It has often been said that a crisis is an opportunity in disguise. The implicit logic – difficult times can energize nations to undertake extraordinary actions – can also be applied to less dire but nevertheless challenging circumstances. The economic slowdown in China, it seems, qualifies for such a situation.
After three decades of double-digit growth, the Chinese economy has lost steam in recent years. The official figure for GDP growth last year – 7.4 percent – is the slowest since 1990. The last time China reported double-digit annual growth was 2010, when the economy expanded by 10.4 percent. The 3-percentage fall within a five-year period represents growth deceleration on the order of roughly 30 percent. For any economy, growth deterioration of this magnitude would be a serious problem. For the world’s second-largest economy, losing such momentum in a relatively short period of time generates global repercussions.
Unfortunately, the Chinese economy has yet to bottom out. In the coming two to three years, strong headwinds against growth will come from three directions: the real estate bubble, excessive debt, and manufacturing overcapacity. In the real estate sector, an estimated 50-60 million unoccupied housing units will continue to depress construction activities. Debt-to-GDP ratio, which reflects financial leverage of the economy, is estimated around 250 percent, the highest for a major emerging market economy. Manufacturing overcapacity – with reported capacity utilization rate of around 70 percent – creates deflationary pressures and destroys corporate profitability (for example, the price of steel in China is lower than that of cabbage).
These near-term difficulties present enormous challenges to President Xi Jinping and Premier Li Keqiang. Since the economic actors with most to lose in the current low-growth environment – real estate developers, deeply indebted local governments and unprofitable state-owned enterprises – have powerful voices inside the government, they are expected to push for government assistance in the form of easy credit, loan extensions, and subsidies. They will argue for various stimulus packages in disguise to help them get out of their current mess.
The Chinese government should ignore such pleas for assistance because injecting more credit into a highly leveraged economy will only result in inflating the twin credit and real estate bubble even further and keeping zombie firms alive. The long-term consequences to the Chinese economy will be catastrophic.
To be sure, Beijing must take care to avoid dramatic financial deleveraging (such as tightening credit dramatically) since this move could result in a cascade of bankruptcies and hurt otherwise relatively healthy firms.
The right approach is to use the slowdown as an opportunity to restructure an economy overly dependent on investment and manufacturing. Such restructuring can take place without a drastic or risky shock therapy. Instead, Beijing can maintain credit at a relatively stable level but direct the credit to more productive sectors, in particular private firms. Studies of the Chinese economy consistently show that private firms are far more productive and dynamic than state-owned enterprises. If they can gain easier access to capital, their growth will spur the Chinese economy.
Another vital reform is to shift resources from the saturated manufacturing sector to services. One piece of good news from China is that this shift is finally taking place. In 2008, manufacturing and construction accounted for 47.4 percent of the GDP (the share of construction was 6.0 percent) while service was 41.8 percent of the GDP. In 2013, for the first time in Chinese history, the service sector’s share of the GDP – 46.1 percent – was bigger than the manufacturing and construction (43.9 percent).
The data for 2014 are even more encouraging. While manufacturing and construction grew 7.3 percent, the service sector expanded by 8.1 percent, faster than GDP growth. As a result, the service sector accounts for roughly 50 percent of the GDP. Since the service sector is dominated by private firms and employs more labor, this shift will make the Chinese economy more efficient and balanced.
Although this shift has taken place largely thanks to market forces, government policy can help. In particular, deregulation and tax incentives will further encourage private entrepreneurs to set up service firms. So far Beijing has made some progress in deregulation, but it needs to think of more positive incentives as well.
Finally, the Chinese government must accelerate the shift to a consumption-driven economy. This will not only provide a short-term stimulus to the economy, but also create the foundations for sustainable long-term growth. The key to this transition is increasing social spending. At the moment, public spending on social spending (education, healthcare, pensions, and welfare) is under 10 percent of GDP (the bulk of the fiscal revenue goes toward capital investment and government administrative expenses). Channeling resources into social spending will raise the effective household income, thus stimulating consumption.
Chinese leaders are familiar with these measures for restructuring the Chinese economy. They have also declared their resolve to undertake them. In the last two years since the new leadership assumed power, not enough action has occurred. With the continuing deceleration of the Chinese economy, now seems to be an opportune moment to embrace these reforms.
