Post by LWPD on Aug 22, 2011 18:10:22 GMT -5
Through massive public investments in infrastructure, China has been able to maintain high GDP growth in the face of the recent global economic slowdown. Yet those immediate term gains are likely to come with very heavy future consequences. In this article, economist Nouriel Roubini analyzes the composition of China's growth model. Given the powerful interests involved, the challenge of moving their economy away from export driven growth and more toward domestic consumption will be daunting!
Courtesy of Roubini.com
China’s Unsustainable Growth Model: The Rising Risk of a Hard Landing After 2013
By Nouriel Roubini
This paper presents the findings of my latest trip to China in the summer of 2011, following two trips in the spring. Here, I update and expand my previous analysis on the risks of a hard landing in China after 2013.
Excessive investment—now close to 50% of GDP—has created a latent debt problem and massive overcapacity that eventually will slow down economic growth and could lead to a hard landing (i.e., a sharp slowdown in growth to 5% or lower).
Until the change in political leadership in 2012, China’s policy makers may be able to maintain high growth with investment, to ensure a smooth transition. But by 2013, China’s unbalanced growth model will start showing signs of strain.
To stave off a hard landing in 2013-14, China needs to work toward a more balanced, sustainable growth model. We are somewhat pessimistic that China will be able to significantly increase the contribution of consumption to growth before the investment boom turns into a bust: The reasons that savings rates are high and consumption rates are low are structural, and decades of painful, politically difficult reforms are required to change these factors.
THE DEMISE OF CHINA’S EXPORT-LED, HIGH-SAVINGS GROWTH MODEL
While in the short run the Chinese economy is overheating—growing faster than potential and thus fanning inflationary flames—the biggest problem that the economy will face starting in 2012-13 will be overinvestment, triggered by a massive increase in fixed investment. Already, fixed investment is close to 50% of GDP.
China’s traditional growth model was based on export-led industrialization, with a weak currency; large net export and fixed investment contributions to GDP; high corporate and household savings rates; and a very low consumption contribution to GDP. As consumption fell as a share of GDP from 52.0% in the 1980s to 33.8% in 2010, growth became increasingly dependent on net exports and fixed investment. Until 2008, the growth rate was predominantly a product of the sharp rise of net exports as a share of GDP: from effectively zero in the early 1990s to a peak of 9% in 2007.
When the global recession caused China’s net exports to plummet from 7.7% of GDP in 2008 to 4.3% in 2009, China reacted not by raising the consumption share of GDP—which stayed stuck at 35% in 2008-09—but rather by further increasing the gross capital formation share of GDP from 44.0% to 47.5% in 2009 alone. Thus, the collapse of net exports in 2009 did not lead to a severe recession—as occurred in Japan, Germany, emerging Asia and other export-led economies—only because fixed investment surged beyond its already excessively high share of GDP. Consumption’s share continued to fall, to 33.8% in 2010, while that of fixed investment increased further in 2010-11 to a level closer to 50% of GDP, via infrastructure spending, commercial and residential real estate investment and cheap loans from state-owned banks to state-owned enterprises (SOEs). These SOEs were told to produce more, hire more and increase capacity, despite the existing glut of capacity in manufacturing (steel, cement, aluminum, autos, etc.).
No country in the world can be productive enough to take almost 50% of GDP and reinvest it into new capital stock without eventually facing massive overcapacity, a nonperforming loan (NPL) problem for the banking system and a surge in public debt. Keeping fixed investment at a level close to 50% of GDP is clearly unsustainable and eventually—most likely after 2013—would lead to a hard landing. By hard landing, we mean a scenario where Chinese growth falls for a significant period of time to a much lower level than China has experienced in the last 30 years. A growth rate of 5% or below would qualify as a hard landing as China needs a growth rate of about 8% to maintain its social and political stability. In a companion paper by RGE Research Analyst Adam Wolfe, we consider alternative hard-landing scenarios in more detail.
THE PROBLEMS THAT LIE AHEAD
Rising NPLs, Rising Public Debt
The NPL problem in the banking system is hidden, for the time being, as NPLs are being ever-greened and rolled over even if the underlying loans are nonperforming. With over a third of infrastructure projects having zero cash return rates, there is no doubt that many of these infrastructure projects will go bust. The only question is who in the public sector—state-owned banks, the central government or the provincial governments that implicitly or explicitly backstop the thousands of special purpose vehicles (SPVs) that financed these infrastructure projects—will pick up the tab when these projects implode. If provincial governments don’t explicitly backstop the SPVs, the state-owned banks will go bust. If instead the provincial governments support the SPVs, the losses will show up as provincial debt; if the provincial governments cannot bear the additional burden of the debt, then the central government will have to provide the backstop. No matter what, some agent of the public sector will see its debt surge.
Recent work by a number of scholars, including RGE analysts, suggests that Chinese public debt is much higher than the central government’s official 17% of GDP. Including the debts of the provincial governments, the People’s Bank of China (PBoC) and the Railway Ministry and those from last decade’s bank bailout, the public debt figure becomes 77% of GDP in 2010 and rising, according to RGE estimates.
Overinvestment Boom: Infrastructure, Real Estate and Industrial and Manufacturing Capacity
Excessive investment—now close to 50% of GDP—is also leading to massive overcapacity that eventually will slow down economic growth and could lead to a hard landing. China is rife with overinvestment in physical, infrastructural and property capital stock. There is an excessive amount of infrastructure for China’s level of per-capita GDP: brand-new empty airports, sleek bullet trains (also empty) that will obviate the 45 planned airports, highways to nowhere, massive new government buildings and ghost towns. There is also excessive commercial and high-end residential investment and an excessive amount of capex. China has nearly half of global capacity in steel and cement, and the country has to keep brand-new aluminum smelters closed to prevent global prices from plunging. Meanwhile, the massive increase in auto capacity has overshot auto sales, despite their surge.
The argument that China will eventually need all these infrastructures to support its urbanization and industrialization does not make sense. The infrastructure needs of any country depend on its rates of per-capita income and labor productivity, as more infrastructure increases the productivity of labor. For a country with a per-capita GDP of just over US$8,000—even on a purchasing-power-parity (PPP) basis—having infrastructure projects that are much larger per capita than those of advanced economies with per-capita incomes four to six times higher than China’s does not make sense. China’s infrastructure is a depreciating asset, likely at a quite rapid rate given the speed at which it was built; thus, it makes no sense to build today what won’t be fully utilized for another 10-20 years, especially because in the meantime the debts with which those investments were funded will come due. The duplication and triplication of infrastructure projects is also illogical: China must decide if it needs 10,000 miles of new high-speed train tracks, 10,000 miles of new highways or 45 new airports on top of the 50 just-built and semi-empty ones.
While in the short run the investment boom will lead to resource-intensive growth, overheating and inflation, over time the overcapacity will cause serious deflationary pressures, starting with the manufacturing and real estate sectors.
The Lessons of History
In the last 50 years, literally all historical episodes of excessive investment have ended with a hard landing, a financial crisis and/or a long period of low growth. And these hard landings have occurred not only in cases of housing booms, which always end with a crash and burn, as the recent episodes in the U.S., UK, Iceland, Ireland, Spain and Dubai show. More importantly, even episodes of overinvestment in manufacturing and industrial capacity end in a hard landing, with no exception: from the Soviet Union in the 1960s-80s, to Latin America in the 1970s-early 1980s, to Japan in the 1980s, to the U.S. in the 1990s, to East Asia in the 1990s. In each episode, the result was a crash and a hard landing. In East Asia, the most relevant case study for China, fixed investment peaked around 35% of GDP in 1997 at the onset of the financial crisis. In China, investment was already 40% before the 2007-09 global crisis and since then has surged to a level closer to 50% of GDP. It is thus clear that, to avoid a hard landing, China needs to reduce the GDP contributions of fixed investment and net exports and increase that of consumption.
