China’s Slow Road

NOTTINGHAM – As the eurozone crisis deepens, investors worldwide are sifting through the semantics of China’s economic-policy pronouncements with increasing desperation. They seek signs of an economic “miracle”: a rerun of the RMB4 trillion ($628 billion) stimulus of 2008 that maintained impressive Chinese growth as the West slipped into recession – and shielded the global economy from a worse collapse.

But rolling out another investment program on such a scale would be financial suicide for China. Investors worldwide must face an uncomfortable reality: China’s economy is slowing, and will likely continue to do so.

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Analysts have been quick to predict whether the China’s economic landing will be hard, soft, or bumpy. But vague labels hold little value, given sharp disagreement over their meaning. Indeed, while economists often define a hard landing in terms of declining GDP growth rates, placing it at 4-7%, a simpler model based on the principles of econometrics is enough.

According to this measure, a soft landing indicates a short-term fall in economic growth – a fluctuation rather than a trend. A hard landing reflects a structural break – an intense downward adjustment that would prevent China’s economy from rebounding for at least three years, and possibly for much longer. Of the two scenarios, the most compelling evidence indicates the latter for China.

Indeed, Chinese Premier Wen Jiabao has set an annual growth target of 7.5% for 2012 – the first time in a decade that China has aimed for growth of less than 8%. This realistic growth figure could set China on a more sustainable path of development, protecting the environment while raising citizens’ living standards.

But there is little evidence that the decline in growth is a result of the Chinese government’s progress in rebalancing its economy, from an export-led model, based on low-cost manufacturing, to one driven by domestic demand and innovation. Although the central authorities have issued plenty of weighty exhortations over the last decade about the need for industrial restructuring, they have taken little real action. Imitation, rather than creation, is still the order of the day in the majority of China’s factories.

Yet China’s export competitiveness is shrinking. Rising wages, an aging workforce, and increasing commodity prices have taken their toll. To be sure, many Western companies are unlikely to leave China, given the great expense, in search of another low-cost Asian exporter. Rather, higher costs will be passed on to Western consumers.

To offset the weakening export sector, China needs more private-sector technological innovation and a surge in domestic consumption – both of which require long-term strategic planning. But, in recent weeks, China’s authorities, unnerved, have focused on short-term measures to revive growth: more public-sector investment.

In recent years, such investment has soared by 25% annually, underpinning China’s 10% annual GDP growth. As a result, citizens’ livelihoods have suffered. With 50% of GDP channeled into industrial investment, rather than a more comprehensive social-security system, Chinese society is becoming increasingly divided. And tensions between workers and employers, the people and the government, will only intensify.

China’s low employment elasticity – a drop in GDP will trigger a sharp decline in employment – constitutes another serious structural flaw. Rural migrants occupying low-skilled jobs comprise roughly 60% of China’s urban workforce. Increasing these workers’ skills through training – “upskilling” – will be a massive challenge. And seven million university graduates seek employment each year, not to mention non-college-educated urban youth.

The 2008 fiscal stimulus yielded a freshet of wasteful infrastructure projects, often with no long-term return – other than high pollution. Repeating that is not feasible. As long as inflation remains under control, the government can reduce bank’s mandatory reserve ratio and cut interest rates – a decision that it took recently. Still, the long-term benefits will be minimal.

Chinese policymakers must fulfill their promises to boost private-sector growth and competitiveness by increasing lending and offering tax incentives. Indeed, the monopolistic environment in which China’s state-owned enterprises operate is in urgent need of radical reform. When the economy is booming, SOEs enjoy disproportionate profits, so they feel little pressure to innovate. During hard times, they are bailed out by the central government, perpetuating a vicious cycle.

But whatever the concerns about the industrial sector, China’s sword of Damocles has long been its housing market – and the bubble surrounding it. A raft of government policies has successfully curbed real-estate price inflation in major cities. But, while citizens welcome falling house prices, the trend raises concerns that the bubble will burst, exposing many property developers to a credit crunch. The housing market’s collapse would lead to an accumulation of banks’ non-performing loans, and cash-strapped local governments would see revenues from (often legally dubious) land sales plummet.

The OECD expects Chinese growth to reach 8.2% this year, and to accelerate to 9.3% in 2013. But, with the eurozone crisis threatening to incapacitate China’s largest trade partner, this is unlikely. A gradual decline to 6.5% is more realistic.

Of course, eternal double-digit growth was never possible. Now the Chinese people must prepare themselves for at least three years of hardship. And the West – which relies excessively on China to prop up the global economy – must adjust its expectations accordingly.