Headlines in June carried a flurry of conflicting news about China’s economy. The country’s growth flagged, but exports strengthened. Bank lending recovered in May, but industrial production and retail sales were weak. World markets plummeted as the data was released, then recovered as Chinese leaders promised stimulus measures.
Depending on who one listened to, China’s economy was slowing, stabilizing, or dropping off a cliff. The country seemed to be suffering from a surfeit of statistics and a lack of consensus – the only agreement being that blind optimism about China’s miracle growth story is no longer appropriate.
The path of the world’s second-largest economy has clear implications for global growth. Unfortunately, that path remains very uncertain. Economists continue to debate whether China’s slowing economy merits stimulus measures, and, if so, what the most appropriate measures would be. Their ideas differ, but most economists are united on one point: Beijing should avoid another surge in bank lending and local government spending like the one it carried out in 2008.
“What are the don’ts [for new stimulus]?” said Tom Byrne, senior vice president of Moody’s Investment Service. “Don’t do another [RMB] four trillion stimulus package.”
Stimulus part two?
China’s GDP grew 8.1% annually in the first quarter, the slowest pace in nearly three years. In April, data hinted at a further slowdown, and investment banks rushed to push back their predictions for when China’s economy would “bottom out” to the second quarter.
The slowdown is due to pressures both inside and outside the country. The ongoing euro zone crisis and a sluggish recovery in the West have reduced Chinese exports and thus industrial activity. At the same time, regulations within China aimed at dampening inflation and deflating a potential real estate bubble have dragged on growth. China is also undergoing an economic transformation: Annual wage growth is in the double digits, and workers and industries are seeking to move up the value chain.
China’s growth figures may still look stellar compared to the rest of the world. Yet some economists are concerned that growth of even 6-7% might feel like a recession in China, because that rate of expansion may not provide full employment for all the new workers entering the economy. In addition, a slowdown in Chinese growth would obviously weigh heavy on other struggling economies in the West.
Some economists believe that China requires stimulus measures to keep its economy on track. However, most seem united around the idea that China should not launch another stimulus package like it did in 2008, when it encouraged banks to lend freely to local governments and state-owned enterprises. The government has also acknowledged that another huge stimulus program would be a bad idea: “The Chinese government’s intention is very clear: It will not roll out another massive stimulus plan to seek high economic growth,” Xinhua reported in late May, without attributing the information.
Awash in cash
There are several reasons for this. One is that China already has too much liquidity, said Ruchir Sharma, the head of emerging market equities and global macro at Morgan Stanley Investment Management. Sharma points out that there is now more money in circulation in China (about US$10 trillion) than in the US (about US$8 trillion), though the US is a much larger economy. China’s consumer price inflation slowed to a multi-year low in April, but it could become a concern again if banks increase lending.
Secondly, the first stimulus package and the country’s loose monetary policy since then have led to a build-up of debt in the private sector. China’s total debt to GDP ratio is roughly 170%, relatively reasonable compared with a global average of 200%, Li Yang, deputy head of the Chinese Academy of Social Sciences, said at a press conference in May. But debt among Chinese enterprises is equivalent to 105.4% of GDP, higher than in many countries, including the US and Japan.
These withdrawals have taken a toll on the banks that financed much of this activity: Chinese financial institutions were facing about US$69.5 billion in unrecoverable loans at the end of March, up RMB10.3 billion (US$1.6 billion) from three months earlier. “This time the banking regulator will be more cautious [about extending loans],” said Wei Yao, China economist at investment bank Societe Generale.
Another reason is that, after decades of construction, the marginal return on additional investments in infrastructure is dropping. China’s incremental capital output ratio, an index that shows how much investment is needed to produce an additional unit of production, has been climbing steadily since 2003. In other words, pumping money into factories and roads just doesn’t produce the GDP boost that it used to.
Finally, another 2008-style stimulus would go against the much-vaunted goal of rebalancing the economy towards consumption and away from exports and investment. In 2008, the stimulus mainly took the form of bank loans to state-owned enterprises and local government infrastructure projects, causing fixed-asset investment to bloat and consumption to fall as a share of the economy.