Low and Falling Return on Investment and Additional Capital Stock
Having investment at 50% of GDP is not only a source of excess capacity; it also implies a low and falling return on excess capital stock. From a macroeconomic point of view, the return on investment in an economy is equal to the change in the flow of output (dY) divided by the change in the stock of capital (dK), or dY/dK, like the microeconomic definition. Since the change in the stock of capital is equal to fixed investment (I), the macro marginal return to capital is also equal to dY/I. Dividing both the numerator and denominator by real GDP (Y), we see that it is also equal to (dY/Y)/(I/Y), or the ratio of the growth rate of the economy and fixed investment as a share of GDP.
For the last 30 years, China’s average growth rate has been 10%, and recently it has slowed to 9%. In contrast, the investment growth rate has gone from 36% in the 1980s-90s, to 40% in 2000-08, to 49% in 2010. Thus, the gross marginal return on capital at the macro level has fallen from 28% in the 1980s, to 26% in 2000-08, to 19% by 2010, and the return on investment has fallen by almost 40% between the 1980s and 2010. In a matter of a few years, China’s overinvestment has caused a massive, rapid deterioration of the return on capital in the economy. It used to take 36% of GDP in fixed investment to get a growth rate of 10%; now it takes almost 50% of GDP in fixed investment to achieve a growth rate of 9%. Put simply, China needs to operate faster, with more fixed investment, to achieve a lower growth rate.
These results are consistent with recent studies showing that the rate of total factor productivity growth in China is low and falling. Paul Krugman’s famous 1994 critique of the East Asian growth model applies today to China: You can produce many more sausages that no one eats by quickly increasing the number of sausage-making machines. In economic terms, a rise in investment and physical capital can artificially increase GDP, and an excessive and unsustainable investment boom has done so for China.
CHINA’S HIGH SAVINGS RATE: STRUCTURAL FACTORS AT WORK
Demographic Factors Driving the Savings Rate
The trouble is that the reasons the Chinese save a lot and consume little are structural, the product of incentives that will take over two decades of reform to change. Traditional explanations of the high savings rate (lack of a social safety net, limited social security, limited public services like health and education) solve only part of the puzzle. For example, take the argument that the Chinese save a lot because their pension benefits are very low. That can’t be the main explanation: U.S. household savings rates are low in spite of good social security benefits, while in Germany and Japan, with similarly high per-capita income and similarly generous pension systems, household savings rates historically have been high. Conversely, the household savings rate in India, which has low per-capita income and limited pension benefits, is much lower than that in China. So what makes China, with its low per-capita income, have a similar savings rate to the much-richer economies of Japan and Germany? And what makes India’s household savings rate similar to that of the U.S.? The main difference is demographics. China, Germany and Japan are aging fast, and households must save accordingly, while population growth is still robust in India and the U.S. Traditionally, the Asian model of social security was not a government-sponsored pension system; rather, parents would have many children who could eventually take care of their elders. But this social security system is breaking down in China for two reasons. First, households now have one child to take care of two parents and four grandparents. Second, urbanization has broken down the old model of parents living with their children in a rural, agrarian community.
The underdevelopment of capital markets also has increased the savings rate. Down payments on home purchases in China are very high compared to the U.S.: typically 30-50% in the former compared to 20% (and unofficially close to 0% in the years of the subprime mortgage bubble) in the latter. Thus, in order to be able to purchase a first home, the Chinese need to save a lot to be able to make the down payment, especially since a housing bubble has artificially boosted prices. Cross-country academic studies have shown a significant correlation between mortgage down payment rates (themselves correlated in part with the economy’s stage of financial development) and the savings rates of the household sector.
Moreover, given China’s imbalanced sex ratio (a product of selective abortions resulting from the one-child policy) young Chinese men need to own a home and a car to be able to find a suitable bride in a tough marriage market. This further distorts and increases the savings rate among young Chinese males.
Other factors tend to exacerbate the high savings rate of Chinese households. Migrant workers are subject to movement and registration restrictions and do not benefit from the social services that formal residents of cities enjoy; thus they need to save more. The lack of property rights over land and the income/wealth uncertainty it creates also lead to higher savings. And the entire system of consumer finance—not just mortgages but also consumer lending, including credit cards—is very underdeveloped, leading to low rates of debt accumulation and high levels of savings by households.
The High Savings Rate of the Chinese Corporate Sector
There is a myth that Chinese cultural norms are to blame for the country’s high savings rate. But Chinese households in China don’t have a larger propensity to save than Chinese households in Hong Kong, Singapore or Taiwan; they are all Confucian and all save about 30% of their disposable income. The big difference between the Chinese in China and elsewhere is that the share of GDP going to China’s household sector is very low, at barely 50%. After saving 30%, there is little left for consumption, which is why it contributes only about 34% of GDP. On top of household savings, there is another 25% of GDP represented by the savings (retained earnings) of the corporate sector, mostly SOEs. And almost all of these retained earnings go into capital spending, thus leading to the massive overinvestment in the economy.
Several Chinese policies have led to a massive transfer of income from the politically weak household sector to the politically powerful corporate sector (SOEs, import-competing firms, exporters).
A weak currency reduces the purchasing power of households by making imports expensive and instead benefits import-competing SOEs and exporters by boosting their income/profits.
Low interest rates on deposits—well below the rising inflation rate—and low lending rates (negative in real terms) for corporates and developers imply that the massive savings of the household sector receive negative rates of return while the real cost of borrowing for SOEs is also negative, creating a powerful incentive to overinvest. This tax on savings implies a transfer of income from households to SOEs, most of which would be losing money if they had to borrow at higher market interest rates.
A policy of labor repression for the last 30 years has caused wages to grow much slower than productivity, reducing unit labor costs and, again, transferring income from households to the corporate sector.
So China’s problem is excessive saving not by households but by the corporate sector. To change this repression of household income—and thus of household consumption—China would need much more significant appreciation of the RMB, liberalization of interest rates to increase the return on household savings and a much sharper increase in wage growth in excess of productivity growth. But more importantly, China also would need to privatize the SOEs so that their profits become income for households and/or massively tax SOEs’ profits and then transfer those fiscal resources to the household sector, either directly via transfers or indirectly through provision of public goods. But privatizing the SOEs is not even on the reform agenda, and policy proposals to tax some of the profits of the SOEs and transfer the income to households have languished for years in the face of political resistance from powerful SOE lobbies.
What Do China, Germany and Japan Have in Common?
The pitfalls of Chinese corporate governance—state ownership of too many firms that leads to excessive retention of profits and not enough distribution of dividends to shareholders, thus leading to excessive corporate savings—are also evident in similar forms in other economies. In Germany and Japan, the existence of large conglomerates (such as the Japanese keiretsu) and the cross-holding of shares among firms imply excessive corporate savings, with profits mostly retained rather than distributed to shareholders. In China, high corporate savings have led to excessive capital spending and investment; in Germany and Japan, where there is less investment in capital stock because of the lower return on capital, high corporate savings have led to high national savings and large current account surpluses. So China, Germany and Japan share features—aging populations, poor corporate ownership and governance structure and underdeveloped consumer finance—that cause high private and public savings rates, large current account surpluses and, in the case of China, excessive fixed investment.
THE LONG ROAD TO CONSUMPTION-LED GROWTH
Overcoming the Political Bias Toward Maximization of Growth and Overinvestment at the Provincial Level
The transformation of the Chinese economy from reliance on exports and fixed investment toward a greater contribution from consumption requires a change in the distribution of income from capital to labor, from profits to wages and from the corporate sector to the household sector. China’s political economy is such that the groups in favor of the status quo—SOEs, provincial governments, export lobbies, state-owned banks—are powerful, while households are weak. The decentralization of political power in China has exacerbated the problem of overinvestment. Party officials at the provincial and city levels want to maximize the growth rates of their provinces as their political power—including the biggest prize of all, becoming one of the nine members of the Politburo Standing Committee, the top governing body in China—depends on it. Once a Party secretary is promoted to a senior central government position, any economic woes left behind become the headache of the next local leader. Thus, local leaders have a powerful incentive to control state-owned banks; create thousands of SPVs to finance overinvestment in infrastructure; manage land use and sales to maximize revenues and ensure excessive real estate development; and interfere in local SOEs to maximize capacity and employment growth. This leads to widespread duplication of investment projects across provinces; no wonder each province has its own steel and aluminum mills, auto factories, textile and apparel plants, electronics plants and cement factories. At the macro level, the result is fixed investment comprising almost 50% of GDP.
