improve productivity or public services.
China's handling of its 10.7 trillion RMB in local government debts is typical of this imbalance in the economy. In early February, the central government asked Chinese banks to roll over local government debts that accrued during the massive recession-fighting stimulus binge in 2009 — essentially sweeping them under the rug for a later reckoning. More than half of those loans are to come due over the next three years.
By far, many analysts say, the biggest shift required is a redistribution of resources that will unleash the potential spending power of the Chinese public. "China needs to rebalance the composition of its GDP more toward consumption, develop a more market-based monetary policy, reduce the excessive privileges of state-owned enterprises, ease income inequality and focus on promoting more productive and environmentally friendly industries," according to Rob Subbaraman, chief economist with Nomura International in Hong Kong. Moving toward a more market-based monetary policy, involving a more flexible exchange rate and deregulated interest rates, would push bank deposit rates higher, helping to reduce the need for saving and also improving investment options so that families do not rely so heavily on real estate to grow their nest eggs. Meanwhile, the government needs to make the politically difficult choice of reducing preferential treatment for state companies, which now includes preferential access to bank credit and government subsidies of land, labor and electric power. The aim is "to redistribute income from the corporate sector to the household sector," he says.
Subbaraman sees a one-in-three likelihood of a hard landing and believes China could resort to extra stimulus spending to avert such a worst case scenario. But without the necessary reforms, the stimulus money would just go to waste, he notes. "The key with future fiscal stimulus is to direct it more efficiently at consumption and more productive areas of investment."
Repairing the Net
Apart from the overall structure of the economy, another key reason for the Chinese obsession with scrimping and saving is the dire lack of public services and social welfare. Education, likewise, is a huge cost for most families. "Right now, taxes are too great a burden for households and the private sector, while China spends too little on social security, medical care and education. There is a lot they can do there," says Yao.
Meyer agrees. "There is room to repair the social safety net. Since there is not adequate medical care and social security in China, people feel they have to save 40% to 50% of their income. If they feel they have some safety net in their old age, they will be less prone to save." As China's population ages, it will have a growing need for services for the elderly, and spending on such areas will increase if the supply is there to meet demand, Meyer says. "You can increase consumption if customers get what they want."
In fact, Bottelier sees China's services sector as one of the most powerful potential engines for growth, and one that has not been fully realized. "Even at lower growth rates of 6% or 7%, China can maintain full employment if the contribution of the service sector to the economy expands more rapidly than the contribution of construction or manufacturing. You can get more growth in the service sector per dollar invested," Bottlier says. He views such changes as inevitable. "We have to see how China responds to this in coming years. If they postpone [these kinds of reforms] again, messy political consequences will be waiting."
Overall, the consensus among most economists is that it is time for China to bite the bullet and move ahead on politically difficult, painful reforms that could lay the foundation for sustainable growth in the future. It would not be the first time: In the 1990s, then-Premier Zhu Rongji carried out the first big overhaul of state industries, laying off millions of workers. Housing reforms helped create a commercial property sector from scratch that, despite its ups and downs, has helped establish a growing middle class. Given the strong hold of vested interests, especially at the local level, such changes are difficult but necessary for a rebalancing of the overall economy, notes Chovanec.
"My advice [to the government] is to drop this obsession with high-level GDP growth," Chovanec says. "Driving 8% to 9% GDP growth through investment may not pay off, and is not in the long-term interests of anyone in the Chinese economy. Accepting lower rates of expansion is a first step to putting China on the path toward long-term, sustainable growth."
The views expressed in this article are the author's own and do not necessarily reflect Fair Observer’s editorial policy.
*[This article was originally published by Knowledge@Wharton on March 28, 2012].