At the all-encompassing “two meetings” half a year ago, Chinese Premier Li Keqiang announced a lower GDP growth target of “around 7 per cent”, hailing it as “a new normal” for the Chinese economy.
Even before Li’s speech, China’s GDP growth had been decelerating, standing at 7.7 per cent in 2012 and 2013 and 7.4 per cent in 2014.
Analysts suspect that the already low figures might still have been inflated. Richard Jones, head of the Hong Kong research office of Soros Fund Management, put the 2014 figure at 5.6 percent.
So China’s economic engine is slowing down, unambiguously. Is this a cause for concern?
To some, the economic slowdown is but a natural consequence of the end of cheap China.
As Cai Fung, vice-president of the Chinese Academy of Social Sciences, put it, “it is the weakening of the economy’s growth capacity causing the deceleration of the growth rate in China”.
China’s labor force is simply shrinking, thanks in part to its one-child policy. China’s dependency ratio (the ratio of children and elderly to working-age adults) started rising in 2011. China will get old before it gets rich.
With the true share of agriculture in the labor force a mere 20 percent as estimated by Cai, the once-limitless pool of migrant workers from rural areas is also rapidly drying up.
China has reached what economists call the Lewis Turning Point. Labor shortage raises production costs and renders low-end manufacturing uncompetitive, hurting Chinese exports.
An aging population will condemn China to permanently lower growth rates, but it does not necessarily mark the end of the Chinese economic miracle.
If managed carefully, labor shortage may boost wages to the extent that it sets in motion China’s long-awaited rebalancing from wasteful investment to service-based consumption.
What is worrisome, however, is that China’s economic slowdown seems to have more to do with lackluster demand than with deficient supply.
To see the point, note that China is facing micro-level industrial overcapacity rather than macro-level labor market tightening.
The Caixin China General Manufacturing Purchasing Managers’ Index dropped to 47.1 in the first three weeks of August 2015, signaling the biggest contraction of China’s manufacturing sector in six years. In terms of producer prices, China has been in outright deflation for nearly three years.
Higher wages have yet to bring about more consumption. Retail sales grew at their slowest pace in a decade last month; imports fell 17.6 percent year on year in US dollar terms in May, contributing to a collapse in the prices of commodities ranging from oil to iron ore.
All this data unambiguously points to a remarkable fall in aggregate demand, accounting for the recent slowdown.
So, what is going wrong with demand?
The tale starts with China’s four trillion yuan fiscal stimulus package in 2008-09 in the aftermath of the global financial crisis, with local governments entrusted with the task of reviving the domestic economy.
Local governments thus borrowed from banks, via rule-evading “local government financing vehicles” (LGFV), to launch mega infrastructure and real estate projects to inject momentum into the economy.
As a result, unprecedented levels of liquidity had pushed property prices to an all-time high, boosting household incomes while stimulating property-related industries, now amounting to up to a quarter of China’s US$10 trillion economy.
Yet, the iron law of economics states that what goes up must come down.
The property market has since then been flooded with unsold flats, or even “ghost cities”, depressing prices. Average nationwide housing prices were down at an annual rate of 4.3 percent in December 2014.
This fact is particularly cruel when it comes to small Chinese cities, which constructed two-thirds of China’s property in 2013 but lacked the fundamentals to justify the prices.
Local governments collect 35 percent of their revenues from land sales, which in turn are dependent on strong property demand and prices, according to Deutsche Bank.
With property prices falling, local governments find it difficult to make both ends meet, thus, in a self-defeating way, propping up land values by purchasing their own land via LGFVs.
Unsurprisingly, by mid-2014, local governments and LGFVs accumulated 20.8 trillion yuan of outstanding debt.
As the central government began to crack down on the use of LGFVs, local governments cannot but cut back spending commitments, contributing to what analysts dub a “fiscal slide”.
“Local governments’ fiscal constraints were a key cause of the slowdown at the start of the year and have limited the effectiveness of growth stabilization measures,” argues Zhu Haibin, chief China economist at JPMorgan.
In fact, the same thing about local governments may be said of state-owned enterprises (SOEs) and banks, which are just as indebted as they have unleashed investments they would have otherwise not made were it not for the stimulus plan.
This brings us to a process of deleveraging and the so-called balance-sheet recession. With debt-to-GDP ratio at 282 percent, neither local governments nor SOEs nor banks have the appetite to spend; and when everyone saves, the economy stops moving forward.
The stock market rally early this year can thus be seen as a veiled (and failed) attempt to inject liquidity to companies and banks alike through the equity market.
Similarly, the recent mini-devaluation was urgently called on to restore a stagnating economy, where exports in July fell 8.3 percent on an annual basis.
What unites the two episodes is their inadequacy. Can China do anything to avert a hard landing?
On the monetary policy front, the People’s Bank of China has cut interest rates four times since late last year, lowered reserve requirements repeatedly and expanded localities’ freedom to issue bonds directly (and ordered banks to keep lending to them).
In fiscal policy, Beijing acknowledged that the fiscal deficit for 2015 will be higher than previously indicated. The Ministry of Finance even allowed local governments to use funds in the treasury to finance LGFV projects.
The policy responses are, at best, tactical. They resemble what Chen Long of Gavekal Dragonomics describes as a Greek-style “extending and pretending”, in the hope that an estimated 22 trillion yuan of questionable local government debt would eventually all be repaid.
As George Magnus, a senior advisor to UBS, summarizes neatly, “For now, the policy stance is to stick to the status quo, but sooner or later, the authorities will have to swallow land and shut down the debt dependency.”
Eventually, the problem of debt overhang has to go. A good first step could be a fiscal stimulus, albeit in the form of expenditures on education and R&D. This helps lift the economy and also facilitate rebalancing.
Another good step would be to modernize China’s tax system to divert from the reliance on land sales.
A third one would be to reform the hukou system, granting migrant workers more entitlements to spend and attracting many more to cities.
Clearly, rather than entering a “new normal”, the Chinese economy is currently at the most abnormal stage ever since 1978.
Restoring it to a more sustainable path will require not only normal efforts but also supernormal calm, courage and ingenuity.
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