But while there are many reasons for Beijing to avoid lending too much to infrastructure projects, the capital has not been entirely deterred. The National Development and Reform Commission (NDRC), China’s economic planning agency, began accelerating approvals in late May for new investment projects by companies and governments in an effort to ease the growth slowdown. Chinese bank loans also surged in May after several months of weak lending, indicating that companies are again pursuing fixed-asset investments.
The scope of these approvals is clearly much more modest than in 2008 and 2009, said Yao of Societe Generale. “The goal is to manage a less painful deceleration [of the economy] rather than reacceleration,” she said. Still, these measures run counter to China’s goals of rebalancing the economy, and they could usher more banking debt and non-performing loans into the system – easing pain in the short term but magnifying it in the long run.
The NDRC’s move may not be smart economics, but it is likely the political path of least resistance. Power in China’s central government has become more diffuse in the past decade, with state-owned enterprises taking a stronger role in governance than ever. With SOEs at the helm, the temptation may be to continue channeling them more funds for less-efficient investments, regardless of the long-term consequences.
Looking out for Zhou the plumber
Most China-focused economists show far more support for fiscal stimulus measures in the form of government spending on social programs or tax breaks, rather than further bank loans and infrastructure spending. Beijing not only has more capacity to introduce fiscal measures, but its spending could also help advance economic rebalancing.
“During the 2008-2009 period, China actually didn’t do much on the fiscal side. They did the stimulus package, but that was mostly based on borrowing from banks,” said Qinwei Wang, a China economist with Capital Economics in London. By spending to improve the social safety net, Beijing should be able to reduce the amount consumers need to save to make big payments for medical care, retirement costs and education, and thereby boost consumer spending, Wang argued.
To do this, the government could concentrate on fulfilling existing spending targets directed at rebalancing the economy, such as portions of the 12th Five-Year Plan. It could also simply meet its 2012 targets for fiscal spending (1.5% of GDP) and money supply growth (14% year-on-year), instead of undershooting them as it usually does, said Shuang Ding, a senior China economist at Citi Investment Research.
jing could also rebalance the economy towards consumption by offering certain consumption subsidies, as it did for cars and white goods in 2008, and by cutting taxes that weigh more heavily on consumers, such as the value-added tax. “If you look at the tax burden, it’s falling on the households, it’s falling on the private sector. But when it comes to fiscal expenditure the households get a very small piece of the pie,” said Wei Yao of Societe Generale.
The new normal
Most economists agree that some stimulus measures are in order. However, some say not much stimulus is needed unless global growth slows sharply, perhaps due to further crisis in the euro zone. They argue that, after decades of economic development and wage growth, China’s potential growth is simply a lot lower now than it used to be.
Ding of Citi pointed to ongoing labor shortages as a sign of lower potential growth. “Even with the economy slowing rapidly, there are still some reports of labor shortages … That means if China boosts growth too much the labor shortage would become even more severe and that would cause inflation. So that is a signal that China can no longer grow very fast,” he said.
Sharma of Morgan Stanley also argued that slowing growth is a necessary precondition for rebalancing the economy. In other words, consumption doesn’t need to grow faster as a share of the economy; rather, fixed-asset investments and exports need to grow more slowly. “Consumption has been increasing at 8% already, so I don’t know how much more you can boost that. The point is that for the economy to rebalance, the rebalancing has to happen on the downside, rather than the upside,” Sharma said.
The services sector (which is driven by consumption) typically employs about 35% more jobs per unit of GDP than exports and fixed-asset investment do, said Stephen Roach, a senior executive at Morgan Stanley and a professor at Yale University. In other words, China’s economy could shift to a more consumption-driven model and allow growth to slow, while still maintaining full employment.
Yet that shift will clearly take time, and it will be a tricky one to navigate given China’s upcoming year of political transition. The risk, of course, is that exports and fixed-asset investment could slow too quickly, triggering massive unemployment.
In the end, the biggest obstacle that China is struggling with may be expectations. The country’s growth has already been remarkable; its economy has expanded at 10% a year for three decades. But China is now approaching a per capita income level of US$6,000 per person, a point at which maturing economies such as Japan, South Korea and Taiwan all began to slow significantly, said Sharma of Morgan Stanley.
“It’s only natural that a country like China slows down at this per capita income level. And yet, what I find is that very few people have made this adjustment. If you look at all the forecasts, you see how they keep talking about how China will grow at 8%,” he said. “The problem in China I find is that it’s a victim of its own success.”