reflatingthedragon.doc

China's economy

Reflating the dragon

Can the world’s fastest-growing economy avoid a sharp downturn?

WHEN Deng Xiaoping set China on the road of economic reforms in 1978, Western economists argued that “Only capitalism can save China.” Exactly 30 years later, some pundits are claiming that “Only China can save capitalism.” Most rich economies are now facing recession. But if China, the world’s third-biggest economy, can manage to sustain reasonably robust growth, it will help to cushion global output. A massive stimulus package of 4 trillion yuan (nearly $600 billion) announced by the government on November 9th was therefore widely cheered at home and abroad. Will it be enough to re-stoke the dragon’s fire?

After growing by an annual average of over 10% over the past five years, China’s economy has suddenly cooled more quickly than expected. GDP growth slowed to 9% in the year to the third quarter, from 11.9% in 2007. That still sounds pretty impressive, but other indicators suggest weaker times ahead. Construction, steel demand, electricity consumption, car sales and air travel have all been falling in recent months. Industrial production grew by only 8.2% in the year to October, less than half its pace a year ago and its slowest for seven years. Share prices have slumped by 70% from their peak and house prices have started to drop. Property sales are running 40-50% lower than a year ago. Unsurprisingly, surveys show that consumer and business confidence is cracking.

China’s slowdown only partly reflects weaker exports as the world economy sags. Some of it is home-grown, caused by a deliberate tightening of monetary policy to curb inflation and an overheated property market. Indeed, export growth has held up surprisingly well. In the first ten months of this year exports were 21% higher in dollar terms than a year ago, compared with growth of 26% in 2007. They have slowed more sharply in real terms, but were still up by 13% in the year to the third quarter.

Guangdong province, in southern China, has been hit hardest. Thousands of firms making shoes, toys and clothing have been forced to close this year, partly as a result of a new labour law that has lifted wage costs, as well as weaker foreign sales. According to local newspaper reports, half of China’s toymakers and one-third of its shoe firms have disappeared this year. Yet toys and shoes now account for less than 5% of China’s total exports. Exports of machinery and transport equipment (almost half of the total) are still rising at an annual rate of more than 20% in volume terms.

The doom and gloom in Guangdong may be overdone. Many small factories close every year as a result of consolidation. Others have moved to cheaper parts of the country. The troubles of many firms in low-value sectors, such as toys and shoes, partly reflect China’s success in moving up into higher-value industries, which has pushed up wages.

Across China, companies report that foreign orders have shrunk sharply over the past couple of months as the developed world has slipped into recession. Some economists reckon that next year China’s exports may see no growth (in dollar terms) for the first time in more than 25 years. Imports are also slowing sharply, reflecting the high import content of many Chinese exports. Even so, UBS, a bank, forecasts that in 2009 net exports will be a negative drag on GDP growth. In 2007, net exports contributed almost three percentage points of the 12% increase in GDP.

Dismal export prospects will also depress manufacturing investment next year. Residential property construction is likely to continue to fall at least until mid-year, which, in turn, will reduce demand in industries such as steel and cement. However, China’s housing bust is not as serious as those in many developed economies. Although too many luxury homes were built in some cities, there is no massive oversupply at the national level, and urbanisation and rising incomes will continue to support demand for housing.

One bright light amid the darkness is retail sales, which rose by 17% in real terms in the year to October. Some sectors, such as furniture and household electronics, are feeling the pinch from the property downturn, but overall spending is expected to remain brisk next year, thanks to rising incomes and households’ low level of debt. Over the past year real incomes have risen by 10% in urban areas and 14% in the countryside. A fall in house prices will hurt Chinese consumers much less than their American counterparts, because Chinese households are not up to their necks in debt. Total household debt (including mortgages) amounts to only 13% of GDP, against 100% in America. During America’s boom, it was easy to get a mortgage for 100% or more of the value of a home, but Chinese buyers have had to put down a minimum deposit of 30%.

Adding net exports, business investment, construction and consumption together, China’s growth next year would probably drop to less than 6% without any government help—its slowest rate for almost two decades. Most countries would still be happy with such a figure, but it has become an article of faith in China that output needs to grow by at least 8% a year to create enough jobs for the millions of rural Chinese moving to cities. Growth of less than 8%, it is claimed, will lead to rising unemployment and social unrest.

In fact, the original estimate for China’s required minimum rate of growth, which was made in the mid-1990s, was 7%, not 8%. And the correct figure is now probably lower, because the original estimate was based not only on the flood of people out of the countryside, but also on the number of new jobs that were needed to absorb massive lay-offs by state firms. In addition, the number of young people joining the labour force each year has fallen with the birth rate, and a spurt in rural incomes in recent years has encouraged some to stay on the farm rather than move to the city.

But even if the 8% rule is no longer based on sound economics, it clearly still carries a lot of weight with government officials. Over the past two months the government has announced a series of measures aimed at sustaining domestic demand. The People’s Bank of China has cut interest rates three times and strict controls on bank lending have been scrapped. Measures to encourage home-buying have also been introduced: the minimum deposit on a mortgage has been cut from 30% to 20%, mortgage rates have been lowered and transaction taxes on homes reduced. A far more important boost, however, will come from the planned surge in infrastructure spending.