The past is not always a good guide to the futureby / November 10, 2014 / Leave a comment
In the wake of a sustained slowdown in China’s economic growth, from about 11 per cent between 2006-11 to a little over 7 per cent in 2014, some people are wondering whether China could stall. That would hurt economic and social stability in China, and would add to recession and deflation risks in the world economy. But why would the world’s largest economy stall?
The empirical evidence doesn’t support the idea that economies get blown off-course simply because they are growing slowly or slowing down before they succumb to a sudden stop. Research conducted by the Federal Reserve Board and the Bank for International Settlements in the last few years, for example, found scant evidence of any low-growth threshold that preceded a stall, and concluded that some sort of shock was needed to produce a “knife-edge” moment.
With China slowing down to 7 per cent, it ought to be nowhere near stall speed, but if we look at the sudden growth stops that struck emerging markets in the 1990s, for example in Thailand, South Korea, Russia, Mexico and Brazil, they showed no evidence of decelerating growth before they crashed. On the contrary, in these and some other cases, growth was actually elevated or accelerating before they did. Their circumstances at the time were different from China’s today in many ways, but this doesn’t mean that China’s growth is assured.
For the first time, the International Monetary Fund is predicting that China will slow over the medium-term, to 6.3 per cent by 2019. I would go further. The serial downgrades to China’s growth forecasts since 2011 are likely to continue for the foreseeable future and I expect growth to fall to about 4 per cent–– over the next several years. In and of itself, this need not be a disaster, but if it happened quickly, say in 2015-16, it would constitute precisely the kind of stall that would send strong shockwaves around the world.
China’s spectacular economic ascent over the last 10-15 years has been unprecedented. The past, though, is not necessarily a good guide to the future. No country has been able to sustain much more than a decade of double-digit growth. The extraordinarily benign and rapid globalisation of trade, finance and investment, on which China was able to piggy-back, is over. In some respects, globalisation itself has stalled, if not gone into reverse, and western consumer markets, in particular, have become much more sober. Moreover, the speed of China’s leap up the global size league has been achieved on the back of unrepeatable accomplishments. Some things you can only do once, for example joining the World Trade Organisation; the higher educational attainment from enrolling most children in secondary schools; the productivity growth from shifting labour from rural activities to urban manufacturing; and the efficiencies from building essential infrastructure.
Consider also that Chinese wage costs are climbing significantly. Relative unit labour costs have risen since 2000 much faster than in the United States, Europe, Japan and other major emerging markets. Productivity growth has cooled off a lot, and China’s debt to Gross Domestic Product ratio has soared by 100 per cent of GDP to 250 per cent since 2004, with more and more credit needed to produce increments of growth in GDP.
Put another way, the economic development model that brought China out of poverty to what it is today is no longer fit for purpose. It has to be rebalanced. China’s economy has been allowed to develop serious structural imbalances. Capital investment has grown from 33 per cent of GDP in 2000 to around 50 per cent at the expense mainly of the share of consumption. The investment-centric economy, however, is now marked by declining productivity growth, and because so much investment has been financed by credit creation, debt, leverage, and bad loans are becoming increasingly problematic. Manufacturing growth has outpaced the development of household services. State-owned enterprises, banks and agents of development have enjoyed preferential access to resources and favours, compared with those in the private sector.
Economic rebalancing, then, is about shifting China’s growth model towards household goods and services, and reallocating capital from the state sector to private and family firms. This shift can only be done effectively in the context of lower economic growth as the investment rate falls back, allowing the consumption share of the economy to expand more significantly. Rebalancing has certainly begun—though progress has not been rapid—and is bound to continue. The major question, and one that is highly relevant to the issue of a stall, is how it happens.
The key to a relatively orderly transition is the implementation of comprehensive economic reforms spanning, for example, land ownership and property rights, state-owned enterprises, the use of markets in allocating resources, financial liberalisation, local government finances and governance, urban residency registration, social safety nets, and the legal system.
Although the authorities have started to work on a host of reform proposals aired at the Communist Party’s Third Plenum at the end of 2013, we should be under no illusion that politically more contentious reforms will be carried out, or that reform, itself, can be implemented without a cost to economic growth.
In addition, President Xi Jinping is still waging a robust anti-corruption campaign, designed not only to remove political enemies, but importantly also to purify the party, to use the Leninist description, so as to make cadres and officials more compliant, and less resistant to awkward reforms. This, too, has resulted in a significant cooling off of, for example, ostentatious consumption.
The biggest risk over the next 12 months, though, lies in the residential property market, where investment amounts to 13 per cent of GDP, and perhaps 16 per cent including construction materials and housing-related manufacturing. Investment growth has fallen from 35-40 per cent in 2011 to less than 15 per cent, and is still falling. This sector, which was the leading edge of growth over the last decade or so, is now fading with transactions volumes and prices falling, and inventories of unsold homes rising to 25-45 months of supply in a growing number of cities, away from Beijing, Shanghai and Shenzhen. Household mortgage volumes are rather limited in China, and so the financial risks lie with state and other companies, which have leveraged up in the property market, and with local governments. Over-supply, and over-investment, along with new regulations affecting land development, people resettlement and environmental standards will continue to suppress residential investment, despite palliative measures to improve mortgage terms and banking liquidity, and lower interest rates.
The latest consensus growth forecast for China in 2015 is 7.1 per cent but the headwinds are gaining in strength. The radical change in China’s growth environment, economic rebalancing, the struggle to implement reforms including the anti-graft campaign, and downswing in credit creation and the property market are all leaning heavily on the consensus.
Even if growth were to slip to “only” 5-6 per cent next year, it would look as if China’s economy were beginning to stall.