For the large part, I think the challenges facing the Chinese economy are simply part of the challenges that the global economy has been confronting. The “imbalances” of the Chinese economy reflect the “imbalances” of the global economy.
China’s massive trade surplus was a result of policy, which, for the most part of more than a decade, tried to stop the Chinese Yuan from appreciating quickly, fearing that it would hurt the export sector. As a result of trying to keep exchange rate low under such a background, China had to create a lot of money to reduce upward pressure on the currency, with the side-effect of creating a permanently excessive money supply growth. Credit would be easy, so even pointless investments and speculations could get funded. On the other side, as the central bank creates local currency to keep the exchange rate low, the currency it creates will have to be used to purchase foreign assets, and that creates the massive foreign exchange reserve. Hence China inadvertently became the largest creditor country, and inadvertently contributed to the problems in the West.
As the West struggles and the imbalances are set to be unwound, it should have been obvious that the growth model of the past decade or more was unsustainable, and it will inevitably be changed. Chinese consumption’s contribution to the GDP will have to rise as exports and investment have to fall. These are inevitable. The only big question that really matters is how.
An optimistic view would believe that as labour shortages become more of a problem for China, wages will have to rise, thus consumption will have to increase. At the same time, wages increase will put upward pressure on general price level, leading to inflation. Meanwhile, as China urbanises and as people will have to become more wealthy in general, that will be able to support real estate prices, so what looks like a bubble today will not look as bad.
In that scenario, using the contributions of various parts of the economy from the official data for 2010 as a starting point, one might assume that China can go on growing at very fast rate (let’s say 7-8% per annum in real terms), and consumption growth will outpace other (let’s say 10-15% per annum in real terms) while investment growth will slow to low single digit such that the contribution of consumption would increase to 50% by the end of a 10-year period (with the remaining parts of the economy growing in-line overall).
My analyses, however, suggest that there could be a real possibility that as the real estate bubble bursts and the investment boom ends, it suddenly appears that there is too much excess capacity owing to over-investment in the past. Debt will become non-performing (even though banks might try to tell otherwise), and debt deflation occurs.
While the PBOC can perform “quantitative easing” theoretically, it won’t help the falling asset prices whatsoever (but that could undermine the strength of Chinese Yuan exchange rate in the endgame). Even though, as the dependency ratio increases and as Chinese consumers will have to contribute more to the GDP, as the economy slows and prices fall, their income growth will slow, so consumption growth will slow as well, just perhaps less than the other parts of the economy.
In that type of scenario, one has to assume that investment growth will have a real possibility of turning negative in real terms. If investment growth turned negative in real terms, consumption growth will have to be around 15-16% on average in real terms for the next 10 years in order to achieve around 8% GDP growth per annum. The result of such pattern of growth will increase the contribution of consumption to 65.8%, which is better than 50% we have got above. However, and understandably, that rate of consumption growth would be much harder to be achieved when investment fell in real terms.
In a medium growth scenario of 5% GDP growth, an average of 11.3% growth for consumption is required to get that GDP growth rate, with somewhat lower contribution of consumption at the end.
Finally, in a low growth scenario of 3% GDP growth, an average of 8.3% for consumption would be required.
Below is the growth of China’s consumption expenditure (GDP basis) in real terms. As you can see, growth has been in single digit for the best part of the first decade of the 21st century.
Source: National Bureau of Statistics
If the conjecture that China’s real estate bubble is bursting and that debt deflation cycle could happen, it would be difficult to imagine how household income can really grow very rapidly as the economy would have slowed, even though the demographic factors are on their side. Thus the likely scenario is judged to be a low growth scenario with consumption growing not as slow.
Final conclusion: hard landing and policy responses
I would still expect growth to slow dramatic over the next few years (or a hard landing, if you prefer that wordings), but it will be very hard to get the timing of it absolutely right, except that the growth model is flawed and has been pushed to its limit, and the transition will be difficult, if not impossible, to be smooth. Hard landing is almost inevitable.
Here I would offer a few thoughts with respect to the policy tools China has. It seems to be widely believed that China has almost unlimited tools and power to gear the economy towards whatever direction they would like to. It is probably true in some respects. For instance, there are rooms to cut interest rates and reserve requirement ratios, and if you believe the official data (which I don’t) that China has very sound fiscal position, they can certainly throw trillions RMB to invest in more pointless stuff for the sake of generating GDP growth and create jobs.
However, we have already heard deposits flight where households are seeking better returns, and if China slows down (as it is, and as I expect), it will not be surprising to see capital outflow and trade surplus shrinking. In the likely event of these happening, it will tighten the screw of monetary policy automatically, and cutting the reserve requirement ratio, while it looks useful, could be seen as offsetting the tightening effect of capital outflow and other things.
Furthermore, if money is flowing out of the banking system (for whatever reasons, like capital outflow), that makes it difficult to cut interest rates. As I mentioned earlier, the view here is that while reserve requirement ratio will be cut, it is important to understand that it may not make monetary condition easier, and that interest rates may not be an available tool at all. And if things get so bad, we could expect a small probability that RMB will have to be depreciated. And with respect to the fiscal side of the story, if my analysis on the debt side of the story is accurate, the Chinese government’s fiscal position might not be as good as it seems, one will have to question 1) whether they have the financial resources to invest in more for the sake of creating GDP growth and 2) whether it still makes sense to invest in a place where over-investment has happened.
The key conjectures (or the only things that you need to know) are:
1. Inflation might actually surprise on the downside. We might even see deflation.
2. Real estate industry will slow down drastically, and drag the whole economy.
3. Home prices and other asset prices will fall, possibly resulting in debt deflation.
4. The government and central bank may have some tools to help the economy, but the tools are not unlimited.