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China’s Struggle to Slow

BEIJING – At the opening of the annual session of China’s parliament, the National People’s Congress (NPC), Premier Wen Jiabao announced that the government’s target for annual economic growth in 2012 was 7.5%. With the global economy still struggling to recover, Wen’s announcement of such a significant dip in China’s growth rate naturally sparked widespread concern around the world.

But it is important to note that Wen was expressing a policy rather than forecasting performance. The purpose of targeting a lower growth rate, he explained, is “to guide people in all sectors to focus their work on accelerating the transformation of the pattern of economic development and making economic development more sustainable and efficient.”

Fixed-asset investment is the most important engine of China’s growth. As a developing country with annual per capita income of less than $5,000, there is still significant room for China to increase its capital stock. But the growth rate of investment is too high. The issue is not whether China needs more investment, but whether China’s absorption capacity can continue to accommodate the rapid investment growth of the past decade.

In this sense, the investment rate, which in China approaches 50% of GDP and is rising, can be regarded as a measure of the stress that fixed investment places on the economy. It is not entirely an exaggeration to say that the economy’s capacity for investment growth has reached its limit.

The recent high-speed rail debacle is a case in point. In 2003, China built its first high-speed-rail project. As a key component of the RMB4 trillion ($630 billion) stimulus package introduced during the 2008-2009 global financial crisis, investment in high-speed-rail construction increased by leaps and bounds. By the end of 2010, China’s operational high-speed-rail network surpassed 8,000 kilometers, with an additional 17,000 kilometers under construction. By contrast, all Western countries combined took a half-century to build a total of 6,500 kilometers. Built in such haste, catastrophe was almost inevitable.

Investment growth that surpasses an economy’s absorption capacity will lead to a rapid deterioration in the efficiency of investment, which in turn will harm long-term growth prospects. Evidence of this in China today is all too prevalent. To reverse this trend, some respite in investment growth is not only necessary, but also inevitable in a profit-driven economy.

While China’s investment rate should be brought down to a sustainable level, an equally, if not more, important challenge is to adjust the structure of investment. For many years, the single most important category of investment in China has been real-estate development, which accounts for roughly 10% of GDP and a quarter of total investment. But resources need to be allocated to projects that build up human capital, provide public goods, and foster creativity and innovation. Adjusting the investment structure, however, will inevitably cause investment growth to decelerate, at least in the transitional period, thus leading to a slowdown in overall GDP growth.

International trade has played a pivotal role in China’s economic development over the past 30 years. However, the global market is no longer able to absorb China’s massive exports, not to mention the immediate impact of economic malaise in Europe and the United States on export demand. Moreover, rising labor costs and a stronger renminbi will also undermine China’s export sector, causing GDP growth to slow this year.

Few would argue against China’s need for slower but better growth. The problem is that if China wishes to lower the GDP growth rate to 7.5% in 2012, from 9.2% in 2011, without worsening the growth pattern by raising the high investment rate even further, the annual growth rate of investment must be equal to or less than 7.5%.

A back-of-the-envelope calculation suffices to show that, unless the government is prepared to tolerate a further increase in the investment rate, achieving a GDP growth target of 7.5% implies a significant fall in the growth rate of investment. To compensate for the negative impact on GDP growth, and with export growth constrained by weak global demand, consumption must rise even more sharply, which is hard to imagine. In other words, lowering the GDP growth rate to 7.5% without making China’s growth pattern even more irrational is an impossible mission.

So a more likely growth scenario for 2012 is that China’s growth will be lower than in 2011, but still significantly higher than 7.5%. Correspondingly, its investment-driven growth pattern will be strengthened further, though at a slowing pace. Otherwise, a policy-induced hard landing would be difficult to avoid.

Indeed, how to achieve a more moderate growth rate without causing a hard landing is one of the most severe challenges confronting the Chinese government. A hard landing is simply not an option.

With the country’s fiscal position still positive, it is difficult to image that the Chinese leadership would be so headstrong about “accelerating the transformation of the pattern of economic development” as to risk such an outcome. Even if it is, GDP-obsessed and debt-ridden local governments are likely to strive to achieve the highest possible growth rates for themselves, while paying lip service to Wen’s call for a slowdown. That is why, despite the official target, most Chinese economists still bet on a growth rate well above 8% for 2012.

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