SHANGHAI – Three years of persistent economic slowdown have rattled Chinese economists and policymakers. Financial analysts are in a tizzy over whether GDP growth will fall below 7%, parsing official statements for clues as to whether and when the government will act.
The government’s financial viziers seem none too alarmed. Beneath this cool exterior, however, China’s leaders are very worried indeed. As Liu Shijin, Vice Minister of the Development Research Center of the State Council, recently explained, the dilemma facing the authorities is that another massive stimulus plan to boost growth would mean more outstanding credit – a problematic approach, given the enormous debt and financial risks that local governments have accumulated. But an excessively sluggish economy poses its own risks.
To be sure, China’s government was in a similar situation ten years ago. But the economy today is not performing as it was a decade ago. China needs new solutions.
To varying degrees, China’s economy has long swung from short-term growth spurts, fueled by the over-issuance of currency and conventional credit expansion, to contraction, triggered by government action to prevent overheating. Once the risks are under control, the government gradually restores growth-oriented policies. This “prosperity cycle” – sustained by the abundance of new investment opportunities that were available to neutralize mounting debt and financial risks – has long enabled China to avoid a hard landing.
A decade ago, when China was fighting deflation, the World Trade Organization came to its rescue, opening up massive new export markets. More important, the huge dividend of the just-launched domestic housing reform had yet to pay off. The resulting surge of new investment opportunities diminished the risks posed by idle capital and risky debt, while driving increases in investment efficiency and labor productivity.
But the latest round of deflation-fighting policies, together with the massive stimulus package that the government launched in the wake of the global economic crisis, has led to oversupply in the housing market and idle capital in the manufacturing sector. Making matters worse, demand for Chinese exports in Europe and the United States has weakened considerably, and is not expected to rebound. All of this has diminished short-term investment opportunities in China, raising fears of a hard landing.
Of course, China still boasts tremendous investment potential in the long term, especially given the relatively low urbanization rate and the need for structural reform and industrial upgrading. In the interim, however, Premier Li Keqiang’s government must achieve a prudent balance between economic growth and financial risk. To that end, the government has adjusted its policy target from “economic recovery” to “growth stabilization,” expressing its willingness to accept declining GDP growth up to a certain point – probably 7%, or even lower – in order to keep financial risk under control.
But the balance itself is not the goal. In Li’s view, what the government really needs to do is buy time for structural adjustment and reform, which are critical to generating the next wave of investment opportunities.
Li has even adopted a structural approach to stimulating economic growth. For example, the mini-stimulus package that was unveiled last month diverts investment to railroads, agriculture, the smart grid, and other productive services.
But maintaining this balance will not be easy. The first challenge will be to ensure that the real-estate market progresses into the adjustment and clearance phases. This will require cautious but continuous policy action.
The good news is that many local governments have recently loosened their grip on local real-estate markets, most likely following a central-government directive. This could be the start of a virtuous circle, with price adjustments helping to clear up stock. The movement of the housing market into a clearance phase, without causing a panic or collapsing, would be a crowning achievement for Li’s tenure.
Another major challenge is managing credit risk. This will require policies that reduce the rate of credit expansion, without putting so much pressure on local governments and state-owned enterprises that they turn to off-balance-sheet credit and the shadow-banking sector.
Moreover, the government must revitalize the stock of local-government assets and credit by securitizing these portfolios. The problem is that China’s domestic capital market remains underdeveloped, owing to administrative restrictions, a non-diverse structure, and a lack of innovation – all of which means that progress in the short term is unlikely.
This highlights the need for structural reforms aimed at creating a more efficient, open, and competitive capital market, commensurate with the size of the economy. This would facilitate the production of innovative financial products, link monetary policy more closely with capital markets, and allow fixed assets to become liquid (and vice versa).
A multi-tiered capital market and diverse financial products can help to free China from its excessive dependence on credit. But that will require change in the way that the Chinese government manages the macroeconomy. And that is a story for another day.