China will struggle to keep its momentum
Chinese officials love slogans. I was reminded of this at last month’s China Development Forum, an annual meeting of top Chinese officials, international business people and policy intellectuals. This year’s slogan is “the new normal”, a notion first advanced (to my knowledge) by McKinsey in 2009. Residents of high-income countries are now used to the idea that the performance of their economies has changed fundamentally. But what does new normal mean to the Chinese?
At the forum, Zhang Gaoli, the vice-premier and a member of the politburo, characterised it thus: first, “development remains China’s top task”, despite lower rates of growth; second, the old growth model “featuring high input, high energy consumption and over-dependence on external demand is no longer sustainable”; third, the Chinese still enjoy important “strategic opportunities”, and so “are fully confident about our future”.
Should we be as confident? I can see two big reasons why the answer should be “yes” and two why it might be “no”.
The first reason why the answer should be yes is past performance. China’s gross domestic product per head (at purchasing power parity) has risen from just above 2 per cent of US levels in 1980 to 24 per cent last year, according to the International Monetary Fund. For such a huge country to have achieved this is extraordinary. Whatever we might think of its politics, we have to recognise the competence that underlies such a success, one that has transformed the world economically and is on its way to transforming it politically.
The second reason why the answer should be yes is that the country possesses huge strengths and potential.
China’s people are famously hard-working, entrepreneurial and education-minded. The national savings rate is close to 50 per cent of GDP (see chart). Thus, despite its high investment rate, the country is a huge creditor.
Furthermore, productivity still lags far behind levels in high-income countries. As the Organisation for Economic Co-operation and Development notes in a new economic survey of China: “Given that around half of the population still lives in rural areas, further productivity gains can be achieved through continued migration to cities, which host more productive urban jobs.” Reform and liberalisation of the household registration system will promote such migration.
Additional sources of opportunity are today’s defective policies and practices. Returns on investment are falling because of excessive subsidies. The contribution to growth of “total factor productivity” — improvements in the efficiency with which capital and labour are used — is also falling. Planned shifts towards greater reliance on market forces, a more predictable legal system, and stronger household and public consumption, might release the potential for another two decades of catch-up growth, albeit at a more measured pace than in recent decades.
With this record and this potential, why should anybody doubt China’s ability to grow quickly for years?
The first reason is that growing very quickly is rather like riding a bicycle: it goes well so long as speed is maintained. Once it slows, however, a bicycle starts to wobble. This is why managing deceleration is so hard. The second reason is crucial: the Chinese economy is highly unbalanced. Slowing an unbalanced economy is particularly hard.
A salient aspect of the unbalanced economy is the high savings rate and thus its reliance on investment as a source of demand. Yet, as the economy slows, the demand for investment is likely to fall more than proportionately. The reason is that past investment was done on the assumption of annual growth at 10 per cent. With growth substantially slower, excess capacity will be chronic. What do people do when they have excess capacity? They stop investing. That is also why China’s government needs to keep growth up: if it fails to do so, investment might collapse, with devastating effects.
That is not all. The combination of a debt overhang with a slowing economy is particularly damaging. Yet that is what the credit-fuelled, property-related investment boom has created. As growth slows so would the ability to service debt, even if underlying investments might ultimately be profitable. This decline in debt-servicing capacity would generate a “balance-sheet recession” in demand. That would add to the adjustment to investment outlined above. This combination is what laid the Japanese economy low in the 1990s.
If the Chinese economy is to shift into its new normal on a stable and sustainable basis, it has to avoid any such collapse. To achieve this will require very deft macroeconomic management. It is already easy to imagine that China will end up with short-term interest rates at zero. The central government might soon be forced to increase its fiscal deficit substantially, particularly if heavily-indebted subnational governments were to cut back. The People’s Bank might finance such an increased central government deficit directly. Alternatively, the government might borrow from commercial banks and accelerate development of a bond market. With overall public debt estimated by the OECD at only 50 per cent of GDP, room for further borrowing certainly exists.
How China manages these adjustments is fraught with implications for the rest of the world. Already, the country’s slowdown has played an important role in lowering demand for (and prices of) commodities. If a hard landing for domestic investment were to occur, while savings stayed so high, trade surpluses might explode. That would exacerbate the global savings glut at what is already a very difficult time. The world must pray the Chinese authorities manage this transition successfully. The alternative is not to be contemplated.