Transformation of Demand and Supply Structure Likely to Be Bumpy and Risky
This complex transition is a bumpy, perilous road, with the potential to fork into a hard landing. If investment remains at a high share of GDP, and overcapacity, NPLs and public debt become excessive, a hard landing will occur. But even if Chinese policy makers are able to accelerate the rebalancing of the economy, the transition will still be risky for many reasons.
If the changes in wage, exchange rate and interest rate policies were to occur too fast, many SOEs would fail as their profits would disappear. The fall in SOE production would lead to a fall in employment, and the outcome would be lower labor income, even as the labor share of income rises. Labor strife, including strikes and union militancy, is one potential cause of a too-rapid and thus disruptive increase in nominal and real wages.
Change is necessary not only in the structure of demand (less from exports and fixed investment, more from consumption) but also in the structure of supply. The consumer goods exported abroad may have a higher value added than those that the Chinese can consume at home; plus, industrial/manufacturing production needs to fall relative to production of household services. These transformations require a difficult movement of labor and capital from declining sectors to expanding sectors; the new demand pattern needs to match a new and different supply structure pattern.
A change in productive structure requires a massive amount of corporate restructuring by closing unproductive and/or unprofitable firms to allow the consolidation and growth of stronger firms. This will disrupt regional and sectoral employment and capacity. For example, in China today, there are almost 100 automakers (down from 110 a few years ago); while the U.S. has only three domestic car producers. The reason there are so many auto firms—as well as steel, cement, textile and other firms—is that every province wants to have a few. The necessary consolidation and restructuring of the corporate sector requires closing down inefficient and/or unprofitable firms, which implies massive regional and sectoral labor shedding that will be politically difficult and involve transition costs for the laid-off workers.
Finally, the reduction in labor use in declining sectors—heavy industry and manufacturing—may occur faster than the increase in employment in rising sectors such as services, thus leading to employment problems.
Given the powerful contingents that are adverse to change and the inherent risks and costs, the political path of least resistance is the status quo—export-led growth, excessive investment and insufficient consumption—in spite of the stated goal in the new Five-Year Plan (like the previous ones) of raising the share of consumption in GDP.
Political Management of Key Relative Prices Distorts Demand and Supply
The distortions in the structure of aggregate demand and supply in China are exacerbated by the fact that the government controls three fundamental relative prices that determine this structure.
The relative price of foreign to domestic goods is controlled by the government via the nominal exchange rate, which drives the short-term movement of the real exchange rate. Because this keeps the currency undervalued, imports are expensive and consumption of imported goods is low, while production of exports and import-competing goods is subsidized. This distorts the distribution of aggregate demand (too many exports and too little consumption) and stimulates excessive production of exports and import-competing goods, while limiting the supply of non-traded goods and services.
The government also controls and distorts the cost of capital relative to wages by allowing the protected corporate sector to borrow too cheaply (at a negative cost in real terms). The combination of the taxation of the household sector to transfer income to the corporate sector (via wage, currency and interest rate policies) and the too-low cost of capital for the corporate sector implies excessive corporate savings and fixed investment. Paradoxically, in spite of relatively low wage rates, China’s growth model is highly capital-intensive, as the cost of capital is too low for those firms—mostly SOEs—that have access to cheap financing from state-owned banks. So, in a country with a massive surplus of labor, many investment projects—from heavy industry to infrastructure—are highly capital-intensive. This distortion in the cost of capital is behind China’s overinvestment and excessive production of capital goods.
The cost of land relative to other goods and assets is too low, leading to overinvestment in commercial and residential real estate. The land is mostly controlled by the government, expropriated from farmers and urban residents with little reward and sold at a highly subsidized rate to real estate developers, who thus overinvest in high-end residential and commercial real estate.
By aggressively controlling three key relative prices, China distorts demand, amplifying real estate investment, capex and exports while repressing consumption spending. At the same time, it distorts the structure of aggregate supply, encouraging excessive production of physical capital (machinery, real estate and infrastructure) and insufficient production of consumer goods and services. Until these key relative prices are liberalized—with a more flexible exchange rate and market-determined deposit and lending rates and land prices—the distortions in the structure of aggregate demand and supply will remain. And these distortions, together with the repression of wage growth, contribute to a low level of household income and thus of consumption.
Counterarguments to the View That Consumption Rates Cannot Rise Fast Enough to Avoid a Hard Landing
The most sophisticated analysts acknowledge that the Chinese economy is imbalanced and that the share of consumption in GDP is too low. But some argue that China may be able to transform itself into a consumption-based economy faster than we have argued here.
Some note that wages in 2010 and 2011 grew faster than productivity for the first time in decades, thus increasing the labor share of income. While this is true, two years do not make a trend; wages would have to grow much faster than productivity for many years to change the distribution of income between wages and profits. Also, the aforementioned reasons for the low household share of income aren’t only related to wage growth, and the reasons that household savings are high are numerous, complex and not reversible in a short period of time. Thus, the faster growth of wages in the last two years is a positive sign but not an indication that the household savings rate is set to shrink significantly any time soon.
Some, like Goldman Sachs’ Jim O’Neill, have stressed that the micro and macro data point to very rapid growth in retail sales and consumption in China in recent years. But with the economy still growing at a real rate of 9-10% y/y and with inflation above 6%, even nominal retail sales or nominal consumption growth rates of 15-16% per year imply that the consumption share of GDP has fallen to a low of less than 34%. For that share to increase, the rate of growth of nominal consumption has to be significantly higher than nominal GDP growth, i.e., much higher than 15-16% per year. This is not happening yet, based on the macroeconomic data we have seen.
Some suggest that the private consumption share of GDP is underestimated because of the recent rise of household spending on services in the underground economy, which are not easily measured. Also, fixed investment probably is overstated in GDP because land values and transfers are not adequately stripped out of the data. Personal spending on household services such as cleaning and educational help for children may underestimate the consumption share of GDP. This argument may be valid, but its significance is limited by three factors. First, the amount of such household spending on unreported services may not be large enough to have a significant effect on the share of consumption in GDP. Second, though some private consumption may go unreported, this is balanced by other factors that cause the consumption share to be overestimated, such as the inclusion of some public-sector consumption with private consumption. Third, in the last three years, consumption growth has been artificially boosted by temporary measures that have stolen demand from the future; e.g., tax rebates for the purchase of private cars (the Chinese equivalent of the U.S. “cash for clunkers” program) and government-subsidized appliances for rural populations. Note also that if fixed investment is overestimated and consumption is underestimated then GDP (absolute and per capita) is slightly smaller than officially estimated. Thus, even if I/GDP is lower and C/GDP is higher, with a lower per-capita GDP it is going to take longer for China to be able to fully utilize its existing, depreciating capital stock.
It has been argued that young Chinese are not as frugal as their parents, as cultural mores have changed; thus, over time the savings rate may fall. As rigorous studies of young generations’ marginal propensity to spend and save have yet to be completed, the legitimacy of this argument is difficult to gauge. Other factors suggest that this argument may not have a strong empirical base. Young Chinese may be more conscious of brands and fashion, but they face the same constraints on income generation and the same necessity to save. Even middle-class Chinese youth face rising costs of housing, education and health care, as well as an overall inflation rate that is probably higher than officially measured. Young Chinese may or may not be less Confucian than their parents, but the aspiration to spend is not the same as the ability to spend. The latter is still sharply constrained by the small share of GDP—about 50%—represented by household income.
While over time the consumption share of GDP may increase, the structural factors that constrain consumption growth will not radically change in the short run. China will eventually become a consumer society, but this is occurring at a snail’s pace. Thus, once China reaches the overinvestment limit and slows down fixed investment, consumption growth may not occur fast enough to prevent a sharp economic slowdown, if not a hard landing.
