Markets & Politics - Four challenges for China

How to manage a slowing growth rate and remain the world’s second economic power.

REUTERS/CONTRASTO/ALY SONG
Following the introduction of economic reforms by Deng Xiaoping in 1978, China has enjoyed 35 years of amazing growth, lifting hundreds of millions of people out of poverty, building the world’s biggest war chest of foreign reserves and gaining widespread influence around the world.

In the process, China has become the world’s second-largest economy with a GDP of about $10.5 trillion (€9.3tn), or 13.5% of global GDP, behind the US with a GDP of $17.4 trillion (€15.4tn) and roughly three times the size of countries such as Japan and Germany.

China’s impressive growth rates were achieved by a combination of market liberalization, the opening up of trade and investment to the rest of the world, and a massive program to bring the mostly rural population into the cities – in the order of 20 million people a year – to work in the newly built factories. China has also improved its economic institutions, particularly in the educational arena.

However, other institutions, such as a free press or even internet access, that could provide a system of checks and balances over the political powers are absent.

With China’s GDP growth running at around 8% per year for many years (and even higher during the 2002-07 period), it eased towards the end of 2014 and into 2015.

Initially, this was countered with orthodox fiscal and monetary policy easing, which worked quite well.

In sharp contrast, the handling of the dramatic stock market correction earlier this year, triggered by a huge speculative bubble, caused confusion, which turned to unmitigated anxiety when the minidevaluation of China’s official currency, the renminbi, was announced in August. It was a startling departure from the predictable and credible exchange rate policies that had been followed for many years.

The devaluation – trifling in economic terms – brought about sweeping market disruptions worldwide, which in turn caused the US Federal Reserve to delay the otherwise well-announced first interest rate hike in September.

Confusing policy messages have led many market players to suggest that the Chinese slowdown could be considerably worse than the official GDP growth rate of 7%. Many have suggested that growth may now be only a couple of percentage points strong, if positive at all.

Such concerns are groundless. At UniCredit, we have compared the official GDP growth rate with a large number of other indicators, including electricity consumption, sales and foreign trade, and the outcome is a consistent picture of growth in the 6-6.5% range. This is not quite the 7% claimed by the authorities, but it is a far cry from the claimed, and feared, collapse of the Chinese economy. Yet, while the short term outlook in China is far from gloomy, the Chinese authorities face four significant challenges in the medium to longer term:

First, loans to the non-financial sector have exploded in recent years and the response to the slowdown included measures that encourage still more debt and investment. From about 120% of GDP in 2007 (a rather high level), the ratio now stands at almost 200% of GDP. This is about double the ratio of what is usually considered comfortable. To reduce this number back to ‘normal’ debt levels without causing more serious disruptions to growth will be a high-wire act rarely managed successfully. Of course, China’s war chest may come in handy in this operation.

Second, while deleveraging needs to take place, China also needs to shift from an investment-led growth model to a consumption-led set-up. At about 45% of GDP, Chinese investment remains way too high, and consumption, which stands at about the same level, way too low for long-term sustainability. As a reasonable benchmark, when Japan and Hong Kong enjoyed annual GDP growth rates of nearly 10% (during 1961-70) followed by South Korea (1982-91), their investment ratios were typically at 20-30% of GDP with consumption around 50-65%. In other words, in terms of sheer size, China faces the unprecedented task of shifting away from investment and towards consumption. This is by no means a trivial task; it will require nothing short of a miracle to undertake without disrupting the path to growth.

Third, China is facing severe headwinds due to demographics. Within a couple of years, the working-age population will begin to fall, courtesy of many years of the one-child policy. In addition, the availability of a sufficient number of qualified workers prepared to move to the cities in order to match the increasingly sophisticated capital equipment is no longer guaranteed. Academic analyses that superimpose the various curves for demographics, urbanization and capital suggests that within the next 5-10 years, the annual growth rates in China will likely drop to around 3%. This is what we economists term the Lewis Turning Point. Again, this is partly a reflection of the past years’ successes, but it still needs to be managed.

Fourth, these specific challenges and all the other ups and downs that characterise a market economy will have to be handled without the usual political framework in place in other market economies, including the standard checks and balances on power. Without these, corruption and other misappropriations of financial resources in favour of those ‘on the inside’ tend to be more pronounced than in economies with free media. President Xi Jinping has launched a major anti-corruption drive, but its effectiveness remains unclear. And as the overall size of the cake – the Chinese GDP – inevitably begins to grow less rapidly, how that cake is distributed between regions and social classes will pose a political challenge no one-party system has ever had to tackle before. 

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