To the disappointment of those China observers, who bet on a coming collapse of the Chinese economy, the year of 2014 for China was rather uneventful. The real estate market didn't crash and there were no major defaults of shadow banks. Local government debts are still under control. Overcapacity? Yes, but it failed to drag the economy into a hard landing. At this point in time, it should be a bygone conclusion that China will achieve a growth rate not far apart from 7.5 percent, the target set by the government for 2014.
What is predicted for the Chinese economy in 2015? Until 2012, most Chinese economists still hoped that the economy would rebound strongly and return to the growth trajectory they had become accustomed to. Now, they have given up such hope. Instead, they believe that the economy has entered a new stage, in which a significant lower growth rate will last for a relatively long period of time. This is the so-called “New Normal,” which is characterized by three changes.
First, the high growth of the Chinese economy has become a thing of the past. For a quite long period of time in the future, growth of the economy will be hovering around an unimpressive rate of 7% or lower. Second, the government will avoid using expansionary fiscal and monetary policy to stimulate growth as long as the growth rate has yet to hit an unspecified bottom line—7 percent probably, even if there is still ammunition left in the government arsenal. Third, further market-orientated reforms will be implemented in a firmer manner even at the expense of growth—up to a limit. The just wrapped-up central economic work conference, which is the most important annual conference on economic affairs each year, seemed to have endorsed this view.
Overcapacity is the key feature of the economy in 2014. When an economy is suffering from overcapacity, the traditional countermeasure is straightforward: using expansionary fiscal and monetary policy to stimulate aggregate demand. However, China's current overcapacity is structural rather than cyclical. Its growth paradigm over the past two decades characterized by investment and driven by exports has run out of steam.
China's investment roughly consists of three main components: manufacturing investment, real estate investment and infrastructure investment, which, according to Morgan Stanley, account for 34 percent, 23 percent and 18 percent of fixed asset investment, respectively, in 2013.[1] Since 1998, as the single most important driver for growth, China's real estate investment has maintained a growth rate of more than 20 percent, more than double of that of GDP growth.
After two decades' investment-mania in real estate, China simply has built too many luxury five-star hotels, ugly skyscrapers, empty shopping malls, imposing government office buildings, and high-end condominiums. As a country with per capita income of $6,700, China's home ownership has surpassed 80 percent, dwarfing the U.S.'s 65 percent, let alone Germany's 40 percent. This is a massive misallocation of resources.
The government is worried about real estate bubbles and the growing resentment towards skyrocketing house prices among ordinary people, especially those dwellers of municipal cities. According to a recent study, more than 1 in 5 homes in Chinese cities are empty.[2] However, at the same time, for a young couple in Shanghai, they have to work for 24 years without spending a single penny to save enough money to buy a moderate flat. In response, the government tries to adjust the structure of house supply and clamp down on house prices at the same time. For the former, it is easily said than done. As a result of the latter, growth of real estate investment has fallen to 12.6 percent up to October in 2014. Now even the most bullish real estate developers have changed their views and admitted that real estate investment is likely to fall further in 2015.
The slowdown of real estate investment not only has hit growth directly but also dragged down the economy via its impact on manufacturing investment. The government has mistakenly targeted real estate development as the pillar of the economy since early 2000s. A very large proportion of economic activities are subject to the need of real estate development. The steel industry is a case in point. China has built thousands of steel mills with production capacity of 1 billion tons, which accounts for half of the global total. With the slowing down of real estate development, the bulk of steel mills immediately went under. In 2013, profit of two-ton steel was just enough to buy a lollypop. In 2014, the situation will not change much. The same is true of many other industries in the manufacturing sector.
Then, how about export and consumption? Export has been a drag on growth for years. China has already been the world's largest export nation. The world is too small for China's export drive. China's exports are competitive, but not invincible.
Are there any components of aggregate demand in China that can increase fast enough to offset the negative impact of the fall in real estate investment and export growth on growth of the economy? In recent years, household consumption has tended to increase, while having some ups and downs. However, due to its relatively small share in the economy and consumer inertia, consumption growth cannot suddenly become the engine of growth.
Perhaps, the only straw is infrastructure investment. In fact, China has planned to build more railways and highways. The so-called silk-road strategy certainly can help China to cushion a hard landing, though it is also likely that this new endeavor will cause new problems for the economy. Besides this grand project, China's air is chocking and poisoning water; it is aging quickly; its medical services are pathetic. China has to make up the deficiency in investment in these areas. Nevertheless, to do so, China has to put adequate incentive in place first, and, due to the limits of absorption capacity and funding difficulties, public investment has to increase in a gradual fashion. Rome was not built in one day. You can build many hospitals in one year, but you cannot train qualified doctors and nurses in a short period of time.
As a result the high growth rates of investment and export over the past decades, China's share of investment in GDP has approached 50 percent of GDP, by far the highest in the world, and its share of export in GDP is also the highest among the large economies. Even if China still has the fiscal and financial ability to speed up investment and export growth, it should refrain to do so. Otherwise, overcapacity will get worse in the future.
What China needs to do is to shift the growth paradigm from demand-led to innovation-based. Only when the growth is based on innovation and creation, can supply automatically lead to demand and the Chinese-style overcapacity be overcome. However, this is no longer simply an economic issue and the change will take time. Even if China can embark on such adjustment, some long-term unfavorable factors such as aging will creep in and create large uncertainty for China's economic future.
In short, on the one hand, due to the overcapacity, the Chinese economy will continue to slowdown; on the other hand, growth in infrastructure investment and household consumption can partially fill in the demand deficiency left by the fall in growth of real estate investment. As a result, the Chinese economy should be able to obtain a growth rate of 7 percent in 2015.
China's financial situation in 2015 is more precarious. The specter of a financial crisis will continue to loom over the economy. However, it is difficult to judge whether, when, and how a financial crisis will be triggered in China. There are many potential triggers. Among them are a real estate bubble, shadow-bank activities, defaults of local government finance vehicles (LGFV), and capital flight. Whatever the trigger is, the fundamental cause of the financial crisis is, almost without exception, attributable to the unsustainability of debts. China's total debt-to-GDP ratio has surpassed 250. Its corporate debt-to-GDP ratio is around 120 to150 percent, by far the highest in the world. Fortunately, on top of its very strong external position, China's household debt-to-GDP ratio is low and its public debt on the whole is still in a good shape. In my view, the biggest challenge facing China in 2015 and beyond is the high corporate debt ratio compounded by the slowdown of the economy.
All in all, 2015 will be a very challenging year for China. However, no one should forget China's extraordinary ability to muddle through challenges and keep the economy going. To bet on the coming collapse of the Chinese economy is a very dangerous business. China observers should have learned this lesson.
[1] http://www.forbeschina.com/column/ZhuHaibin
[2] http://www.wsj.com/articles/more-than-1-in-5-homes-in-chinese-cities-are-empty-survey-says-1402484499