RISING RISK OF A HARD LANDING IN 2013 AND BEYOND
Until the change in political leadership in October 2012, when the new president and premier will be chosen, China’s policy makers may be able to maintain high growth by continuing with high levels of investment. To ensure a smooth transition, China’s policy makers will do everything necessary to maintain a growth rate above 8% y/y and an inflation rate of 5-6% or below. If the economy slows down too much, they will accelerate infrastructure spending (including on the planned 10 million new units of public housing) and implement fiscal, credit and monetary stimulus. If inflation accelerates, they will tighten monetary and credit policy and utilize non-market measures, like administrative tools. So the chances of a hard landing before the end of 2012 are relatively small.
But in 2013, China’s unbalanced growth model will start showing signs of strain. If a hard landing is to occur, it would likely be in 2013 or 2014 but not much later. Recognizing that overinvestment booms can last for a long period of time (take the case of the Soviet Union), we see several reasons that the risk of a hard landing in China will rise significantly in 2013-14, rather than later.
In the next two years, the rise in NPLs will force banks to slow down the process of ever-greening their losses and start recognizing the holes in their balance sheets. How much of a hit the banks take depends not only on the size of their NPLs—driven by bad loans to local governments, local government financing vehicles (LGFVs), real estate developers, SOEs and private firms—but also on whether those losses are socialized directly by the provincial and central government or imposed first on the banks before they are recapitalized by the central government. But either way, the balance sheets and the profit-and-loss statements of the banks will take a hit, forcing a slowdown in credit growth—if not an outright credit crunch—that will weigh on the economy.
The rise in the size of the public debt will require a crackdown on local government borrowing and a slowdown of the debt buildup of other parts of the public sector. For example, the Railway Ministry is now effectively bankrupt after its borrowing spree to finance 10,000 miles of high-speed trains, even if its debts are effectively those of the sovereign. Larger fiscal deficits will emerge when the central government has to recognize the losses driven by an unsustainable borrowing binge at all levels of the public sector. Rising defaults on bonds issued by sub-national public-sector agents may increase credit spreads, adding to the credit crunch, especially once the new leadership is in place and ready to deal with the excessive borrowing and spending of the 2009-12 period.
It will become increasingly unsustainable to maintain fixed investment near 50% of GDP. Private investment by exporters will slow down as the G3 economies’ anemic recovery limits the market for Chinese goods. The overinvestment in high-end residential and commercial real estate will end when a price correction causes a fall in speculative demand, rendering SOEs unable to put down more real estate as collateral for their bank borrowings. The correction in commercial real estate investment will become significant when the excessive office space investment, especially by SOEs, reaches its saturation point. Opportunities for more infrastructure spending—particularly on transportation—will start to decline as these projects conclude and new ones become more expensive and less marginally beneficial to undertake; plus, the fiscal squeeze on local government finances and LGFVs’ balance sheets will cut down on infrastructure binges. Also, the excessively fast buildup of the high-speed train system has led to repeated, serious train accidents and malfunctions that have caused public outcry about safety; these issues, together with the effective bankruptcy of the Railway Ministry, will trigger a slowdown in the pace of investment in new high-speed lines. Across the board, SOEs will be forced to reduce their rates of capex, especially if stressed banks have to limit credit creation.
By 2013, it is possible that the G3 economies will experience further economic slowdown (they are already at stall speed and at risk of double-dip recession), thus limiting China’s ability to rely on exports for growth. U.S. growth is already constrained by deleveraging, and this serious weakness will accelerate in 2012-13, when fiscal austerity will imply more direct fiscal drag and will force another round of household deleveraging, once transfer payments are reduced and taxes are increased. The probability of a U.S. double dip over the next year is now close to 50%. The eurozone (EZ) will become unable to kick the can down the road once the European Stability Mechanism is created in 2013. There will be more bail-ins and orderly restructurings of public debt—in Ireland and Portugal after Greece, and possibly even in Italy and Spain, which are now at risk of losing market access—and more restructurings of banks’ unsustainable senior debts (starting with those in Ireland). Economic stagnation will persist in the EZ periphery as fiscal austerity accelerates while the ECB normalizes policy rates. And Japan will return to its long-term stagnation once the temporary boost from a modest fiscal stimulus package for postquake reconstruction fizzles out by 2013.
These four factors suggest that in 2012 and especially in 2013, China will begin to find it increasingly hard to kick the can down the road and sustain a growth model based on excessive investment. Political considerations will determine the timing of when the central government stops the credit and debt binge and accelerates reforms that eventually will increase the incentive to consume.
Deflationary Effects of a Chinese Hard Landing and Risk of Trade Wars
While in the short run, China faces a problem of overheating and rising inflation, as its investment boom heightened demand for raw materials, this overinvestment in capital capacity may eventually lead to disinflationary if not deflationary pressures, both within the country and globally. Within the country, the bursting of the real estate bubble would lead to home and commercial real estate price deflation after years of surging prices. A sharp slowdown in economic growth would also increase the slack in the labor market, with higher unemployment weighing on wage growth, and in the goods market, with excessive capacity constraining the pricing power of firms, on top of real estate price deflation.
Globally, a sharp slowdown of China’s growth would have a disinflationary effect via prices of traded goods. Commodity prices would plummet as Chinese demand would drop. Plus, China would dump excess supply of industrial and manufactured goods—steel, cement, aluminum, cars, apparel, consumer electronics, etc.—into global markets. Even today, with growth still above 9%, there is so much industrial overcapacity in China that the excess is already exported in global markets, hurting foreign producers of these traded goods. For example, in spite of the demand for steel for highways, railroads, airports, real estate, etc., there is so much overcapacity in China that a lot of its steel is exported abroad, hurting the market share and profitability of global steel producers. Once China experiences a slowdown of growth, the excess capacity of steel, aluminum and other manufactured goods will be sold on global markets, depressing prices.
Of course, the U.S., Europe and other advanced economies as well as emerging markets would not sit idly and accept Chinese dumping of its overcapacity in global traded goods markets. The most likely result would be protectionism and trade wars. The rest of the world is already concerned about China’s exports; these trade tensions would escalate if China were to witness a plunge in domestic demand and dump the excess capacity in global markets. If China has a hard landing, either massive global deflation or severe trade wars will result.
CONCLUSION
To stave off a hard landing in 2013, China needs to work toward a more balanced, sustainable growth model. Net exports, fixed investment and savings need to fall as a share of GDP, while private consumption needs to sharply rise. On the supply side, China must reduce its reliance on production of capital goods and exports and increase the production of consumer goods and services. We are somewhat pessimistic that China will be able to significantly increase the contribution of consumption to growth before the investment boom turns into a bust: The reasons that savings rates are high and consumption rates are low in China are structural, and decades of painful, politically difficult reforms are required to resolve these issues.
On the other hand, in the last few decades Chinese policy makers have shown flexibility and policy innovation that have allowed consistent growth of about 10%, in spite of major domestic and external economic and financial shocks. So one should not underestimate the ability and flexibility of Chinese policy makers to do what is necessary to maintain a high level of economic growth. The new leadership that will run the country from 2013 on may decide to accelerate reforms to rebalance economic growth and make it more sustainable.
But there are enormous challenges standing in their way. The economic and political forces in favor of the status quo—provincial governments, SOEs, export and import-competing sectors—are influential, while Chinese households are politically weak. After the political transition, it will be clear if the new leadership is committed to accelerating reforms to rebalance growth and prevent a hard landing. The risk is that the reforms will be too little and too late to prevent the hard landing toward which the current growth model is heading. Certainly, it is likely that by 2013-14 the unsustainability of China’s current growth model will manifest itself.
In a follow-up paper, we will analyze in detail a variety of scenarios for China in 2013-14. One is a full-blown “crash and burn,” with a severe economic and banking crisis. Another is a “muddle through” situation, in which the central government offers a full bailout of local debts and the banking sector, which smoothes over for a decade with a gradual fall in the investment rate and a weakening of economic growth, short of a real hard landing. In a third scenario, a “slow grind,” the government offers a partial bailout to the banking sector to clean up the large default rate on local government debts. Burden-sharing between local governments, Beijing, SOEs and the banks results in a significant decline in investment and economic growth but prevents a full-blown financial crisis.
