As China’s growth decelerates, some U.S. observers see slowing Chinese growth as the “biggest threat to the global economy.” However, they mistake China’s secular challenges with its cyclical slowdown.
A slowdown in China is the greatest threat to the global economy, Harvard economist Kenneth Rogoff told the BBC in an interview in late September. “The [Chinese] economy is slowing down much more than the official figures show.” As the International Monetary Fund’s former chief economist, Rogoff’s comments can move markets, and U.S. financial media was quick to report on them.
After years of double-digit growth, China’s economy is slowing. The IMF expects China’s gross domestic product (GDP) to grow by 6.6% this year. According to Rogoff, the Chinese economy is already in the midst of a “pretty sharp landing.” In reality, the “sharpness” of this landing is much more complex.
Among other things, Rogoff bases his view on China’s debt-to-GDP gap. Recently, the Bank of International Settlements (BIS) reported that this gap – the amount of debt in an economy relative to annual growth – stood at 30.1%, increasing fears that China’s economic boom was based on an unstable credit bubble.
Certainly, large gaps are usually reliable early warning indicators of banking crises or severe distress. Nevertheless, what the media neglects to mention is that the ratio is also criticized for creating three key challenges: measurement problems; policy decisions that conflict with countercyclical capital buffers; and being a less-than-optimal early warning indicator for banking crises in emerging economies. In the case of China, the largest emerging economy, these qualifications cannot be ignored.
Austerity advocates have a mixed track record. During the Great Recession, Rogoff and his colleague Carmela Reinhart published a bestseller, This Time It Is Different (2009), a study of financial crises. Their work was subsequently used to legitimize neoliberal austerity doctrines in major advanced economies. Yet critics, including Paul Krugman, showed that Rogoff and Reinhart periodized their findings to boost their ideological views. To the embarrassment of the authors, a group of students and professors at Massachusetts-Amherst showed that the Rogoff-Reinhart methods and data were in fact flawed. Furthermore, the implementation of austerity measures made economic challenges worse by aggravating unemployment and extremist political groups in major advanced economies, particularly in Europe.
While China’s growth is currently fueled by credit, a simplistic application of the debt-to-credit gap is misguided. According to Rogoff, China is amid a “hard landing.” Simon Baptist, chief economist of the Economist Intelligence Unit (EIU), seconded these views. Both believe that slowing growth in China is definitive proof of a hard landing, but a closer analysis reveals that this conclusion may not be wholly accurate.
While the concept of hard landing seems familiar, there is no consensus definition for it. Usually, it refers to an economic state wherein the economy is slowing down sharply or is tipped into outright recession after a period of rapid growth. Consequently, China’s rapid economic growth often gives rise to speculation about the possibility of a hard landing. Some observers have repeated this narrative for almost two decades, including Gordon G. Chang, who predicted The Coming Collapse of China since 2001; investor Jim Chanos, who in 2009 forecasted a China bust “a thousand times worse than Dubai”; and more recently George Soros, who is hoping to short the yuan. In each case, the “China crash” argument served as a pretext for ideological or profit motive. However, the Chinese currency is not the British pound, and 2016 is not 1992.
Assuming that China is due for a hard landing, the implications are large. First, such a landing is typically accompanied by interest rate hikes to slow growth. The People’s Bank of China (PBOC) has in fact cut rates . In October, PBOC raised an obscure interest rate to signal that it is no longer willing to provide limitless cheap funds, but the policy rate is 1.50% and likely to prevail in the foreseeable future. Second, a hard landing also implies rising inflation.
Chinese inflation is expected to increase or vary around 1.5% to 2.2%, on par with historic trends. Hard landing is predicated on a business cycle and often indicates an economic slowdown. China’s cyclical growth is stabilizing, but lower growth is a result of its structural rebalancing. As long as Chinese growth is close to 6.5%, still three to four times faster than growth rates in major advanced economies, it reflects structural deceleration, not recession.
In light of these facts, the hard landing theory is not fully persuasive. Nevertheless, as long as China’s credit target of 13% is almost twice its nominal GDP, Chinese growth will be fueled by a reduced quality of growth. Indeed, continued excessive leverage could result in hard landing, which is well-known in Beijing.
