Three years after the collapse of Lehman Brothers, which turned America’s financial crisis into a global one, China’s economy is again riding high. Many observers, however, fear that a sharp downturn in the next few years is all but inevitable. While a number of factors give cause for concern, a “hard landing” is unlikely.
China’s economy is in better shape now than it was a few years ago. Its composite manufacturing Purchasing Managers Index (PMI), which had been widely expected to fall below 50 in August, increased marginally to 50.9 from 50.7 in July.(1) Private investment, meanwhile, is growing faster than state-sponsored investment.
With growth in 2011 well above the official 7 percent target for the 2011-2016 Five Year Plan, a slowdown is both planned and needed. But even if the economy decelerates too quickly and another stimulus program is required, there is fiscal room for it. Finally, the government is keenly aware of the need to rebalance China’s growth model and poised to address the main problems that could hinder progress on this front.
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A Quick Look Back
A sharp decline in China’s exports in the second half of 2008, together with aggressive efforts to tame high inflation and an overheating housing market in the preceding eighteen months, brought growth to a near standstill in the last quarter of 2008. Layoffs, especially in construction and export manufacturing, ran into the tens of millions.(2)
Beijing responded to the crisis within weeks of the Lehman collapse, announcing a massive stimulus program that included infrastructure projects, a wide range of consumer subsidies, expansion of social programs, and a new, extremely ambitious state-sponsored “affordable housing” program.(3) Although the stimulus had obvious downsides—it relied too heavily on government investment, resulted in some waste, and helped reinflate the housing bubble—it was on balance very successful.(4)
Employment and growth quickly returned. By mid-2009, labor shortages began to appear and real wages rose even faster than before the crisis. Growth in 2010 was a robust 10.4 percent; in the first half of 2011, it was 9.6 percent.(5) Consensus growth projections for 2011 as a whole and for 2012 are 9.3 and 8.8 percent, respectively.
Still, China’s remarkable recovery has raised new concerns. By sharply increasing (mostly government-sponsored) investment—fixed capital formation accounted for 90 percent of growth in 2009—China has to a degree traded export dependency for investment dependency. This burst temporarily put China’s goal of economic rebalancing on hold, though Beijing recognizes that this level of investment, at an unprecedented 46 percent of GDP in 2010, is not sustainable.(6) In addition, new overheating fears, especially in real estate, have also cropped up, prompting the central bank to begin tightening monetary policy in the third quarter of 2009.
Looking Forward: What Could Go Wrong?
Growth will likely slow down, but by how much and how quickly? At the macro level, the big question for the next five years is whether household and government consumption will accelerate enough to compensate for the inevitable deceleration of capital formation. Since household consumption in China is already growing by about 10 percent a year—slightly faster than GDP growth in 2011 so far—and cannot be increased by much more in the short run, the government will have to further increase budget outlays for social services (mainly education, health, and social security) for aggregate spending to rise significantly. Fortunately, China can afford to do this.
If government consumption continues to grow rapidly, real wages continue to rise faster than GDP, and access to consumer credit continues to improve—all three of which seem likely—it may be that the recent period represents a bottoming out of China’s low share of consumption in GDP (about 48 percent in 2009).(7) Depending on the rate at which investment growth is brought down, a “hard landing” in the next few years can be avoided, provided the quality of investment is adequate.
China’s leaders cannot be complacent, however, and must guard against several risks.
First, relatively high consumer price inflation—6.2 percent in August, down a little from 6.5 percent in July—remains a top concern for the government. Since inflation largely increased in recent years due to rising food prices—and critical food items such as pork began to slow last month—the CPI probably peaked in July. Inflation will likely remain higher than normal for some time because there is still excess liquidity in the system.(8) But the global slowdown, gradual tightening of monetary policy, and increased food and feed imports (especially corn)—combined with additional releases of pork from government reserves and pork imports from the United States—mean inflation will likely moderate.
In addition, Beijing remains concerned about a housing bubble and has been actively trying to curb speculative investment in residential housing in big eastern cities since April 2010. Here, too, the news is reassuring. While official housing price statistics are not reliable, several private sources confirm that urban house and land prices stopped rising in recent months and even fell a little in July and August. Price declines, however, must be gradual. Although housing affordability in major eastern cities is a significant social problem, a sharp drop in housing prices would threaten financial sector stability as it did in the United States in 2008. Because of very strong underlying demand, though, the chances of a U.S.-style housing price collapse are slim in China.