Courtesy of Roubini.com
China’s Unsustainable Growth Model: The Rising Risk of a Hard Landing After 2013
By Nouriel Roubini
This paper presents the findings of my latest trip to China in the summer of 2011, following two trips in the spring. Here, I update and expand my previous analysis on the risks of a hard landing in China after 2013.
Excessive investment—now close to 50% of GDP—has created a latent debt problem and massive overcapacity that eventually will slow down economic growth and could lead to a hard landing (i.e., a sharp slowdown in growth to 5% or lower).
Until the change in political leadership in 2012, China’s policy makers may be able to maintain high growth with investment, to ensure a smooth transition. But by 2013, China’s unbalanced growth model will start showing signs of strain.
To stave off a hard landing in 2013-14, China needs to work toward a more balanced, sustainable growth model. We are somewhat pessimistic that China will be able to significantly increase the contribution of consumption to growth before the investment boom turns into a bust: The reasons that savings rates are high and consumption rates are low are structural, and decades of painful, politically difficult reforms are required to change these factors.
THE DEMISE OF CHINA’S EXPORT-LED, HIGH-SAVINGS GROWTH MODEL
While in the short run the Chinese economy is overheating—growing faster than potential and thus fanning inflationary flames—the biggest problem that the economy will face starting in 2012-13 will be overinvestment, triggered by a massive increase in fixed investment. Already, fixed investment is close to 50% of GDP.
China’s traditional growth model was based on export-led industrialization, with a weak currency; large net export and fixed investment contributions to GDP; high corporate and household savings rates; and a very low consumption contribution to GDP. As consumption fell as a share of GDP from 52.0% in the 1980s to 33.8% in 2010, growth became increasingly dependent on net exports and fixed investment. Until 2008, the growth rate was predominantly a product of the sharp rise of net exports as a share of GDP: from effectively zero in the early 1990s to a peak of 9% in 2007.
When the global recession caused China’s net exports to plummet from 7.7% of GDP in 2008 to 4.3% in 2009, China reacted not by raising the consumption share of GDP—which stayed stuck at 35% in 2008-09—but rather by further increasing the gross capital formation share of GDP from 44.0% to 47.5% in 2009 alone. Thus, the collapse of net exports in 2009 did not lead to a severe recession—as occurred in Japan, Germany, emerging Asia and other export-led economies—only because fixed investment surged beyond its already excessively high share of GDP. Consumption’s share continued to fall, to 33.8% in 2010, while that of fixed investment increased further in 2010-11 to a level closer to 50% of GDP, via infrastructure spending, commercial and residential real estate investment and cheap loans from state-owned banks to state-owned enterprises (SOEs). These SOEs were told to produce more, hire more and increase capacity, despite the existing glut of capacity in manufacturing (steel, cement, aluminum, autos, etc.).
No country in the world can be productive enough to take almost 50% of GDP and reinvest it into new capital stock without eventually facing massive overcapacity, a nonperforming loan (NPL) problem for the banking system and a surge in public debt. Keeping fixed investment at a level close to 50% of GDP is clearly unsustainable and eventually—most likely after 2013—would lead to a hard landing. By hard landing, we mean a scenario where Chinese growth falls for a significant period of time to a much lower level than China has experienced in the last 30 years. A growth rate of 5% or below would qualify as a hard landing as China needs a growth rate of about 8% to maintain its social and political stability. In a companion paper by RGE Research Analyst Adam Wolfe, we consider alternative hard-landing scenarios in more detail.
THE PROBLEMS THAT LIE AHEAD
Rising NPLs, Rising Public Debt
The NPL problem in the banking system is hidden, for the time being, as NPLs are being ever-greened and rolled over even if the underlying loans are nonperforming. With over a third of infrastructure projects having zero cash return rates, there is no doubt that many of these infrastructure projects will go bust. The only question is who in the public sector—state-owned banks, the central government or the provincial governments that implicitly or explicitly backstop the thousands of special purpose vehicles (SPVs) that financed these infrastructure projects—will pick up the tab when these projects implode. If provincial governments don’t explicitly backstop the SPVs, the state-owned banks will go bust. If instead the provincial governments support the SPVs, the losses will show up as provincial debt; if the provincial governments cannot bear the additional burden of the debt, then the central government will have to provide the backstop. No matter what, some agent of the public sector will see its debt surge.
Recent work by a number of scholars, including RGE analysts, suggests that Chinese public debt is much higher than the central government’s official 17% of GDP. Including the debts of the provincial governments, the People’s Bank of China (PBoC) and the Railway Ministry and those from last decade’s bank bailout, the public debt figure becomes 77% of GDP in 2010 and rising, according to RGE estimates.
Overinvestment Boom: Infrastructure, Real Estate and Industrial and Manufacturing Capacity
Excessive investment—now close to 50% of GDP—is also leading to massive overcapacity that eventually will slow down economic growth and could lead to a hard landing. China is rife with overinvestment in physical, infrastructural and property capital stock. There is an excessive amount of infrastructure for China’s level of per-capita GDP: brand-new empty airports, sleek bullet trains (also empty) that will obviate the 45 planned airports, highways to nowhere, massive new government buildings and ghost towns. There is also excessive commercial and high-end residential investment and an excessive amount of capex. China has nearly half of global capacity in steel and cement, and the country has to keep brand-new aluminum smelters closed to prevent global prices from plunging. Meanwhile, the massive increase in auto capacity has overshot auto sales, despite their surge.
The argument that China will eventually need all these infrastructures to support its urbanization and industrialization does not make sense. The infrastructure needs of any country depend on its rates of per-capita income and labor productivity, as more infrastructure increases the productivity of labor. For a country with a per-capita GDP of just over US$8,000—even on a purchasing-power-parity (PPP) basis—having infrastructure projects that are much larger per capita than those of advanced economies with per-capita incomes four to six times higher than China’s does not make sense. China’s infrastructure is a depreciating asset, likely at a quite rapid rate given the speed at which it was built; thus, it makes no sense to build today what won’t be fully utilized for another 10-20 years, especially because in the meantime the debts with which those investments were funded will come due. The duplication and triplication of infrastructure projects is also illogical: China must decide if it needs 10,000 miles of new high-speed train tracks, 10,000 miles of new highways or 45 new airports on top of the 50 just-built and semi-empty ones.
While in the short run the investment boom will lead to resource-intensive growth, overheating and inflation, over time the overcapacity will cause serious deflationary pressures, starting with the manufacturing and real estate sectors.
The Lessons of History
In the last 50 years, literally all historical episodes of excessive investment have ended with a hard landing, a financial crisis and/or a long period of low growth. And these hard landings have occurred not only in cases of housing booms, which always end with a crash and burn, as the recent episodes in the U.S., UK, Iceland, Ireland, Spain and Dubai show. More importantly, even episodes of overinvestment in manufacturing and industrial capacity end in a hard landing, with no exception: from the Soviet Union in the 1960s-80s, to Latin America in the 1970s-early 1980s, to Japan in the 1980s, to the U.S. in the 1990s, to East Asia in the 1990s. In each episode, the result was a crash and a hard landing. In East Asia, the most relevant case study for China, fixed investment peaked around 35% of GDP in 1997 at the onset of the financial crisis. In China, investment was already 40% before the 2007-09 global crisis and since then has surged to a level closer to 50% of GDP. It is thus clear that, to avoid a hard landing, China needs to reduce the GDP contributions of fixed investment and net exports and increase that of consumption.
Low and Falling Return on Investment and Additional Capital Stock
Having investment at 50% of GDP is not only a source of excess capacity; it also implies a low and falling return on excess capital stock. From a macroeconomic point of view, the return on investment in an economy is equal to the change in the flow of output (dY) divided by the change in the stock of capital (dK), or dY/dK, like the microeconomic definition. Since the change in the stock of capital is equal to fixed investment (I), the macro marginal return to capital is also equal to dY/I. Dividing both the numerator and denominator by real GDP (Y), we see that it is also equal to (dY/Y)/(I/Y), or the ratio of the growth rate of the economy and fixed investment as a share of GDP.
