After 30 years of breakneck growth, the Chinese economy has entered a new stage, which is described in China’s party documents as a “New Normal”. The key feature of China’s New Normal is the significant slowdown of its growth potential. The consensus among Chinese economists is that China’s potential growth rate has fallen from about 10 percent to about 7 percent, or even lower. At the moment, the officially accepted growth figure is 6.5 percent.
While accepting the fact that China’s potential growth rate has fallen significantly, it is worth emphasizing that 6.5 percent is a very respectable growth rate. If China is able to maintain such a rate, it will achieve its objective set in 2010 of quadrupling per capita income by the end of 2020.
Over the past 30 years, one of the most important features of China’s growth mode is its dependence on investment, especially on real estate investment. China’s growth rate of investment has been consistently higher than that of GDP. As a result, China’s investment rate—investment divided by GDP— has reached 47 percent, by far the highest amongst the world’s major economies. Though there are disputes on how high China’s investment rate really is, most economists would agree that China’s investment rate is way too high.
China’s investment consists of three categories: real estate investment, infrastructure investment and manufacturing investment. Among them, real estate investment accounts for a fourth of the total investment. For a long period of time, real estate has been the most profitable area of investment in China. Naturally, money from all walks of life poured into the real estate market. By the end of 2013, besides the numerous condominiums all over the country, China had built some 700 five-star hotels with another 500 under construction. It has 470 skyscrapers with another 332 under construction. Among the 10 highest skyscrapers under construction in the world, five are located in China.
Clearly, China has gone too far in real estate development. The government started to take measures to cool down the real estate investment fever in 2012. The measures were largely aimed at discouraging demand for real estate properties. As a result, demand for new house space has fallen steadily, and in the second- and third-tiers cities the fall has been dramatic. By the end of 2015, the unsold house floor space for the country as a whole was 700 million square meters, while the average annual sale of house floor space in normal time was 1.3 billion square meters. Facing a double-digit growth in inventory, naturally, real estate developers cut their investment deeply. At the moment, the growth rate of real estate investment has dropped to almost zero. Without stretching the imagination, one can be sure that in 2016 growth of real estate investment will enter into negative territory. Taking into consideration the large share of real estate development in GDP and links between real estate development and other sectors such as steel, cement, plate glass, aluminium, coal, construction materials and so on, it is easy to see how large the impact of the fall in real estate investment on overall growth of the economy will be.
Ideally, the Chinese government should encourage more consumption by the household sector to offset the fall in real estate investment. However, that is easier said than done. Household consumption is largely stimulated from within, and it is unlikely to increase at a very fast pace while the growth rate of the economy is at its lowest level in a decade.
There is no doubt that the fundamental cause of the current slowdown is structural. On top of the diminishing return to scale, the misallocation of resources, made manifest in the investment fever in real estate development, is the main contributing factor to China’s falling potential growth rate. However, in 2016, a more imminent problem facing China is not that the growth rate will fall to something like 6.5 percent, which is largely in line with China’s long-term growth potential, but that due to deflationary spiral, China’s growth may fall well below its potential and end with a hard landing.
Due to the overcapacity as a result of dramatic fall in real estate investment, China’s producer price index (PPI) fell. So far it has been falling for 46 consecutive months without any material sign of improvement. At the beginning of 2015, China’s GDP deflator also turned negative. Though China’s CPI is still in positive territory, it is beyond doubt that China currently is in the grips of deflation. In contrast to a one-off price adjustment, deflation means that the price index will continue to fall and so will be the growth rate of the economy. The fall in prices and growth will reinforce each other to form a vicious circle.
There are two types of spiral that are working on the Chinese economy. The first type is the overcapacity-deflation spiral: falling PPI caused by overcapacity leads to falling profitability of corporations. In response, they have to deleverage and reduce investment, which in turn will lead immediately to more overcapacity and an imminent further fall in PPI, though it will help to stabilize prices in the future.
The second type is a debt-deflation spiral: falling PPI leads to rising real debt, which in turn leads to falling profitability of corporations. In response, corporations again have to do deleverage and reduce investment, which in turn will also lead to the same results as above.
Faced with the possibility of a larger than tolerable fall in the growth rate, in my view the government should provide a stimulus package to break the overcapacity-deflation and debt-deflation spirals, while continuing to push for reforms and structural adjustment. It should be emphasize that a stimulus package that consists mainly infrastructural investment and provision of public goods and services should be financed by the issuance of government bonds rather than credit expansion.
Despite that fact that to break a debt-deflation spiral will be very hard, China’s economic fundamentals are not that bad due to its high saving rate and relatively strong fiscal position; as long as the government can implement an appropriate policy mix, the economy can rebound and return to a slower but still inspiring growth path.
Needless to say, any stimulus package can only obtain some breathing time for China. The key to a sustainable growth for China is to bring the entrepreneurship of individuals into full play. To achieve this objective, the government has drawn up comprehensive plans for reforms of ownership system, financial system, and innovation and creation support system. To what extent creation and innovation will become a major driver for economic growth is hard to predict and measure. But we have seen lots of individual cases of success in Shenzhen and other places. Chinese companies such as Huawei and Zhongxing have made tremendous inroads into the global market. Surprisingly, some enterprises in the Northeast, the rust belt of China, have succeeded in creation and innovation. For example, Shenyang Machine Tool Co Ltd has become a formidable competitor to German machine tool manufacturers. It was reported that the technological level of its products has surpassed its German peers in many aspects. It can be argued that the spring shoots are everywhere in China. Certainly, no one is quite sure whether the green shoots can blossom in the near future. It may take years for us to see results. But no one should be too pessimistic about China’s economic prospects. China will muddle through, as it did time and again in the past 30 years.