China's Gravity-defying Economy: How Hard Will It Fall?
Published: March 28, 2012 in Knowledge@Wharton
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 U.S. 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 U.S. 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
U.S. 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."
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