For the last 30 years, China’s average growth rate has been 10%, and recently it has slowed to 9%. In contrast, the investment growth rate has gone from 36% in the 1980s-90s, to 40% in 2000-08, to 49% in 2010. Thus, the gross marginal return on capital at the macro level has fallen from 28% in the 1980s, to 26% in 2000-08, to 19% by 2010, and the return on investment has fallen by almost 40% between the 1980s and 2010. In a matter of a few years, China’s overinvestment has caused a massive, rapid deterioration of the return on capital in the economy. It used to take 36% of GDP in fixed investment to get a growth rate of 10%; now it takes almost 50% of GDP in fixed investment to achieve a growth rate of 9%. Put simply, China needs to operate faster, with more fixed investment, to achieve a lower growth rate.
These results are consistent with recent studies showing that the rate of total factor productivity growth in China is low and falling. Paul Krugman’s famous 1994 critique of the East Asian growth model applies today to China: You can produce many more sausages that no one eats by quickly increasing the number of sausage-making machines. In economic terms, a rise in investment and physical capital can artificially increase GDP, and an excessive and unsustainable investment boom has done so for China.
CHINA’S HIGH SAVINGS RATE: STRUCTURAL FACTORS AT WORK
Demographic Factors Driving the Savings Rate
The trouble is that the reasons the Chinese save a lot and consume little are structural, the product of incentives that will take over two decades of reform to change. Traditional explanations of the high savings rate (lack of a social safety net, limited social security, limited public services like health and education) solve only part of the puzzle. For example, take the argument that the Chinese save a lot because their pension benefits are very low. That can’t be the main explanation: U.S. household savings rates are low in spite of good social security benefits, while in Germany and Japan, with similarly high per-capita income and similarly generous pension systems, household savings rates historically have been high. Conversely, the household savings rate in India, which has low per-capita income and limited pension benefits, is much lower than that in China. So what makes China, with its low per-capita income, have a similar savings rate to the much-richer economies of Japan and Germany? And what makes India’s household savings rate similar to that of the U.S.? The main difference is demographics. China, Germany and Japan are aging fast, and households must save accordingly, while population growth is still robust in India and the U.S. Traditionally, the Asian model of social security was not a government-sponsored pension system; rather, parents would have many children who could eventually take care of their elders. But this social security system is breaking down in China for two reasons. First, households now have one child to take care of two parents and four grandparents. Second, urbanization has broken down the old model of parents living with their children in a rural, agrarian community.
The underdevelopment of capital markets also has increased the savings rate. Down payments on home purchases in China are very high compared to the U.S.: typically 30-50% in the former compared to 20% (and unofficially close to 0% in the years of the subprime mortgage bubble) in the latter. Thus, in order to be able to purchase a first home, the Chinese need to save a lot to be able to make the down payment, especially since a housing bubble has artificially boosted prices. Cross-country academic studies have shown a significant correlation between mortgage down payment rates (themselves correlated in part with the economy’s stage of financial development) and the savings rates of the household sector.
Moreover, given China’s imbalanced sex ratio (a product of selective abortions resulting from the one-child policy) young Chinese men need to own a home and a car to be able to find a suitable bride in a tough marriage market. This further distorts and increases the savings rate among young Chinese males.
Other factors tend to exacerbate the high savings rate of Chinese households. Migrant workers are subject to movement and registration restrictions and do not benefit from the social services that formal residents of cities enjoy; thus they need to save more. The lack of property rights over land and the income/wealth uncertainty it creates also lead to higher savings. And the entire system of consumer finance—not just mortgages but also consumer lending, including credit cards—is very underdeveloped, leading to low rates of debt accumulation and high levels of savings by households.
The High Savings Rate of the Chinese Corporate Sector
There is a myth that Chinese cultural norms are to blame for the country’s high savings rate. But Chinese households in China don’t have a larger propensity to save than Chinese households in Hong Kong, Singapore or Taiwan; they are all Confucian and all save about 30% of their disposable income. The big difference between the Chinese in China and elsewhere is that the share of GDP going to China’s household sector is very low, at barely 50%. After saving 30%, there is little left for consumption, which is why it contributes only about 34% of GDP. On top of household savings, there is another 25% of GDP represented by the savings (retained earnings) of the corporate sector, mostly SOEs. And almost all of these retained earnings go into capital spending, thus leading to the massive overinvestment in the economy.
Several Chinese policies have led to a massive transfer of income from the politically weak household sector to the politically powerful corporate sector (SOEs, import-competing firms, exporters).
A weak currency reduces the purchasing power of households by making imports expensive and instead benefits import-competing SOEs and exporters by boosting their income/profits.
Low interest rates on deposits—well below the rising inflation rate—and low lending rates (negative in real terms) for corporates and developers imply that the massive savings of the household sector receive negative rates of return while the real cost of borrowing for SOEs is also negative, creating a powerful incentive to overinvest. This tax on savings implies a transfer of income from households to SOEs, most of which would be losing money if they had to borrow at higher market interest rates.
A policy of labor repression for the last 30 years has caused wages to grow much slower than productivity, reducing unit labor costs and, again, transferring income from households to the corporate sector.
So China’s problem is excessive saving not by households but by the corporate sector. To change this repression of household income—and thus of household consumption—China would need much more significant appreciation of the RMB, liberalization of interest rates to increase the return on household savings and a much sharper increase in wage growth in excess of productivity growth. But more importantly, China also would need to privatize the SOEs so that their profits become income for households and/or massively tax SOEs’ profits and then transfer those fiscal resources to the household sector, either directly via transfers or indirectly through provision of public goods. But privatizing the SOEs is not even on the reform agenda, and policy proposals to tax some of the profits of the SOEs and transfer the income to households have languished for years in the face of political resistance from powerful SOE lobbies.
What Do China, Germany and Japan Have in Common?
The pitfalls of Chinese corporate governance—state ownership of too many firms that leads to excessive retention of profits and not enough distribution of dividends to shareholders, thus leading to excessive corporate savings—are also evident in similar forms in other economies. In Germany and Japan, the existence of large conglomerates (such as the Japanese keiretsu) and the cross-holding of shares among firms imply excessive corporate savings, with profits mostly retained rather than distributed to shareholders. In China, high corporate savings have led to excessive capital spending and investment; in Germany and Japan, where there is less investment in capital stock because of the lower return on capital, high corporate savings have led to high national savings and large current account surpluses. So China, Germany and Japan share features—aging populations, poor corporate ownership and governance structure and underdeveloped consumer finance—that cause high private and public savings rates, large current account surpluses and, in the case of China, excessive fixed investment.
THE LONG ROAD TO CONSUMPTION-LED GROWTH
Overcoming the Political Bias Toward Maximization of Growth and Overinvestment at the Provincial Level
The transformation of the Chinese economy from reliance on exports and fixed investment toward a greater contribution from consumption requires a change in the distribution of income from capital to labor, from profits to wages and from the corporate sector to the household sector. China’s political economy is such that the groups in favor of the status quo—SOEs, provincial governments, export lobbies, state-owned banks—are powerful, while households are weak. The decentralization of political power in China has exacerbated the problem of overinvestment. Party officials at the provincial and city levels want to maximize the growth rates of their provinces as their political power—including the biggest prize of all, becoming one of the nine members of the Politburo Standing Committee, the top governing body in China—depends on it. Once a Party secretary is promoted to a senior central government position, any economic woes left behind become the headache of the next local leader. Thus, local leaders have a powerful incentive to control state-owned banks; create thousands of SPVs to finance overinvestment in infrastructure; manage land use and sales to maximize revenues and ensure excessive real estate development; and interfere in local SOEs to maximize capacity and employment growth. This leads to widespread duplication of investment projects across provinces; no wonder each province has its own steel and aluminum mills, auto factories, textile and apparel plants, electronics plants and cement factories. At the macro level, the result is fixed investment comprising almost 50% of GDP.
