Anyone who thought China was impervious to either the perilous state of the global recovery or the laws of basic economics should take a look at the data streaming out of the country in recent months. GDP growth in the second quarter slipped to 7.6%, the slowest clip in three years. Manufacturing output and exports have been weak and the property sector has stalled. The IMF recently lowered its forecast for China’s growth in 2012 to 8% — which would be the economy’s worst performance since 1999. And with the sagging data have come louder and louder cries for greater government stimulus to pump up growth, as Beijing’s policymakers did successfully after the 2008 financial crisis. “There’s lots more the government can do to ratchet things up,” HSBC said in a recent report.
That’s exactly what China doesn’t need, however. Government policies to greatly boost growth will only exacerbate the percolating dangers within the Chinese economy — dangers that could even result in an economic crisis. Instead, the current slowdown shows how badly China needs a new growth model, and the reform necessary to build one.
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For several years now, economists have been warning that China’s growth is unbalanced and, therefore, unsustainable. The economy is too dependent on investment and exports to drive growth, they argue, and to fix that problem, Beijing has to do more to encourage domestic consumption as another pillar of development. Not much has really been done to “rebalance” the economy, however, and sometimes it seemed that didn’t much matter. As the economists babbled, the economy continued to grow.
As the global recovery stumbles and Europe remains embroiled in a debt crisis, Chinese exports have taken a hit. At home, meanwhile, Beijing’s efforts to control rapidly rising property prices dampened investment in real estate. Property-investment growth in the first half of 2012 was half the rate posted in the same period of 2011. China, though, has nothing else to keep growth going. Its own consumers can’t fill in the gap. Private consumption in China relative to GDP is among the lowest of any major economy and remains constrained by government policies that punish consumers to subsidize investment. Thus the need to rebalance. If China’s consumers played a bigger role in overall national growth, the country would have another leg to stand on when the others weaken.
Why hasn’t China done more to rebalance? The scale of the adjustment necessary to switch from an investment-led to consumption-led growth machine is so monstrous that the country would likely experience a lower rate of growth while it is taking place — something policymakers so far have been reluctant to accept. Rebalancing will also require major reforms within the economy — such as liberalizing regulated interest rates and curtailing the influence of the state sector — which would pinch powerful interest groups. Policymakers have thus chosen to talk about rebalancing while perpetuating the policies that prevent it from happening.
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Beijing has trotted out many of the same stimulus policies used after the 2008 Lehman Brothers collapse to stimulate growth. China’s central bank cut its benchmark interest rate twice in less than a month recently, and the amount of cash that banks must hold in reserve has been reduced to encourage lending. The government is also fast-tracking approvals of new infrastructure projects. Some economists expect more such action to be taken in the second half of the year.
In doing so, however, Beijing will only exacerbate the frightening distortions within the economy. Easier money will fuel even high levels of debt, which have already spiked in recent years. That will come to haunt the financial sector in the form of increased numbers of bad loans. Much of any new lending would end up in the hands of state companies, which are terribly inefficient and wasteful. In other words, large-scale stimulus measures will perpetuate the economy’s reliance on investment, leaving it continually vulnerable rather than building new sources of growth. Rating agency Fitch warned earlier this month of the dangers of pursuing this strategy:
Renewed reliance on investment to support activity threatens to prolong the Chinese economy’s structural imbalances … Statements by senior officials including Premier Wen Jiabao have pointed to renewed emphasis on investment to support growth in the remainder of the year. An investment-led strategy backed by monetary easing is likely to avoid a “hard landing” in the short term … However, this investment-led strategy is likely to be at the cost of postponing resolution of the economy’s structural imbalance towards investment. Moreover, the rise in investment as a share of GDP since 2008, which is inherently unsustainable, has coincided with deteriorating efficiency as measured by the ratio of incremental output per unit of investment.
Yet at the same time, there are indications that China’s policymakers understand the risks inherent in massive stimulus. The current efforts to propel growth are far smaller in scale than what the government employed in 2008–09. Key restrictions on the property sector, like measures to limit speculative purchases of apartments, have remained firmly in place even as the sector has faltered. And as Michael Pettis, a finance professor at Peking University, pointed out in the Financial Times the other day, China has allowed real interest rates to rise substantially — a measure that would curtail investment while boosting the income of savers and thus consumption. Such a policy direction would inevitably lead to slower but ultimately healthier growth — a course, Pettis convincingly argues, the rest of the world should encourage:
As China rebalances we would expect slowing growth and rapidly rising real interest rates, which is exactly what we are seeing. Rather than panicking and demanding that Beijing reverse the process, we should be relieved that China is finally solving its problems.
The intentions of China’s policy mandarins will become clear over the next few months. Taking the proper reform measures will require the government to accept a lower growth rate while the economy adjusts. Will they take more drastic steps to pump up the country’s existing but strained growth model or earnestly start the process of creating a new growth model? The future of China’s economic miracle may well depend on the answer.