BEIJING – The most recent official data show convincingly that the Chinese economy has bottomed out, and it is now widely expected that annual GDP growth should reach roughly 7.8% in 2012. This result should come as no surprise.
To rein in rising house prices and pre-empt the inflationary impact of the strongly expansionary fiscal and monetary policies implemented during the global financial crisis, China’s monetary authorities began to tighten financial conditions in January 2010.
Monetary tightening, administrative measures introduced by various municipal governments to stem the run-up in the housing market, and the waning effect of the government’s ¥4 trillion ($642.3 billion) stimulus package resulted in a gradual economic slowdown. While inflation should have eased in early 2011, rising food prices and commodity prices thwarted expectations. Annual growth in the consumer price index peaked at 6.5% in July 2011.
Vigorous liquidity tightening eventually mitigated inflationary pressure, but it also impeded economic growth, which had slowed steadily after peaking at 12.8% in the first quarter of 2010. By the last quarter of 2011, annual growth had slowed to 8.9%, triggering a surge of bearish sentiment about the Chinese economy among foreign pundits.
Most Chinese economists, by contrast, were less pessimistic, and expected that growth would stabilize at around 8% in 2012. Yet, until recently, economic performance has been disappointing, owing to three factors. The impact of the slowdown in real-estate investment on the economy was stronger than expected, as was that of Europe’s debt crisis. And, though the People’s Bank of China (PBOC) lowered the reserve ratio in November 2011, and some fiscal stimulus was provided, the government largely refrained from more expansionary economic policies to boost growth.
In the last quarter of 2012, the long-expected rebound in growth finally materialized. I, for one, never doubted that it would. After all, China’s potential growth rate remains about 8%. Moreover, China’s fiscal position remains strong: even after accounting for all sorts of contingent liabilities – such as local-government loans, large project loans, and commercial banks’ non-performing loans in the event of a housing-market crash, China’s public debt/GDP ratio is still below 60%. Finally, the PBOC still has ample room to lower the reserve ratio and benchmark interest rate, which still stand at 20% and 6% (for one year loans), respectively, without much fear of stoking inflation.
The true challenges facing China lie in the medium and long term. Indeed, the current economic rebound is not an achievement worthy of much celebration, especially if it comes at the expense of further reform and structural adjustment.
First, as China ages rapidly, the disappearance of its demographic dividend will lower potential growth significantly. Moreover, other things being equal, the extremely rapid rise in fixed-asset investment has eroded China’s investment efficiency and capital efficiency, reducing potential output growth further. And, as China’s economy approaches full technological modernization, its latecomer’s advantage will be exhausted, and its inability to innovate and create may become an important bottleneck to further growth. Although active participation in global production networks has brought significant benefits, it may have locked China into the lower end of the value chain, reducing its scope for future progress.
Other constraints loom as well. Rapid economic expansion implies that supplies of energy and raw materials will increasingly limit potential growth. At the same time, the public’s demand for environmental protection and other basic rights will inevitably increase production costs. Similarly, the external environment may become less favorable, as the long process of global deleveraging impedes economic recovery in China’s key foreign markets.
Finally, despite China’s status as one of the world’s largest net creditors, it has been running a deficit on its investment balance for years. If this pattern persists, China may well face a balance-of-payments constraint on growth in the future.
Compared to these economic vulnerabilities, however, the fate of political reform in China will be much more important to the country’s long-term prosperity. Everything, it is hoped, will go well. But there is no harm in envisaging a crisis scenario, so that China can prevent it from materializing.
Such a scenario can be summarized as follows. Thanks to more than 30 years of breakneck economic growth with little regard for social justice and equality, China has become a stratified society. It is easy to imagine each social group demanding a larger share of national income, which by definition is inflationary.
Indeed, with an increasingly lenient political regime, populism may become irresistible, while the size of the government bureaucracy may continue to bloat. Given a lower growth rate, China’s fiscal position will deteriorate – gradually at first, and then rapidly – with the public debt/GDP ratio eventually rising to an unsustainable level. Making matters worse, when China needs to use its savings – accumulated over two generations and packed into US Treasury bills – to alleviate fiscal constraints, it will find that the value of its foreign-exchange reserves has already evaporated.
To judge China’s economic dynamism, the key indicator is its fiscal position. When, and only when, China’s fiscal position is worsening rapidly will its economy suffer a hard landing.
The next five years hold the key for China’s future; its window of opportunity to complete a difficult process of reform and adjustment may not be longer than that.