Transformation of Demand and Supply Structure Likely to Be Bumpy and Risky
This complex transition is a bumpy, perilous road, with the potential to fork into a hard landing. If investment remains at a high share of GDP, and overcapacity, NPLs and public debt become excessive, a hard landing will occur. But even if Chinese policy makers are able to accelerate the rebalancing of the economy, the transition will still be risky for many reasons.
If the changes in wage, exchange rate and interest rate policies were to occur too fast, many SOEs would fail as their profits would disappear. The fall in SOE production would lead to a fall in employment, and the outcome would be lower labor income, even as the labor share of income rises. Labor strife, including strikes and union militancy, is one potential cause of a too-rapid and thus disruptive increase in nominal and real wages.
Change is necessary not only in the structure of demand (less from exports and fixed investment, more from consumption) but also in the structure of supply. The consumer goods exported abroad may have a higher value added than those that the Chinese can consume at home; plus, industrial/manufacturing production needs to fall relative to production of household services. These transformations require a difficult movement of labor and capital from declining sectors to expanding sectors; the new demand pattern needs to match a new and different supply structure pattern.
A change in productive structure requires a massive amount of corporate restructuring by closing unproductive and/or unprofitable firms to allow the consolidation and growth of stronger firms. This will disrupt regional and sectoral employment and capacity. For example, in China today, there are almost 100 automakers (down from 110 a few years ago); while the U.S. has only three domestic car producers. The reason there are so many auto firms—as well as steel, cement, textile and other firms—is that every province wants to have a few. The necessary consolidation and restructuring of the corporate sector requires closing down inefficient and/or unprofitable firms, which implies massive regional and sectoral labor shedding that will be politically difficult and involve transition costs for the laid-off workers.
Finally, the reduction in labor use in declining sectors—heavy industry and manufacturing—may occur faster than the increase in employment in rising sectors such as services, thus leading to employment problems.
Given the powerful contingents that are adverse to change and the inherent risks and costs, the political path of least resistance is the status quo—export-led growth, excessive investment and insufficient consumption—in spite of the stated goal in the new Five-Year Plan (like the previous ones) of raising the share of consumption in GDP.
Political Management of Key Relative Prices Distorts Demand and Supply
The distortions in the structure of aggregate demand and supply in China are exacerbated by the fact that the government controls three fundamental relative prices that determine this structure.
The relative price of foreign to domestic goods is controlled by the government via the nominal exchange rate, which drives the short-term movement of the real exchange rate. Because this keeps the currency undervalued, imports are expensive and consumption of imported goods is low, while production of exports and import-competing goods is subsidized. This distorts the distribution of aggregate demand (too many exports and too little consumption) and stimulates excessive production of exports and import-competing goods, while limiting the supply of non-traded goods and services.
The government also controls and distorts the cost of capital relative to wages by allowing the protected corporate sector to borrow too cheaply (at a negative cost in real terms). The combination of the taxation of the household sector to transfer income to the corporate sector (via wage, currency and interest rate policies) and the too-low cost of capital for the corporate sector implies excessive corporate savings and fixed investment. Paradoxically, in spite of relatively low wage rates, China’s growth model is highly capital-intensive, as the cost of capital is too low for those firms—mostly SOEs—that have access to cheap financing from state-owned banks. So, in a country with a massive surplus of labor, many investment projects—from heavy industry to infrastructure—are highly capital-intensive. This distortion in the cost of capital is behind China’s overinvestment and excessive production of capital goods.
The cost of land relative to other goods and assets is too low, leading to overinvestment in commercial and residential real estate. The land is mostly controlled by the government, expropriated from farmers and urban residents with little reward and sold at a highly subsidized rate to real estate developers, who thus overinvest in high-end residential and commercial real estate.
By aggressively controlling three key relative prices, China distorts demand, amplifying real estate investment, capex and exports while repressing consumption spending. At the same time, it distorts the structure of aggregate supply, encouraging excessive production of physical capital (machinery, real estate and infrastructure) and insufficient production of consumer goods and services. Until these key relative prices are liberalized—with a more flexible exchange rate and market-determined deposit and lending rates and land prices—the distortions in the structure of aggregate demand and supply will remain. And these distortions, together with the repression of wage growth, contribute to a low level of household income and thus of consumption.
Counterarguments to the View That Consumption Rates Cannot Rise Fast Enough to Avoid a Hard Landing
The most sophisticated analysts acknowledge that the Chinese economy is imbalanced and that the share of consumption in GDP is too low. But some argue that China may be able to transform itself into a consumption-based economy faster than we have argued here.
Some note that wages in 2010 and 2011 grew faster than productivity for the first time in decades, thus increasing the labor share of income. While this is true, two years do not make a trend; wages would have to grow much faster than productivity for many years to change the distribution of income between wages and profits. Also, the aforementioned reasons for the low household share of income aren’t only related to wage growth, and the reasons that household savings are high are numerous, complex and not reversible in a short period of time. Thus, the faster growth of wages in the last two years is a positive sign but not an indication that the household savings rate is set to shrink significantly any time soon.
Some, like Goldman Sachs’ Jim O’Neill, have stressed that the micro and macro data point to very rapid growth in retail sales and consumption in China in recent years. But with the economy still growing at a real rate of 9-10% y/y and with inflation above 6%, even nominal retail sales or nominal consumption growth rates of 15-16% per year imply that the consumption share of GDP has fallen to a low of less than 34%. For that share to increase, the rate of growth of nominal consumption has to be significantly higher than nominal GDP growth, i.e., much higher than 15-16% per year. This is not happening yet, based on the macroeconomic data we have seen.
Some suggest that the private consumption share of GDP is underestimated because of the recent rise of household spending on services in the underground economy, which are not easily measured. Also, fixed investment probably is overstated in GDP because land values and transfers are not adequately stripped out of the data. Personal spending on household services such as cleaning and educational help for children may underestimate the consumption share of GDP. This argument may be valid, but its significance is limited by three factors. First, the amount of such household spending on unreported services may not be large enough to have a significant effect on the share of consumption in GDP. Second, though some private consumption may go unreported, this is balanced by other factors that cause the consumption share to be overestimated, such as the inclusion of some public-sector consumption with private consumption. Third, in the last three years, consumption growth has been artificially boosted by temporary measures that have stolen demand from the future; e.g., tax rebates for the purchase of private cars (the Chinese equivalent of the U.S. “cash for clunkers” program) and government-subsidized appliances for rural populations. Note also that if fixed investment is overestimated and consumption is underestimated then GDP (absolute and per capita) is slightly smaller than officially estimated. Thus, even if I/GDP is lower and C/GDP is higher, with a lower per-capita GDP it is going to take longer for China to be able to fully utilize its existing, depreciating capital stock.
It has been argued that young Chinese are not as frugal as their parents, as cultural mores have changed; thus, over time the savings rate may fall. As rigorous studies of young generations’ marginal propensity to spend and save have yet to be completed, the legitimacy of this argument is difficult to gauge. Other factors suggest that this argument may not have a strong empirical base. Young Chinese may be more conscious of brands and fashion, but they face the same constraints on income generation and the same necessity to save. Even middle-class Chinese youth face rising costs of housing, education and health care, as well as an overall inflation rate that is probably higher than officially measured. Young Chinese may or may not be less Confucian than their parents, but the aspiration to spend is not the same as the ability to spend. The latter is still sharply constrained by the small share of GDP—about 50%—represented by household income.
While over time the consumption share of GDP may increase, the structural factors that constrain consumption growth will not radically change in the short run. China will eventually become a consumer society, but this is occurring at a snail’s pace. Thus, once China reaches the overinvestment limit and slows down fixed investment, consumption growth may not occur fast enough to prevent a sharp economic slowdown, if not a hard landing.
