Author: Nicholas Lardy, PIIE
China’s 2009-10 stimulus program was quite successful: growth ticked down only slightly in 2009 while the rest of the world suffered its sharpest decline in 60 years.
But the stimulus program was not intended to address the longer-term structural problems that in 2007 led China’s premier, Wen Jiabao, to characterise the country’s growth as ‘unsteady, imbalanced, uncoordinated and unsustainable’.
Numerous imbalances have emerged in the Chinese economy in recent years: a low share of private consumption expenditure and a super-elevated share of investment in GDP; an outsized manufacturing sector and a diminutive service sector; an unprecedentedly large hoard of official holdings of foreign exchange; and an increasingly high and probably unsustainable rate of investment in residential property. Mitigating these imbalances will require fundamental market-oriented reforms. Continuing the modest, incremental reforms of recent years will not be sufficient to propel China toward a new growth path.
Perhaps the most important source of China’s economic imbalances is financial repression, most apparent in the negative average real return on one-year deposits in Chinese banks since 2003. This is in sharp contrast with the years 1997-2003 when the average real rate was 3 per cent. Negative real deposit rates have had a double-barrelled adverse effect on private consumption expenditures. First, negative rates have depressed the growth of household income, leading to lower consumption. Second, in response to sustained negative real deposit rates, households have sharply increased the share of their after-tax income that goes to savings, further depressing the share of private consumption expenditure in China’s GDP.
Also in response to negative deposit rates, households have increasingly funnelled their savings into alternative investments, notably housing. Since 2003, returns from owning property have far exceeded the interest rate on bank deposits. Housing investment accounted for 5 per cent of GDP in 2003; by 2010 that share had doubled to 10 per cent. This is far in excess of the average share of residential housing investment in other countries with a comparable level of per capita income. This sharp rise accounts for nearly half of the increased share of investment in GDP between 1997-2003 and 2004-10. In short, residential housing has become the single most important driver of China’s economic growth since the middle of the last decade.
But this is not likely to continue indefinitely. First, the share of household wealth held in the form of property has doubled over the past decade; at some point households are likely to seek greater diversification. Second, bank exposure to property, in the form of mortgages to individuals and loans to property developers, has roughly doubled in the past five years. At some point China’s banks may decide the risk of extending even more property loans exceeds the potential returns. Third, household debt relative to income has doubled in the past few years. Household indebtedness in China as a share of GDP is again half as great as households in countries at comparable levels of economic development. With real estate prices now falling, Chinese households may soon decide the risk of incurring even more debt outweighs the potential returns from additional investments in housing. Any of these developments would lead to a slowdown in the pace of property investment, which could potentially have a negative impact on China’s economic growth.
Market-oriented interest rate liberalisation, eliminating the under-pricing of energy and other factor inputs used predominantly in manufacturing, greater flexibility of the exchange rate and an even more rapid expansion of the social safety net are essential to moving China onto a consumption-driven growth path. Many of these reforms have been on the agenda for a decade or more, yet with the exception of increased social expenditures, progress has been painfully slow. The explanation is that financial repression, the undervaluation of the currency, and factor price distortions advantage some sectors and regions of China at the expense of others.
The beneficiaries of imbalanced growth — including export- and import-competing industries (which enjoy elevated profits at the expense of firms in the service sector), coastal provinces (which have enjoyed supercharged economic growth at the expense of inland regions), the real estate and construction industries (which have benefitted from interest rate policies that have made residential property a preferred asset class), and China’s banks (which enjoy lofty profits that come with the high spreads between deposit and lending rates set by the central bank) — have acquired disproportionate influence over economic policy. And to date they have been able to block much-needed policy reforms. But these reforms are necessary if China is to ever move toward a more balanced, sustainable growth path.
Nicholas Lardy is Anthony M. Solomon Senior Fellow at the Peterson Institute for International Economics. He is the author of Sustaining Economic Growth in China after the Global Financial Crisis.