The third plenum of the 18th Party Congress issued an ambitious reform program to transform China’s economy by 2020 into one that relies on market forces rather than government to allocate resources. Launching the program, however, is hampered by the fragile nature of the economy today. Since 2008 China has depended on a vast property bubble to fund fixed asset investment that leads the economy. Ambitious structural reforms usually involve a period of economic slowdown. Doing so amidst a bubble economy may trigger a deep downturn. This is why financial markets have been focusing on the downside from bursting of the bubble rather than the upside from successful implementation of the reform program.
Reform without pain is possible if businesses increase investment in anticipation of more demand in future. That force could more than offset the retrenchment from the reform. When China revamped state-owned enterprises, privatized housing, and decided to join the WTO in late 1990s, the business response was massive, which soon absorbed all the downside from the economic restructuring. The bad loans, most property and mining assets from the previous cycle of over-investment, soon became good assets due to the rapid economic growth. Many are hoping the same response could boost the economy and make the reforms less painful.
I suspect that China won’t be able to repeat its experience from a dozen years ago. No significant investment response is likely before the reforms have been carried out and the bubble economy deflated. In the late 1990s, China had a massive labour surplus and low export market share. Foreign direct investment was waiting for a signal to pour in to take advantage of the situation. China joining the WTO was the signal that multinationals were waiting for. Today China’s export market is saturated, and overcapacity is widespread across most industries. Hence, even if the government manages to shift the economy to consumption from investment, there is no urgency to expand capacity now. Waiting for a better economy to begin reform is likely to be a long one.
Waiting is costly. At the heart of China’s bubble economy is the iron triangle of local governments, property developers, and banks. The former two mark up land prices through auctions. The later make loans to both with inflated land as collateral. As land prices rise much faster than the economy, credit becomes concentrated in local governments and developers. As they use money inefficiently, inflation has risen, essentially a tax on the household sector. This spiral of credit concentration and inflation is becoming wobbly over time due to its rising share in GDP. The share of fixed asset investment in GDP has risen by over ten percentage points since 2008 and is above half of the economy.
The latest economic works conference has put controlling debt risk as the top policy goal this year. Its substance must be stopping the bubble economy. Otherwise, the debt risk will only rise. The key to rolling back the credit bubble is to stop local governments from borrowing more with land as collateral. Even though banks have become cautious in lending to local governments, they have been able to borrow from the shadow banking system. Because they don’t mind paying high interest rate and rely on the perception that the central government would bail them out, financial market measures wouldn’t be useful. The central government must clarify on its position on bailout. I believe that the central government will clarify its position in 2014, which would lead to substantial credit contraction among most local governments. As their spendings are the driver for the economy, a substantial economic slowdown is likely.
An economic downturn wouldn’t threaten China’s social stability at all. Shortage of manual labour is widespread at present. A downturn would cool inflationary pressures and decrease living costs, which would enhance social stability. While college graduates have been struggling to find jobs, the solution is in restructuring the economy to increase demand for white-collar jobs.
The growth news from China may not be good in 2014. The opinion makers may spin it as the end of China’s growth story. My view is the opposite. I have been sounding the alarm on China’s bubble economy for many years. When the bubble bursts, it can only usher in a better future. China has a bright future. Its labour productivity is comparable to that in developed economies with wages at one seventh as much. The current per capita consumption is just one tenth of the OECD level. A virtuous cycle of consumption demand and productivity growth could take hold for two decades to come. China could easily become the largest economy in the world by 2030, if the system is not too inefficient.
I believe that, when the central government comes out with a plan to recapitalize the financial system, it will mark the bottom of the current cycle. Structural reforms would follow to make China’s economy more efficient and less dependent on investment and exports. A long growth cycle would follow afterwards. For investors and businesses, bad news in China is good news.
Andy Xie is an independent economist and consultant based in Shanghai.