Is a hard landing for the economy unavoidable?
Given all the bad news being reported from China—a slowing economy, mounting debt, rising costs, an increasingly hostile environment for foreign companies, and a political clampdown—we have prepared this series of blogs with the intent of providing some perspective to the dire headlines that draw so much attention.
Is a hard landing or crisis unavoidable for China’s economy?
China’s economic growth is slowing, but that is not necessarily a problem. Given the size and maturity of China’s economy, it is normal for the economic growth rate to drop below the 8-10% average of the last few decades. More problematic is the rapid build-up of debt China has incurred over the last five years as it tried to boost growth. To avert a crisis, China needs to maintain reasonable leverage in the economy and accept a slower growth rate. To maintain growth, China also needs to continue to liberalize its economy as it has been doing for 30 years. China’s leadership has indicated it will do both of the above. Time will tell. But crisis is not unavoidable.
China’s economic growth rate is decreasing
Past growth of 9-10% is being replaced by the “new normal” of 7% or less
GDP growth was 7.4% in 2014, down from 7.6% in 2013. For most of the preceding 30 years, China had averaged GDP growth of 9% or better. Economists expect China to set a target rate of 7% for 2015 although many also think 6.5% or a bit lower is more likely. Economic indicators for 2015 through February confirm the trend of the last few years, with imports, real estate prices, inflation and others indicators all pointing to decelerating growth. Slower growth is definitely a reality.
Slower growth is to be expected given the size and maturity of China’s economy
You can’t growth at 10% forever
To a large degree, slower growth is simply a result of the mathematics of development—the bigger you are, the smaller the percentage growth you can maintain. To put it mathematically, China’s economy is roughly twice as large as it was 8 years ago. Seven percent growth today actually represents 40% more growth than 10% growth was just 8 years ago. So while the percentages are lower, the actual growth is higher. This isn’t bad for China. It also means that, even with lower growth rates, China can still be a large and attractive market for foreign companies.
National debt is nearing dangerous levels
China’s efforts to boost growth have led to a rapid build-up of debt
That’s not to say there isn’t any risk to China’s slowing economy. China’s total debt to GDP is estimated to be nearing 250%, up from roughly 120% just 5 years ago. The rapid increase is largely the result of policies aimed at countering the negative impact of the global financial crisis and a decrease in export growth.
Crash, stagnation, or neither?
Will China’s slowing economy and growing debt burden lead to a crash or a prolonged period of stagnation? Below are two perspectives:
Bears focus on speed
Pessimists say the rapid accumulation of debt will be China’s undoing
This summer the IMF reported that in the last 50 years only four countries have experienced debt accumulation as rapid as China has during the last 5 years—Brazil, Ireland, Spain, and Sweden—and that all four had banking crisis within three years of their supercharged growth. Some would say that the speed of China’s credit growth will necessarily lead to at least a harsh correction, if not a complete implosion.
Bulls focus on total debt
Optimists stress that, as long as China keeps debt within reasonable levels, a crisis will be avoided
While debt has grown quickly in China, the absolute amount is not necessarily punitive as yet. Many developed countries have debt to GDP ratios of 300% or more. Not only is China’s absolute debt level lower, but its higher growth rate (even an adjusted rate of 5-6%) means that, theoretically, China can withstand higher debt levels, if necessary. So while China’s rapid accumulation of debt is certainly cause for concern, the absolute amount of debt has not reached crisis levels yet.
What to watch for: Liberalizing the economy
One key to continued growth for China is continued economic reform
China’s thirty years of spectacular growth are primarily the result of its economic reform program which has been characterized by a gradual, step-by-step transition from communism to free-market capitalism. As long as China continues to liberalize its economy, there is no reason to think that strong growth can’t continue, although “strong” growth is likely to be 5-6% as opposed to 9-10%. So far China’s leadership has indicated that liberalization will continue, although some argue the rate of liberalization has become too slow to support economic growth. For 2015 it will be important to see if China makes any decisive moves relative to liberalization.
What to watch for: Controlling debt
Another key to continued growth for China is to control the growth of debt
If China continues to rely on debt to boost growth it faces the prospect of an economic implosion of the kind that hit the US in 2008. In late 2014 and into 2015, China’s leadership gave strong indications that they prefer slower growth to higher debt levels, which is a good sign. Yet by the end of February, in response to sluggish economic indicators, China had elected to lower interest rates and reserve requirements for banks, both of which are likely to increase debt growth in the economy. That doesn’t mean China is definitely heading for a crisis. In fact, it is likely they are not. But China’s recent policy actions are a reminder that it will be important to keep an eye on total debt levels in China.