China’s Gravity-defying Economy: How Hard Will It Fall?

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Economists, wary of trusting the usual statistics, have racked their brains for ways to corroborate trends, citing measures such as construction equipment orders, demand for cement and electricity generation. There is no tried and true method, while distrust of China’s statistics remains nearly universal. Even if they have improved from earlier decades, the temptation for padding or distortions is intense for local party bosses, whose career prospects depend on what they report to higher levels. Andy Xie, an independent Shanghai-based economist who travels extensively in China, believes that the real situation is much closer to a “hard landing” scenario than statistics show. “There is no reliable data to verify whether it is a hard landing or not,” he says. “The GDP statistics are not meaningful at all…. They are not just incorrect, but way off.”

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Even taking the Statistics Bureau’s data at face value, the signs are not encouraging. Its figures show that out of the 9.2% GDP growth for 2011, 5.0 percentage points came from increases in fixed asset investment. Fixed asset investment (FAI) grew 23.8% in 2011, down from 24.5% growth in 2010. But investment growth slowed through the year, to an 18.5% year-on-year increase in December, after 21.2% in November and 25% in October. “If everything remained constant, and FAI [this year] merely matched last year’s absolute amount … we’d be looking at 4.2% GDP growth,” Chovanec notes. So far this year, fixed asset investment in the first two months rose 21.5% from the same period a year earlier, against market expectations of slower year-on-year growth for all of 2012.

The Weakest Link

Although construction also has been slowed by shortages of financing for various infrastructure projects, Pieter Bottelier, professor of China studies at the School of Advanced International Studies at Johns Hopkins University, views the real estate sector as the weak link in the economy. The risk is not so much a residential market meltdown like those seen in the U.S. and Europe in recent years, since Chinese homeowners rely much less on borrowing than their counterparts in those markets. The greater threat is in the massive, unsustainable borrowing by property developers whose projects are unlikely to pay the originally anticipated returns due to a downturn in prices. “If we get a sudden dip, say a 10% to 20% plunge in prices in the big cities, then we will have a new situation that could become very dangerous,” Bottelier says. China has more than 10,000 real estate developers who are highly leveraged and may have to default on their bank loans if prices fall far enough.

Apart from the damage to banks, which would receive state support if necessary, the spillover into the construction, construction materials and other related sectors would likewise be damaging. Construction activity accounts for about 15% of GDP and a large share of jobs for the unskilled rural workforce. “The construction industry is such a big part of the Chinese economy, it could trigger more serious problems. This could lead to a hard landing,” Bottelier notes.

So far, housing prices have fallen only marginally, although there are anecdotal reports of double-digit declines for some projects in the biggest cities as well as in provincial ones. Overall, prices in China’s largest 100 cities fell 0.3% in February from a month earlier — the sixth consecutive month of decline, according to the China Real Estate Index System. Property prices in 72 cities dropped in February compared with January, while they rose in 27 cities and were flat in one city. In Xie’s view, the property bubble has already burst, though the results are less dramatic than in other major economies, partly because Chinese banks are constrained by political influences and generally do not foreclose on bad loans. “Instead, you see a lot of empty buildings. China has built too many buildings,” he says.

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The government holds the power, still, to open the taps and allow faster growth in the property sector if it chooses to do so, Bottelier notes, but it has to act with caution. “If [the government does this] too quickly, the bubble will return.” But China’s leaders are insisting that they intend to keep firm curbs in place until prices come down to more affordable, less politically risky levels.

At the same time, with the U.S. and European economies still frail, the export manufacturing sector is no longer providing the momentum it once did. China’s export growth declined to 20.4% in 2011 from 31.4% in 2010, and economists are predicting from zero to 10% growth this year. Crisis-stricken Europe accounts for 20% of China’s overall exports. Wharton’s Allen views the risk of a hard landing as only one-in-five — unless things in Europe blow up. “If things in the U.S. and Europe stay as they are at the moment, then [a hard landing] is much more unlikely,” he says. According to the IMF, a deepening of the European debt crisis could pull China’s GDP growth down to 4%.

Beijing’s Balancing Act

Despite the myriad internal and external constraints confronting China’s leaders, Beijing has various options for helping to shift the economy from an investment driven model to one fueled by consumer demand.

First, China needs to improve its allocation of resources to better balance the economy — a step that only can follow reforms in interest rates and other pricing mechanisms. “China has all the wrong prices — including exchange rates, interest rates, gasoline prices and land prices. Those prices are all controlled and managed by the government. If you have the wrong prices, you will have wrong allocations,” notes Yao of Societe Generale. Mispricing of credit makes investment costs cheap for state-owned companies and local governments, encouraging excess construction and waste on projects that yield little or no returns and do not necessarily improve productivity or public services.

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