In early May, a top government source warned about excessive leverage in China that could cause a “systemic financial crisis” if left unchecked. Chinese industries are facing huge overcapacity and potential stagnation as global demand for Chinese goods is on the decline. According to Standard & Poor’s, China’s credit growth is expected to moderate by a third by 2020, but its credit to total ratio could double to 10% from the 2015 estimate, elevating risks of a systemic financial crisis. China’s central government agrees that overcapacity is no longer an option and that the reform of state-owned-enterprises (SOEs) is vital. The real question is how to do it.
The steel industry is a case in point. At the G20 summit in Hangzhou in early September, world leaders had harsh words for China’s steel overcapacity. Before the summit, U.S. lawmakers, unions, and trade associations urged President Barack Obama to blame China’s trade practices for U.S. mill closures and unemployment. They also stressed the need for “aggressive enforcement of U.S. trade remedy laws.” In Brussels, European Commission president Jean-Claude Juncker seconded U.S. concerns. Japanese Prime Minister Shinzo Abe also called for structural reforms to address China’s steel overcapacity. The first major steel crisis, however, already occurred in the 1970s, thanks in part to policies put forth by the United States, European Union, and Japan.
Since the postwar era, crude steel production grew in three phases. Global steel production grew 5% annually and was driven by Europe’s reconstruction and industrialization, as well as by Japan’s and the former Soviet Union’s catch-up growth. As growth ended in the 1970s, a period of stagnation ensued and global steel demand increased by barely 1.1% annually. The United States and Europe sought to protect their steel market through non-tariff barriers and protectionist external policies.
Most recently, from 2000-2015, China experienced a massive expansion in steel production and demand, driving annual output growth by 13%. However, the most intensive period of expansion is now behind us, while China’s urbanization will continue for years to come. Now it is China’s turn to face overcapacity and stagnation.
The United States and Europe are urging China to overcome overcapacity by allowing massive defaults. But in responding to this crisis, China is eager not just to sustain globalization, but also to accelerate world trade and investment. A single-minded focus on privatization would result in the kind of challenges that U.S. and European steel factories coped with in the 1970s and 1980s. Beijing, in contrast, is opting for gradual SOE reforms. To be sure, this is not without its own challenges. If current overcapacity in steel, coal mining, and cement is reduced by 30%, up to 3 million workers will be laid off in China over the next two to three years. To combat this, Beijing is allocating $15.4 billion in the next 2 years to help laid-off workers in the coal and steel sectors find new jobs.
Cyclical stabilization seems to support this quest. China’s economy grew 6.7% for a third consecutive quarter. Manufacturing and service sectors bottomed out around 2015-2016, but have since risen. Consumer price inflation is now at about 2%. After seasonal adjustments, exports and imports reflect stabilization as well. In the first three quarters of 2016, consumption accounted for 70% of GDP growth, almost twice as much as the 37% of GDP growth attributed to investment.
What China is experiencing is structural deceleration, not a cyclical recession. After intensive industrialization, such deceleration is typical to all maturing economies. In the United States, Europe, and Japan, the expansionary industrialization phase ended with the energy crises in the 1970s, effectively halving their growth rates. In China, the deceleration of growth is also the explicit goal of economic rebalancing, which is shifting the mainland’s growth away from investment and net exports and toward consumption and innovation. China’s policy objective is no longer aggregate economic growth, but rather Chinese living standards per capita.
This secular transformation, however, coincides with the cyclical crisis that originates from the 2009 stimulus. While the Chinese stimulus did restore confidence and resulted in a great infrastructure creation, it also led to excessive liquidity and market speculation. This, in turn, resulted in soaring local government debt. (China’s central government debt, however, remains low by international standards.)
Consequently, Beijing’s policy authorities, including President Xi Jinping and Prime Minister Li Keqiang, must cope with the leverage legacy of their predecessors, while paving the way toward a massive secular transformation. The inherent challenges of concurrent secular and cyclical shifts virtually ensure a long and bumpy landing.