Beijing's burden

By Geoff Dyer 2008-09-26

As the credit crisis unfolded over the past year, one of the few certainties in the global economy seemed to be China's ability to plough on regardless at double-digit growth rates.
Not any more. With Wall Street in tatters and Europe's and Japan's economies faltering, many investors are beginning to ask if China too might stumble badly. After five turbocharged years of accelerating growth, the Chinese economy is clearly slowing.
For some, this is no more than a welcome easing from unsustainable rates of expansion. “China is going from supercharged growth to fast growth,” says Andy Rothman, a Shanghai-based economist at CLSA, the regional brokerage. Yet a flurry of recent data and anecdotal reports have raised fears that the economy might be slowing more rapidly – and last week's surprise decision to cut interest rates for the first time in six years indicates that Beijing could share some of those anxieties.

The international crisis has also focused minds in China on the need to update a growth model that – despite huge improvements in productivity – is still too dependent on assembling goods for export without adding much value and on heavy industries that create pollution and suck in lots of capital.
A weak social security network, meanwhile, forces Chinese to save too much and spend less than is good for the economy. “Everyone knows the current system gives too much preference to producers over consumers,” says a leading Chinese economist at a Beijing think-tank. “But now it is much clearer we need to put this theory into practice, which will not be easy.”
Admittedly, China's problems are of a kind that most other countries would envy – few economists predict that its growth will fall below 8 per cent next year. But a harder landing would have big implications for commodities markets and could temper China's ability to cushion the blow to the global economy from the credit crisis. There could also be some unexpected problems at home, notably in the banking sector.
“There are lots of flashing amber lights,” says Nicholas Lardy, a China economy expert at the Peterson Institute in Washington. “Even though most of the rest of the world would die for 8 per cent growth, that still represents a big slowdown and we will have to watch to see what falls off.”
The growing anxiety about China reflects the conflicting signals emanating from the economy. Take exports, one of the bedrocks of China's recent expansion, which have increased at more than 20 per cent a year. Given the US downturn, economists had been expecting a slide in exports this year. Yet these have continued to grow strongly, expanding 22 per cent in the first eight months of the year.
One explanation is that Chinese companies have continued to find new markets for their products in other booming developing economies. Yet some economists believe this is only delaying the inevitable. In particular, there is growing evidence of a sharp contraction in Europe, China's biggest market, which could start to hurt Chinese exports. “This could be the calm before the storm,” says Stephen Green, an economist at Standard Chartered in Shanghai.
If there is a question mark over exports, there are even bigger concerns about the property market – which has been one of the principal components of the investment boom driving the Chinese economy in recent years.
Again, the headline numbers do not look too scary. In the year to August, house prices in the 70 biggest cities in the country increased by 5.3 per cent, even if that was down from a growth rate of 11 per cent earlier in the year. House prices did drop in August from the previous month – although by a meagre 0.1 per cent. The government has been an active participant in the slowdown, restricting credit to both developers and housebuyers in order to limit the scope for speculation and prevent bubbles.
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Yet within those overall figures, there are huge variations. According to Zhang Shuxiao, an estate agent at 21st Century in Xian, a large industrial city in central China: “There is no bubble here like there is in Shanghai or Beijing. The market is very stable without any significant increases or price drops.” However, in Chengdu, in south-western China, big problems are developing. “Prices have dropped 20 per cent in the last year, especially for new apartments,” says Li Qian at Shunchi Real Estate Agency in the city. “It could take two or three years before they come back.” Similar stories of plunging prices are beginning to appear in a number of big cities. Meanwhile, several other indicators point to a slowing property market. Sales have declined and floor area under construction fell in August, while production of steel, cement and air conditioners was flat or down in the month – another sign of weak activity. Analysts say that mortgage approvals have also dropped sharply in recent months. “We believe the likelihood of a property sector meltdown in China is high,” says Jerry Lou, an analyst at Morgan Stanley in Shanghai.
Most economists believe that there is a lower chance of widespread defaults on mortgages in China than in many countries because Chinese housebuyers pay relatively large deposits. “Chinese families will do everything to avoid losing a house,” says one Beijing-based economist. Others point to signs that underlying demand is still strong. In the past fortnight, there have been a number of cases of property developers generating huge interest from buyers after they offered generous discounts on new apartments.
But if the property market does suffer a nasty accident over the next year, the banking sector will feel the pain. Indeed, while few people are predicting growth in gross domestic product much below 8 per cent next year, a worst-case scenario that would cause an even sharper slowdown would be for property woes to cause a collapse in private sector investment.

Given the uncertain outlook for exports and property, much more attention is now being paid to Chinese consumers. So far, the news has been positive. Retail sales have risen by 23 per cent in each of the past two months, the highest rate of growth in nine years. Indeed, such strong figures have encouraged some analysts to predict that consumers will take up some of the slack in a slowing economy.
Again, however, there are warning signs. The rate of increase in urban incomes has dropped sharply this year. Sales of cars have fallen in the past month by 6 per cent and airline travel has been sharply lower this summer (although the Beijing Olympics might be the main cause). Gome, the country's biggest electronics retailer, said that sales per square metre in its shops fell by 3 per cent in the second quarter. The crash in the stock market has also sapped consumer confidence. If growth in China does slump, the biggest casualties will be commodity producing countries from the Middle East to Latin America. Copper prices, for example, have fallen 23 per cent in the past two months, partly on fears over Chinese consumption of the metal, which has fallen by more than half this year. With domestic construction slowing, China has over the past month started exporting more steel as local producers look to offload products overseas.
So can the government respond if the economy does start to slow more sharply? One option would be to loosen the current restrictions on credit – indeed, the government started this last week when it cut interest rates and reduced reserve requirements for small banks.
However, it can loosen monetary policy only so far, for fear of reigniting inflation, which peaked at 8.7 per cent in February before falling to 4.9 per cent in August. Zhou Xiaochuan, head of the central bank, said this month: “Inflation has indeed slowed over the past several months, but we cannot relax because the rate may rebound.”
Beijing has much more room on the fiscal front to boost short-term growth. China has run only small budget deficits in recent years and, in the first half of this year, tax revenues rose by 33 per cent – more than double the government's forecast. China needs to invest heavily in its stretched railway network and to build subways in cities that are rapidly becoming clogged by cars. Given that Beijing has cash to spare, it can accelerate some of its planned infrastructure spending to make up for slower private investment. Tax cuts can also provide a boost to consumption.
Yet for some economists, Beijing will need to do more than make tactical fiscal adjustments if it is to sustain long-term high growth rates. Instead, it has to accelerate a big structural adjustment to the economy that it has already identified.
Four years ago, China's top leaders began to talk about shifting the economic model to allow domestic consumption to play a much larger role. The idea reflected the reality that exports could not keep growing at 20 per cent for ever, nor could the economy keep up such torrid rates of investment.
One way to boost consumption is to improve social security – if workers feel more confident about their pensions, health and education benefits, they will be willing to spend more of their income now. Spending on rural health and education has already increased markedly, although reform of the pension system has been slower.
Consumption would also be encouraged if the huge sums deposited in China's banks did not face negative real interest rates. At the Peterson Institute, Mr Lardy estimates that these negative returns amounted to an implicit tax on households in the first quarter of this year of $36bn, or 4.1 per cent of GDP – which is three times the proceeds from personal income tax.
He adds: “If efforts to rebalance the economy do not happen more quickly, then the growth rate in China could fall even more.”