Though much has been written about China’s debt problem, it also is likely to remain under control. Much of the focus has been on local government debt or, more precisely, debt incurred by local government-owned investment companies that borrowed funds to co-finance infrastructure projects approved under China’s stimulus program. Official sources estimate total local government debt reached RMB 10.7 trillion (about $1.7 trillion, or nearly 27 percent of current GDP) at the end of 2010, but some international observers put the true amount at as much as RMB 14 trillion.(9)
Some local governments will likely default on some of their obligations; however, the central government will almost certainly step in to protect state banks exposed to this debt. Total registered public-sector debt in China (central and local government together) is below 60 percent of GDP(10)—much smaller than in the United States or any large Western economy. Moreover, the very high growth rate of the economy and of government revenue, and China’s large excess foreign exchange reserves, suggest that China’s overall fiscal situation is in fact remarkably strong.
Private-sector debt, however, is more of a concern. Some of China’s large private real estate development companies, which tend to be highly leveraged, could run into serious financial problems if housing and land prices decline significantly and sales slow. A more general private-sector debt problem could arise if the economy slows more sharply than projected (and planned). Since the government will be much less inclined to bail out private borrowers—even if they owe money to state banks—than public-sector companies, the creditworthiness of banks with a heavy exposure to private-sector loans, in particular construction loans, may become an issue.
Furthermore, a double dip recession in the West would also be a serious problem for China, because trade linkages remain very important, even though China is relatively insulated financially. While China can do little to prevent a second dip in the United States, it might use a portion of its enormous reserves to strengthen the capital base of major banks in Europe, which could help solve the euro conundrum and would be a win-win solution for all concerned.
Last but not least, China’s policymakers could make mistakes resulting from overconfidence. Since Deng Xiaoping, economic policymaking was generally preceded by careful deliberation and serious efforts at consensus building. It is still possible, however, that the country’s astonishing success in quickly restoring growth momentum and near-full employment in 2009, combined with the economic problems of the United States and Europe, could lead to complacency and carelessness.
To be sure, these problems could throw a wrench in China’s plans to sustain high growth and rebalance its economy. So far, however, senior leaders have shown sharp awareness of these issues and helped position the country to address them.
1. China’s manufacturing PMI covers a wide range of business indicators (for example, industrial output, employment, orders, stocks, and exports). An index over 50 indicates expansion and under 50 contraction. The non-manufacturing PMI was down a little in August (mainly due to reduced railway investment following a deadly high-speed rail crash in July), but, at 57.6, remains easily in expansion territory.
2. The government estimated in January 2009 that some 20 million workers—mostly migrants—had been laid off in export manufacturing in 2008. While there is no official estimate of layoffs in construction in 2007 and 2008, the number is likely very large.
3. The basic model for financing local infrastructure under China’s stimulus program, which effectively ended in 2010, combined relatively modest additional financing from the central government budget with co-financing by local governments, mainly from borrowed funds, for the bulk of project costs.
4. China’s stimulus program worked for three main reasons. First, a large reservoir of investment projects could be brought forward. Second, banks were able and, given their virtually guaranteed liberal margins, only too willing to lend. Finally, because China was not overleveraged like the United States, stimulus spending in China quickly translated into incremental demand, whereas U.S. stimulus spending compensated at best for deleveraging in the private sector.
5. The contribution of net-exports to growth in the first half of 2011 was minus 0.7 percent.
6. Most investment was in infrastructure and housing, financed from sharp increases in bank lending. The contribution of additional budget-financed expenditures to China’s stimulus program was about 20 percent. Only about 8 percent of incremental bank lending in 2009 went to State Owned Enterprises (SOEs), and bank lending to the private sector expanded faster than lending to the state sector.
7. In a persuasive article in the Financial Times, Yukon Huang argued that consumption in China and the share of consumption in GDP are probably underestimated because of statistical measurement problems.
8. In 2009 and 2010, nominal M2 grew by 27 and 23 percent respectively. In the first half of 2011, the growth rate came down to a sustainable rate of 15-16 percent.
9. China’s debt concerns prompted the State Council to instruct the National Audit Organization to undertake a special study of the problem. The NAO concluded that total local government debt amounted to RMB 10.7 trillion at the end of 2010, but this figure was disputed by some international sources.
10. A recent government statement puts it below 50 percent of GDP.