China’s economic vulnerabilities

Author: Peter Drysdale, East Asia Forum

As we count down the days and now the hours towards the beginning of 2015, what preoccupies most soothsayers of the outlook for the global economy in the coming year is the shape of the Chinese economy. Nudging the United States as the world’s biggest economy in real terms — measured in purchasing power parity it already accounts for 16 per cent of global output — anxiety about how long its growth rate, at more than twice the global average, might continue at this pace is on the rise.

A man carries a child on his shoulders as they visit an annual lights festival held at a shopping mall in Beijing, 27 December 2014. The month long festival spans Christmas and New Year, giving retailers a chance to boost sales as they ring in the New Year. (Photo: AAP).

The proposition that China or any other economy is unlikely to continue growing forever at this year’s rate of almost 7.5 per cent is unexceptionable. But that proposition, to which Summers and Pritchett keep returning in their recent paper on the need to be more cautious about China’s and India’s growth outlook, doesn’t really help very much. The question is when it will slow down and over what trajectory. Will there be a steady transition to lower rates of growth as China’s productivity catches up with more advanced economies? Or will China suddenly drop off the growth cliff, and revert to long run global mean of 2 per cent or thereabouts? Summers and Pritchett acknowledge that either scenario is possible, but they are inclined to have a small wager on China falling over soon, and suddenly.

Every serious analyst inside China and out expects the growth rate to come back from its current rate. Already it has edged back over the past few years from the average 10 per cent at which the economy hurtled along for more than three decades. But there are now more and more questions about how the Chinese leadership and policymaking authorities will be able to manage the next phase of the country’s economic development.

The central question is whether the current deceleration in growth is cyclical or structural in character. Has growth been tapering off because of under-utilised capacity in a weak global economy? Or has the real potential rate of growth of the economy been trimmed as aggregate labour supply has begun to shrink, real wages have begun to climb and compensating productivity growth is yet to kick in?

It’s clear that policymakers have been worried through the year as growth slowed in the first quarter and there was fear that that there could be major problems with unemployment, financial risk (with the bursting of real estate bubbles in major centres) and investor confidence should growth slip below 7.2 per cent, although the evidence on which these fears were based was weak.

There are three big problems for the Chinese economy. The first is the slow global recovery and negative effects of previous stimulus policies that generated over-investment and capacity. The second is a growth model that no longer attacks the burning problems of the day, such as over-investment and income inequality. The third is steering a way through the challenge of the middle-income trap through lifting the productivity of an already shrinking labour force. Only the first of these three problems is cyclical in character: the second two are structural and underline the challenge of maintaining higher growth potential through lifting productivity as the supply of cheap labour dries up.

Chinese exports can no longer, for example, continue to grow at more than 20 per cent a year because of the sheer size of China’s economy and its trade — it is already the largest trader in the world. So the consensus among the experts is that China’s current growth potential will edge down to 7 and 6 per cent over the coming decade — possibly lower than the lower bound, depending on what can be assumed about the speed of putting in place productivity-enhancing reforms.

Is it still possible for China to achieve medium-to-rapid economic growth in the coming decade? That will all depend on the policy strategy. Long-term growth cannot occur via fiscal stimulus, which will create more zombie firms, inhibit productivity, profitability and job creation in viable firms and deliver white elephant public investment projects.

In our special on the eve of 2015, top Chinese economist Yu Yongding gives his own searing assessment of the economic risks that confront China. At the same time he delivers a broadside at the China bears who have prematurely sensed collapse of China’s growth over the past couple of years. The Chinese economy, he points out, failed to implode as widely anticipated when growth faltered earlier in the year and looks set to come in roughly on target, at close to 7.5 per cent in 2014. Chinese economists are far from sanguine about the outlook for growth but now inform their assessments against the ‘new normal’ growth potential that is edging down through 7 per cent — a growth rate that would nonetheless double Chinese incomes in a decade.

Winding the real estate bubble back from its dizzying run over the past decade and a half has been one priority. Doing that has hit growth directly but also dragged down the economy through its impact on investment in durable consumer goods manufacturing and on the steel industry which serviced their production. After growing at 20 per cent since 1998, real estate reached 23 per cent of fixed investment but dropped by 12.6 per cent in the year through to October.

What’s the good news?

Yu says that there is room for infrastructure investment (and the New Silk Road enterprise will feed into that) but no capacity or appetite for massive expansionary expenditures. What China needs now, Yu says, is a shift in the paradigm from demand-led to innovation-based growth. He adds that this is no longer simply an economic issue and the change will take time. Even if China can make the adjustment, long-term unfavorable factors like ageing will creep in and continue to create uncertainty for China’s economic future.

The Chinese economic juggernaut has to slow, Yu concludes. There are serious problems — high corporate debt leverage is one and it will be compounded by economic slowdown. But don’t underestimate China’s ability to muddle through and keep the economy going, with a growth target of 7 per cent still within reach for next year.

And all our very best wishes to you for 2015!

Peter Drysdale is Editor of the East Asia Forum.