21 March 2019
Investment-led development based on continuous borrowings won't be a sustainable strategy for China. Photo: Bloomberg
Investment-led development based on continuous borrowings won't be a sustainable strategy for China. Photo: Bloomberg

Chinese growth: How much will it drop?

Premier Li Keqiang had sought to shore up confidence over the Chinese economy when he addressed global business leaders at the World Economic Forum in Davos last week.

But what are the actual prospects for the Asian economic giant, which some observers feel is continuing to lose traction?

I have turned cautiously pessimistic on China’s economic outlook after being cautiously optimistic earlier when Li’s predecessor Wen Jiabao resorted to a four trillion yuan (US$639.5 billion) stimulus in 2008 and annual money supply increment was set at twice the GDP growth rate in 2011.

China’s GDP expanded by 7.4 percent last year and the figure itself is still commendable but the trend is that the growth rate has tumbled to half of what it was at the 2007 peak of 14.2 percent. The slide is comparable to the US downturn during the subprime mortgage crisis, when its growth fell from 6.5 percent in 2005 to a negative 0.9 percent in 2008.

The question now is whether China’s growth rate will dive further.

Optimistic analysts believe it will stabilize at the level of around six percent while others, such as “Dr. Doom” Nouriel Roubini and Michael Pettis, professor at the Peking University’s Guanghua School of Management, fear that the new low will be between three to four percent.

Now the Communist Party has ordered all of its propaganda organs and mouthpieces to gloss over the slide and call it a “new normal of medium to high economic growth”, stressing that the priority is now quality rather than speed. Such a notion is reminiscent of Wen’s claim that a modest rate is the result of “China’s own initiatives for macroeconomic adjustments”.

When rapid economic growth is the source of all of China’s confidence and national pride, it’s difficult to imagine that Beijing will lower its growth targets.

Given the fact that all sorts of de facto stimulus packages have been rolled out one after another over the years (the latest being the expansion of standing lending facility and medium-term lending facility to cover selected financial institutions), one can tell the slowdown is not engineered.

The rationale for my “cautious pessimism” derives in part from one of Prof. Pettis’ recent articles.

Pettis, a Columbia University graduate who worked at JP Morgan and Bear Sterns and also served as a financial advisor to South Korean and Mexican governments, points out in his research essay “Inverted Balance Sheets and Doubling the Financial Bet” that an inverted balance sheet is the opposite of a hedged balance sheet, and that it involves liabilities whose values are inversely correlated with asset values.

Pettis theory sounds extremely technical, but if we liken China to a firm, it will be a lot easier to understand the risk the country is facing.

China is just like a company which relies substantially on debt to boost the output and earnings. The cost of liabilities is the interest a firm pays, while it uses the money borrowed to purchase land and production facilities or to promote its brand as tangible or intangible asset.

In good days, these assets will gain in value, enabling better risk profile for firms and in turn bringing down interest rates and the cost of liabilities, as the chance of default would be slim. Firms will then have easier access to cheaper loans to pay back maturing ones and enlarge production through new investment. Asset value increment also means that firms can use their assets as collateral to leverage more loans. GDP can soar in the process.

But in bad days, like during times of tepid external demand, asset values may drop while interest rate (cost of liabilities) would rise, stemming the growth in new loans and investment. The value of assets as collateral will also shrink and firms may be asked to pay back debts earlier. GDP growth will plummet in the process.

Carmen Reinhart and Kenneth Rogoff, scholars at Harvard University, addressed the same point in their paper “Public Debt Overhangs: Advanced Economy Episodes Since 1800“.

According to them, manageable and appropriate liabilities will support economic growth, but uncontrolled, excessive borrowings can definitely hinder GDP growth. Specifically, if the ratio of gross public debt to GDP exceeds 90 percent in a given country — a state of “public debt overhang” – for more than five years, economic growth will be dragged down.

Losing even one percentage point per year from the growth rate will mean a substantial decline in the level of output, and a massive cumulative loss.

It’s apparent that such a mode of investment-led development based on continuous borrowings is bound to be unstable: in its heyday the economy may advance by leaps and bounds but if the bottom falls out of the market, the economy will nosedive into a precipitous recession.

Pettis also warns that the management of a firm as well as a country’s top policymakers may become too confident about their capabilities and strategies when the economy is humming and thus they will stick to the same measures in the face of a downturn and further complicate the situation. This is exactly what is happening in China right now: authorities are still pressing banks to issue more loans to rekindle the economy.

Besides, I also have some doubts if China’s 7.3 percent growth rate in the fourth quarter of 2014 has been overstated, as other indices, including the HSBC Producer Price Index, has dropped below 50 during the same period – an indication that industrial output has waned.

Since the manufacturing sector takes up 44 percent of China’s GDP, tertiary and agricultural sectors must achieve a growth rate of no less than 15 percent if the overall economy is to expand at a rate of 7.3 percent. That would be mission impossible as numerous official data have shown that since 2007, the nation’s industrial output growth has been basically in the same pace as that of the tertiary sector.

Li once said that he was usually doubtful about economic statistics, so it won’t be surprising if China’s fourth quarter growth rate has been grossly inflated.

This article appeared in the Hong Kong Economic Journal on Jan. 26. 

Translation by Frank Chen

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Former full-time member of the Hong Kong Government’s Central Policy Unit, former editor-in-chief of the Hong Kong Economic Journal

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