Is China's Recovery Too Strong?

by: Carnegie Endowment

China’s growth has continued to exceed expectations in 2010. The risk of economic overheating now outweighs that of an economic downturn, with both consumer and producer price inflation, as well as urban housing and wages, on the rise. The government has taken steps to pull back monetary stimulus and cool residential property markets, though it is erring on the side of caution. Local government debt levels are also raising concerns, but the problem appears to be manageable. China should be able to exit from stimulus while maintaining strong growth momentum for the next few years.

Continued Strong Recovery but Rising Inflation

In the first two months of 2010, growth was higher than expected. Key economic indicators—industrial production, investment, consumption, exports, and employment—all point to continued strong recovery.

At this point, the risk of economic overheating outweighs the risk of an economic downturn. February’s consumer price inflation (CPI)—2.7 percent (y/y)—was much higher than January’s 1.5 percent (y/y) and higher than expected. Food price increases (caused by an unusually cold winter and related transport cost increases) and high consumer spending during the weeklong Chinese New Year celebration were the primary drivers, but overstimulation of private consumption (as part of China’s stimulus program) may have been a factor as well.

Producer price inflation—which reached 5.4 percent (y/y) in February—is a bigger concern as it reduces producer margins in the current buyers’ market. Margin erosion may reverse if exports continue to grow quickly, as is expected.

The most important cost-push factor, however, is that wages are rising due to labor shortages in eastern industrial areas. This is a surprise, as only a year ago prolonged high unemployment among migrant workers was feared. The dramatic reversal of labor market conditions for migrant workers is due to China’s stronger than expected economic recovery and reduced supply of migrant labor in the coastal areas. The government’s stimulus programs have apparently contributed to improved job opportunities and living conditions in rural China.

Urban housing’s declining affordability amid rapid price increases, which appear to be driven by excessive stimulus-related monetary expansion, is another serious concern. The government’s housing price index for 70 major cities shows that average residential property prices have increased continuously since they bottomed out in March 2009. The reported increase was 9.5 percent (y/y) in January and 10.7 percent (y/y) in February, but these numbers may not be reliable. During questioning by NPC delegates in Beijing, the head of China’s National Bureau of Statistics admitted that there were some problems with the housing price index for 70 major cities and that actual prices may have risen faster. A recent opinion poll shows that housing affordability is the public’s most pressing concern and a broader residential property bubble already may have begun to develop.

Macroeconomic Management and Bank Supervision

In speeches for the annual plenary session of the National People’s Congress (China’s legislature) that started on March 5, the government did not signal any important macroeconomic policy changes for the near future. Instead, Prime Minister Wen Jiabao focused on the need for change in China’s growth model: “We urgently need to transform the pattern of economic development […] and work hard to put economic development onto the track of endogenous growth driven by innovation.” He also emphasized the need to facilitate the development of medium and small-scale enterprises and service industries.

The government reacted calmly to the news that consumer price inflation in February was much higher than in January. Mindful of mistakes made at the end of 2007, when government actions to cool overheating property markets proved overly aggressive—triggering a sharp slowdown in overall growth well before the international financial crisis hit—the government is now proceeding very cautiously in its attempts to control asset bubbles in the property sector.

The government is taking measures, including vastly expanded, subsidized, low-cost housing schemes, to deal with the housing price problem. As part of its efforts to cool residential property markets, the government has also tightened requirements for mortgage loans used to finance non-owner occupied properties. This has slowed market turnover and price inflation at the high-end of the market significantly without causing serious disruptions. Share markets have shown considerable volatility in recent months, but no signs of “irrational exuberance.”

As in the United States, the challenges facing China’s policy makers in managing the country’s exit from the crisis and stimulus are without precedent. If anything, the Chinese government may now be erring on the side of caution in monetary tightening.

Though no significant change has occurred in interest rate policy as of yet, the government began to throttle back monetary stimulus very cautiously in December 2009, as noted in the January Bulletin. In the first two months of 2010, the government raised bank reserve requirements twice, put stricter limits on quarterly loan expansion, and required certain banks to mobilize additional capital. Bank supervision appears to have become more aggressive after the unexpectedly large credit expansion of the first two weeks of January.

No change has occurred in the exchange rate policy either, but the central bank’s governor recently confirmed that China’s decision to re-peg its currency to the dollar in mid-2008 was a temporary emergency measure.

In spite of a prevailing cautious attitude, financial sector reform has continued. For example, the China Securities Regulatory Commission announced that it would permit, for the first time, short selling, margin buying, and stock index futures trading on a trial basis. Private equity finance, including from foreign firms recently licensed to transact in local currency, is rapidly growing.

What About Local Government Debt?

Meanwhile, international skepticism about China’s ability to maintain growth and stability has become more pronounced. Famous Wall Street hedge fund manager James Chanos called on fellow short sellers to short China now, because, in his view, a mighty bubble is about to burst. Harvard professor Kenneth Rogoff added to the anxiety by expressing deep concern about what he called a “debt-fuelled bubble” (resulting from excessive credit expansion in 2009) that will inevitably pop at some point and cause worldwide economic damage.

Much concern has been expressed by Chinese and foreign analysts that a sizable part of new bank lending in China’s stimulus program was allocated to local-government-owned construction companies1 that were implementing state-sponsored infrastructure projects. It is common practice for local governments to establish their own construction companies to compete with other public and private companies. There are many hundreds of such companies and they are not all experienced or creditworthy. Some are registered as shareholding companies under China’s Company Law, however, and well managed. In major cities, they are so large that they can undertake huge projects, such as airports, ring roads, subway lines and light rail networks. They typically borrow from banks, using local government-owned land as collateral.

Because local governments in China, with few recent exceptions, are not allowed to borrow, they typically do not report any debt, and debt owed by their “investment groups” is therefore not recorded as public debt. As a result, reliable information on (de-facto) local government debt is not available. Some private estimates place local government debt at 30 percent of GDP, which would raise the total of official central- and local-government debt to around 50 percent of GDP. Although this is still a modest number by international standards, it does change the overall picture.

Has China Become a Debt-Financed Bubble Economy?

The answer appears to be no. Due to excess capacity, commercial property prices have recently trended down, without triggering a crisis. Leverage/GDP ratios are not excessively high. The average mortgage loan/house value ratio is believed to be well under 50 percent. On the other hand, debt-financed bubbles could become a problem if current trends in property markets are not reversed. The problem appears to be concentrated in high-end residential property markets, but it may already be spreading.

As for de-facto local government debt, there is clearly not enough information to draw firm conclusions, but China’s local government debt problem nonetheless appears to be manageable. Real assets, usually land, back most public debt as collateral. In addition, most local infrastructure projects, like toll roads, subways, and light rail connections, are revenue earning. There is also no problem of maturity or currency mismatches, and local assets and liabilities are all within the government system. Moreover, the central government, keen to ensure that all local government-owned companies operate on sound commercial principles, invited the World Bank some years ago to help achieve this objective. As part of the process, some of the larger companies have come under international rating agency scrutiny, which is believed to have had a wholesome demonstration effect.

As a result, China will most likely be able to manage the exit from stimulus-driven growth successfully and maintain relatively strong (7–8 percent) growth momentum in the next few years despite the risks.

In addition, there are some early, tentative signs that the country’s economic growth pattern is beginning to change: In 2009, domestic consumption grew faster than GDP (for the first time in many years) and China’s current account surplus as a share of GDP fell to 6 percent from 9.6 percent in 2008. If these trends continue in 2010, China will contribute to global rebalancing even without appreciating its currency.


1 Most local governments now call these companies “investment groups.”

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