That the Chinese economy is slowing down as it quickly matures should come as no surprise. The global economic conditions of the two decades leading up to the financial crisis were exceptional; things are far more sober now.
Many of China’s development achievements are unrepeatable. Only once can you:
- Join the WTO;
- Accomplish rural-urban labour transfer;
- Fulfill high secondary school enrollment;
- Boost the investment share of GDP to 50%.
In spite of the current upward bounce in the economy, slower underlying growth is inevitable.
The two main questions are how much slower will growth be and how well will the transition be managed? It is likely that the downshift to around 5% per annum is coming sooner rather than later, but the answer to the latter is pure conjecture at this point. The reason for uncertainty about both questions is that China’s economic model needs a makeover, otherwise known as ‘rebalancing’, which is essentially about politics.
New model for old
One way or another, China will rebalance. It has already made a start, albeit a hesitant and uncertain one. In 2011:
- Capital spending contributed about 48% of GDP growth, the first time it was less than 50% since 2001;
- As this happened – along with weaker net trade – sequential quarterly growth slowed down to around 6% by early 2012;
- That said, easier financing conditions and a shift in government infrastructure policy helped to spur a rebound which has continued into 2013, with leadership passing from the property, residential construction, and materials sectors to infrastructure investment, industrial production and restocking.
For rebalancing, this is the wrong kind of growth. The investment contribution to growth in 2012 was back at around 55%, with Le Keqiang, the next premier, recently calling for “unleashing urbanisation as the most important growth engine”. We shall see how convincing China’s new leaders will be when it comes to rebalancing policies.
From a growth-accounting standpoint, the labour contribution has been largely exhausted. The recent announcement that the working-age population fell for the first time in 2012 came as a timely reminder of the relentless decline that lies ahead. The physical capital accumulation contribution is going to fade significantly as economic rebalancing proceeds, and total factor productivity growth is now back to a more pedestrian 2% or so, after running at twice that rate in the 2000s.
From a national income-accounting standpoint, the almost 50% share of investment in GDP and the surge in China’s capital-output ratio, have become a ‘cause celebre’ in China’s economic rebalancing debate. This isn’t an argument about overinvestment, defined in terms of capital stock per capita, which you can have about any low- or middle-income country. It is about the sensational speed of the increase in the investment rate since 2000, in which time China’s sustainable growth rate has been sliding from lofty levels (Il Houng Lee et al 2012).
The investment-centric nature of growth means that unless China both rebalances away from investment and raises its total factor productivity growth, the investment rate is going to have to climb to over 60% to support the current growth rate. It is widely agreed that this can’t happen without leading to a disruptive investment bust. The problem is that getting the investment rate down to a more sustainable 40% or so over the coming decade, may also be disruptive if not carefully managed, and even then the maths of rebalancing suggest it is most likely to occur at a lower trend of GDP growth rate (Pettis 2012). Note that this is all independent of finance.
Minsky goes east?
As Western nations now know to their huge cost, the handmaiden of rising investment-intensity is rising credit-intensity; and then growing risks to financial stability. Take a bow, Hyman Minsky! In China, rising credit-intensity poses just such a risk. With vanilla bank loans now accounting for less than half of credit creation, compared with 90% a decade ago, attention has switched to the aggregate known as total social financing. The total social financing-to-GDP ratio has risen from 140% in 2008 to around 210% last year – the highest by far among all countries with China’s income per head. Since 2007, total social financing has risen at 2.4 times the rise in GDP, double the rate from 2002-07. Corporations account for much of the expansion in debt financing; local and provincial governments for most of the rest.
Increasingly, credit creation has been in overdrive in newer and sometimes weakly regulated or unregulated areas for the benefit of SOEs and local government financing platforms. These include trust, entrusted and foreign currency loans; banks’ acceptance bills; corporate bonds (mostly from local government); non-financial stock sales; informal lending; and wealth-management products (Edward Chancellor 2013). Many of these schemes pool deposits at relatively short maturities, and pay elevated interest rates. They fund infrastructure and housing projects in asset structures that are fine for as long as asset prices rise, new debt can be raised to finance maturing liabilities, and depositors don’t want their money back. Sound familiar? It is starting to sound familiar in China too.
I wrote above that economic rebalancing will happen, at some point. What we don’t know is how. Why? Because this is all about awkward politics:
- China’s model was last rebooted 20-30 years ago, when radical policies were implemented in the face of entrenched opposition and resistance. A repeat performance is required, starting this spring.
- In 2013, China is richer and more modern, but also more complex and prone to discontinuities that could exact a toll on growth (Magnus 2013).
Some changes may emerge ‘off the economic piste’, as it were. For example, in international relations, the propagation of social and political rights, limits to educational attainment and innovative capacity, and the implications of rapid demographic change. But the economy will doubtless remain centre stage.
Role of the state
The IMF, among others, has articulated that the key to successful rebalancing is to downgrade the role and dominance of the state (IMF 2012). From being the owner of some of the principal means of production, distribution and exchange, it should change to being the facilitator of enterprise, competition, new service industries, top class education, and innovation. The liberalisation of markets and factor prices would be a key part of such a strategy, correcting distortions to the prices of land, resources, money and capital.
To spur rebalancing, the government would also have to vigorously pursue programmes to lower income and social inequality, and widen access to primary healthcare, health insurance, pensions and income support. If Mr Li’s unleashing of urbanisation comes to fruition, this is going to become still more important, not least because of the implications for China’s urban migrants, currently amounting to around 250 million. Without hukou – alien registration – these citizens are excluded from social, educational and medical benefits, as well as secure jobs. Although pilot schemes for hukou reform have been introduced, it remains a ‘hot potato’. Land reform and the establishment of property rights also encroach into this area, because migration and income issues could be alleviated if farmers could sell land based on market prices, rather than be expropriated and offered compensation, which is tantamount to selling at a large discount to all-powerful local governments.
There are many rebalancing agenda items, but the point about them is that the most important ones require strong political engagement and leadership. The highly regarded Caixin magazine carried an editorial late last year that, without mincing words, urged a shift away from the dominance of the state (Caixin 2012). It argued that the heavy hand of the state was stifling competition, distorting markets, and encouraging rent-seeking, corruption, abuse of power and extremes of income inequality.
You can see the point. It’s about the critical role played by inclusive and enabling institutions in steering economic and human development out of poverty, through the middle-income range and ultimately, perhaps, into the limited universe of high-income nations.
From now on, whether China rebalances successfully or more disruptively, and whether or not its growth performance will tip it into a middle-income trap depend above all on the political willingness to engage with and implement widespread reforms that may be incompatible with the primacy of the Communist Party, and in the face of strong vested interests (Magnus 2010). Put simply, it’s the end of extrapolation.
Lee, Il Houng, Murtaza Syed and Liu Xueyan (2012) “Is China Over-Investing and Does it Matter?”, IMF Working paper 12/277, November.
Pettis, Michael (2012), “How to be a China Bull”, China Financial markets , accessible at www.mpettis.com, 7 October.
Chancellor, Edward and Mike Monnelly (2013), “Feeding the Dragon: Why China’s Credit System Looks Vulnerable”, GMO, White Paper, January.
Magnus, George (2013), “Asia’s fading economic miracle”, Centre for European Economic Reform, 11 January.
IMF and Development Research Centre of the State Council (2012), “China 2030 - Building a Modern, Harmonious, and Creative High Income Society”.
Caixin Online (2012), “Deng Xiaoping and the Date for Reform”, 31 October.
Magnus, George (2010), Uprising: will emerging markets shape or shake the world economy?, John Wiley & Sons.