Recent reports confirm that China’s economy is slowing. Just how much is a matter of debate since government statistics are unreliable. The accepted orthodoxy is that China must grow at least 8% a year to satisfy increasing demands for job growth and to maintain political stability. So what is happening and why does it matter?
In 1998, China adopted a development model previously used by Japan, Taiwan, South Korea, and other emerging economies. Through the use of a cheap currency and massive investments in manufacturing and industrial infrastructure, it promoted growth by exporting finished goods to the developed world. Over the course of this process, savings and investment grew, and domestic consumption as a percentage of GDP declined. This model works fine as long as there is increasing external demand. China enjoyed extraordinary export growth fueled by debt financed consumer demand in the developed world. That growth came to an abrupt end in 2008 with the financial crisis and subsequent recessions in Europe and the United States. China’s policy response was to substitute external demand with increased national investment through massive monetary, credit and fiscal stimulus. Remarkably, although the current account dropped from 10% of GDP in 2010 to 2.8% in 2011, China was able to maintain growth in the vicinity of 9%. Does that mean China has rebalanced its economy away from relying on export demand by increasing domestic consumption? Unfortunately, no. Although almost all would agree, even in China, that rebalancing the economy by expanding consumption is ultimately desirable, there is no evidence that transition is underway. Faced with an emergency in 2008, the policy response was to dramatically increase investment, where it is now almost 50% of GDP.
No economy, no matter how productive, can take so much of its GDP and invest it in real estate development, infrastructure and industrial capacity without a dramatic increase in public debt and a subsequent increase in nonperforming loans. China has borrowed a technique developed in the United States in the early 1990s to recapitalize the banks: reduce interest rates paid to savers to subsidize returns to the banks, which could lend the money out at higher rates. In China, however, the banks were directed to lend to State Owned Enterprises (SOEs) and provincial governments in staggering amounts. Satyajit Das, who has written a number of books and articles on risk management, estimates that these loans amount to 30 to 40% of GDP, of which 20 to 25% may be nonperforming. Reports by banks of 1% loan losses and provisions of 2.5 times that are not credible. In February, the authorities ordered the banks to rollover $1.7 trillion in maturing loans, a tacit recognition that loans may not be repaid on time. While no one really knows what the debt to GDP ratio is, Patrick Chovanec, a professor at Tsinghua University, estimates that it is between 100 and 200% of GDP if you include contingent liabilities.
Using financing to increase investment when neither Chinese consumers nor eternal demand will be able to use the capacity puts China in a difficult position. Chovanec notes that although China reported 6.5% growth in the first quarter of 2009, it felt like a contraction to him when looking at electricity consumption and transportation traffic. After all the investment since then, the same measures point to a contraction now. Should China report 5-6% GDP growth this quarter, it would represent a “hard landing” by China followers. Nouriel Roubini estimates growth will come in at 7.8% for the first quarter of 2012.
Chinese authorities appreciate that the current model has reached its limits. However, like politicians the world over, they would prefer avoiding making painful decisions. China will be undergoing a major transition in leadership later this year; so, it is unlikely that we will see any change until after the transition. Revaluation of the Renminbi will probably slow, and the People’s Bank of China will reluctantly ease credit standards to permit continued financing of new projects. Expect Europe and the United States to resist China’s desire to expand its trade surplus. More of the same will make current imbalances more severe and the chances of a severe hard landing more probable.
Satyajit Das speculates that an unfortunate outcome would be for China to embrace an isolationist policy as a means to solve its problems. After turning inward, which China has done periodically during its history, it would redirect its attention to the domestic economy and rebalancing savings, consumption and investment. Inevitably, though, China’s demand for raw materials will decline, benefiting developed economies somewhat by reducing costs while, at the same time, prejudicing exporting countries such as Australia, Brazil and Canada. International trade will suffer.