RISING RISK OF A HARD LANDING IN 2013 AND BEYOND
Until the change in political leadership in October 2012, when the new president and premier will be chosen, China’s policy makers may be able to maintain high growth by continuing with high levels of investment. To ensure a smooth transition, China’s policy makers will do everything necessary to maintain a growth rate above 8% y/y and an inflation rate of 5-6% or below. If the economy slows down too much, they will accelerate infrastructure spending (including on the planned 10 million new units of public housing) and implement fiscal, credit and monetary stimulus. If inflation accelerates, they will tighten monetary and credit policy and utilize non-market measures, like administrative tools. So the chances of a hard landing before the end of 2012 are relatively small.
But in 2013, China’s unbalanced growth model will start showing signs of strain. If a hard landing is to occur, it would likely be in 2013 or 2014 but not much later. Recognizing that overinvestment booms can last for a long period of time (take the case of the Soviet Union), we see several reasons that the risk of a hard landing in China will rise significantly in 2013-14, rather than later.
In the next two years, the rise in NPLs will force banks to slow down the process of ever-greening their losses and start recognizing the holes in their balance sheets. How much of a hit the banks take depends not only on the size of their NPLs—driven by bad loans to local governments, local government financing vehicles (LGFVs), real estate developers, SOEs and private firms—but also on whether those losses are socialized directly by the provincial and central government or imposed first on the banks before they are recapitalized by the central government. But either way, the balance sheets and the profit-and-loss statements of the banks will take a hit, forcing a slowdown in credit growth—if not an outright credit crunch—that will weigh on the economy.
The rise in the size of the public debt will require a crackdown on local government borrowing and a slowdown of the debt buildup of other parts of the public sector. For example, the Railway Ministry is now effectively bankrupt after its borrowing spree to finance 10,000 miles of high-speed trains, even if its debts are effectively those of the sovereign. Larger fiscal deficits will emerge when the central government has to recognize the losses driven by an unsustainable borrowing binge at all levels of the public sector. Rising defaults on bonds issued by sub-national public-sector agents may increase credit spreads, adding to the credit crunch, especially once the new leadership is in place and ready to deal with the excessive borrowing and spending of the 2009-12 period.
It will become increasingly unsustainable to maintain fixed investment near 50% of GDP. Private investment by exporters will slow down as the G3 economies’ anemic recovery limits the market for Chinese goods. The overinvestment in high-end residential and commercial real estate will end when a price correction causes a fall in speculative demand, rendering SOEs unable to put down more real estate as collateral for their bank borrowings. The correction in commercial real estate investment will become significant when the excessive office space investment, especially by SOEs, reaches its saturation point. Opportunities for more infrastructure spending—particularly on transportation—will start to decline as these projects conclude and new ones become more expensive and less marginally beneficial to undertake; plus, the fiscal squeeze on local government finances and LGFVs’ balance sheets will cut down on infrastructure binges. Also, the excessively fast buildup of the high-speed train system has led to repeated, serious train accidents and malfunctions that have caused public outcry about safety; these issues, together with the effective bankruptcy of the Railway Ministry, will trigger a slowdown in the pace of investment in new high-speed lines. Across the board, SOEs will be forced to reduce their rates of capex, especially if stressed banks have to limit credit creation.
By 2013, it is possible that the G3 economies will experience further economic slowdown (they are already at stall speed and at risk of double-dip recession), thus limiting China’s ability to rely on exports for growth. U.S. growth is already constrained by deleveraging, and this serious weakness will accelerate in 2012-13, when fiscal austerity will imply more direct fiscal drag and will force another round of household deleveraging, once transfer payments are reduced and taxes are increased. The probability of a U.S. double dip over the next year is now close to 50%. The eurozone (EZ) will become unable to kick the can down the road once the European Stability Mechanism is created in 2013. There will be more bail-ins and orderly restructurings of public debt—in Ireland and Portugal after Greece, and possibly even in Italy and Spain, which are now at risk of losing market access—and more restructurings of banks’ unsustainable senior debts (starting with those in Ireland). Economic stagnation will persist in the EZ periphery as fiscal austerity accelerates while the ECB normalizes policy rates. And Japan will return to its long-term stagnation once the temporary boost from a modest fiscal stimulus package for postquake reconstruction fizzles out by 2013.
These four factors suggest that in 2012 and especially in 2013, China will begin to find it increasingly hard to kick the can down the road and sustain a growth model based on excessive investment. Political considerations will determine the timing of when the central government stops the credit and debt binge and accelerates reforms that eventually will increase the incentive to consume.
Deflationary Effects of a Chinese Hard Landing and Risk of Trade Wars
While in the short run, China faces a problem of overheating and rising inflation, as its investment boom heightened demand for raw materials, this overinvestment in capital capacity may eventually lead to disinflationary if not deflationary pressures, both within the country and globally. Within the country, the bursting of the real estate bubble would lead to home and commercial real estate price deflation after years of surging prices. A sharp slowdown in economic growth would also increase the slack in the labor market, with higher unemployment weighing on wage growth, and in the goods market, with excessive capacity constraining the pricing power of firms, on top of real estate price deflation.
Globally, a sharp slowdown of China’s growth would have a disinflationary effect via prices of traded goods. Commodity prices would plummet as Chinese demand would drop. Plus, China would dump excess supply of industrial and manufactured goods—steel, cement, aluminum, cars, apparel, consumer electronics, etc.—into global markets. Even today, with growth still above 9%, there is so much industrial overcapacity in China that the excess is already exported in global markets, hurting foreign producers of these traded goods. For example, in spite of the demand for steel for highways, railroads, airports, real estate, etc., there is so much overcapacity in China that a lot of its steel is exported abroad, hurting the market share and profitability of global steel producers. Once China experiences a slowdown of growth, the excess capacity of steel, aluminum and other manufactured goods will be sold on global markets, depressing prices.
Of course, the U.S., Europe and other advanced economies as well as emerging markets would not sit idly and accept Chinese dumping of its overcapacity in global traded goods markets. The most likely result would be protectionism and trade wars. The rest of the world is already concerned about China’s exports; these trade tensions would escalate if China were to witness a plunge in domestic demand and dump the excess capacity in global markets. If China has a hard landing, either massive global deflation or severe trade wars will result.
CONCLUSION
To stave off a hard landing in 2013, China needs to work toward a more balanced, sustainable growth model. Net exports, fixed investment and savings need to fall as a share of GDP, while private consumption needs to sharply rise. On the supply side, China must reduce its reliance on production of capital goods and exports and increase the production of consumer goods and services. We are somewhat pessimistic that China will be able to significantly increase the contribution of consumption to growth before the investment boom turns into a bust: The reasons that savings rates are high and consumption rates are low in China are structural, and decades of painful, politically difficult reforms are required to resolve these issues.
On the other hand, in the last few decades Chinese policy makers have shown flexibility and policy innovation that have allowed consistent growth of about 10%, in spite of major domestic and external economic and financial shocks. So one should not underestimate the ability and flexibility of Chinese policy makers to do what is necessary to maintain a high level of economic growth. The new leadership that will run the country from 2013 on may decide to accelerate reforms to rebalance economic growth and make it more sustainable.
But there are enormous challenges standing in their way. The economic and political forces in favor of the status quo—provincial governments, SOEs, export and import-competing sectors—are influential, while Chinese households are politically weak. After the political transition, it will be clear if the new leadership is committed to accelerating reforms to rebalance growth and prevent a hard landing. The risk is that the reforms will be too little and too late to prevent the hard landing toward which the current growth model is heading. Certainly, it is likely that by 2013-14 the unsustainability of China’s current growth model will manifest itself.
In a follow-up paper, we will analyze in detail a variety of scenarios for China in 2013-14. One is a full-blown “crash and burn,” with a severe economic and banking crisis. Another is a “muddle through” situation, in which the central government offers a full bailout of local debts and the banking sector, which smoothes over for a decade with a gradual fall in the investment rate and a weakening of economic growth, short of a real hard landing. In a third scenario, a “slow grind,” the government offers a partial bailout to the banking sector to clean up the large default rate on local government debts. Burden-sharing between local governments, Beijing, SOEs and the banks results in a significant decline in investment and economic growth but prevents a full-blown financial crisis.
