China’s slowdown is structural, not just cyclical

September 12, 2013 by Ken Davies

China’s economic growth has slowed to just over half the 14% year-on-year rate recorded in 2007: the IMF forecasts that it will grow at around 7.75% in real terms in 2013. It is unlikely that growth will bounce back to the 10% average of recent decades. If China’s leaders take firm measures to prevent a financial crisis and persist with reforms, the country will move to a lower and more sustainable growth path. If it fails, China risks years of lost output.

Over the past five years, China has suffered less than most other crisis-hit economies. Its stimulus programme kept growth above 9% in 2009 and 2010, when many other economies were in recession. Consumer price inflation, at around 3.5% this year, is not dangerous: cost-push pressures are easing as world food prices have softened in recent months and other commodity prices have softened recently; industrial overcapacity resulting from over-investment undermines demand-pull inflation.

China’s external position is also relatively secure. While other countries face chronic debt crises, China will not need to borrow from the IMF: in 2011 China owed the rest of the world $685.4bn, while its foreign exchange reserves at the end of June 2013 were $1.5 trillion, so China could pay off all its external debt to and still have well over $800bn in its reserves.

However, China faces serious challenges in maintaining economic growth while moving to a different growth model. Actual GDP may be smaller, and now growing more slowly, than official statistics suggest. Growth has increasingly been financed by massively increased domestic debt that now threatens economic stability. GDP is not accurately measured in China. Services and the private sector have in the past been undercounted, leading to an upward re-estimation and revision of the official figure.

In boom years GDP may be higher than the official figure and in slowdown years it may be lower, so cyclical fluctuations may be much larger than officially recorded. Proxy statistics such as energy and transport may give a better indication of economic health. Such proxy figures have been slowing much faster this year than GDP, indicating that the latter may be exaggerated.

There is also a well-established tendency for provinces to inflate their GDP growth rates to expedite the careers of provincial governors. This can be clearly seen from the persistent failure of national GDP figures to add up. For example, in 2013, all 31 provinces reported GDP growth rates in 2012 that were higher than the national growth rate, together with a higher national GDP total. This discrepancy first appeared in the mid-1980s and has since widened; local governments appear not to be becoming more truthful.

Currently stalled work on developing a new “green GDP” measure in China has shown that in one year (2004), the country suffered environmental damage equivalent to at least 3% of GDP (almost certainly a large underestimate due to lack of data). The worsening of, for example, air pollution in Beijing and other cities, indicates that this damage has not diminished. Subtracting three percentage points from the current growth rate puts it at well below 5% real GDP growth per year.

These serious uncertainties and inaccuracies in official GDP statistics mean that discussions of China’s GDP growth in terms of variations of fractions of one percentage point are meaningless. The recent media focus on whether the Chinese economy is in for a “hard landing” or a “soft landing” is also meaningless to the extent that it involves watching to see if the official growth rate falls below an arbitrary limit.

A better aviation analogy is the comparison between a landing and a crash. The worst-case scenario – the crash – is a collapse of the wildly over-inflated property market, followed by a banking crisis and the discovery that, unlike in 2009, the government no longer has the resources to fund a massive stimulus programme. In this scenario, there could be a drastic growth slowdown, even a recession, without the prospect of recovery for several years.

The government takes this danger so seriously that it has been attempting for some time to take the wind out of the property market and discourage over-investment. That it has not entirely succeeded is shown by sky-high property prices and the proliferation of ghost cities. While continuing massive rural-urban migration may well eventually populate the empty buildings, this process may take place via a very large and damaging set of market adjustments.

The danger of serial defaults is exacerbated by the recent credit explosion. Domestic credit expansion during the global economic crisis has left China with an increase in total debt from 130% of GDP in 2008 to well over 200% today. This debt burden is spread across corporations, local governments and individuals. China now has the highest proportion (151%) of corporate debt to GDP of major economies. Local governments are also highly indebted – 36 of them have average debt as high as that of Detroit. Because they rely heavily on property income, they are highly vulnerable to a sharp correction in housing prices.

The external environment remains difficult to predict, with the slowest recovery in history threatened by a global debt burden. China can no longer count on the US consumer to keep buying its labour-intensive exports. Asian neighbours are edging into its markets as labour costs have doubled in China in recent years.
The task ahead for the Chinese government is immense. In the short term it has to avert a financial crisis by tackling over-investment and housing prices. In the long term, it has to reverse the decline in productivity by liberalising and restructuring the economy.

The mercantilist model is no longer viable. China has to become a modern economy, reliant on quality rather than quantity of inputs and outputs. Rebalancing towards a consumption-based, instead of investment-based, economy will provide more stable, albeit slower, economic growth and reduce the impact of external demand risk.

Tags: GDP, IMF,

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