China: More pain than gain
China is in for a rough year. The economy is in its most fragile state since 1998, at the nadir of the Asian financial crisis. Gross domestic product grew at an annualised rate of just 6.1% in the last quarter of 2014, and most key indicators suggest that the first half of 2015 is unlikely to be much better. Industrial profits are weakening sharply, which is likely to dampen wage growth and consumption-the two bright spots over the last couple of years. Disinflation is now entrenched. The implied GDP deflator last year was just 0.4%, producer prices have been falling for three years and the steep fall in oil prices, while beneficial in the long run, will only add to the downdraft in industrial pricing power and profits in the short term.
To these problems add structural and policy-induced risks. The construction sector, one of the economy’s main growth engines, looks chronically weak as China has already passed the point of peak housing demand. To bring supply and demand into balance, it is likely that completions of new housing floor space, which tripled between 2000 and 2012, will need to decline by 10-15% over the next decade.
Government programmes for building subsidised social housing—a crying need for the poorer half of the urban population—have helped prop up construction volumes for a few years. But this support is now also weakening, a point emphasised by the news that some local governments plan to buy existing but vacant housing units to convert them into social housing. While this is an eminently sensible way to solve the twin problems of excess high-end and insufficient low-end housing, it is surely bad news for the construction industry.
There are also risks on the fiscal side. This year, local governments will lose the right to use their land holdings as collateral for loans, a mechanism which has provided about 20% of their net revenues in recent years. Tax revenues are also slowing because of the weaker economy. Faced with uncertain revenue, many local governments could well choose to cut back expenditure. Unless the central government is quick to respond with increased transfers, which would push its own deficit above previously accepted levels, there are real risks of an inadvertent fiscal tightening this year.
The positive spin on all this is that the government is serious about the structural work needed to set economic growth on a more sustainable footing. Sharply slower growth for a couple of years is the price that must be paid. The analogy is to the first four years of Premier Zhu Rongji’s tenure (19982001), when China suffered relatively low growth, persistent deflation and rising unemployment as it overhauled stateowned enterprises and the financial sector.
There are three crucial differences between now and then. First, Zhu swiftly executed large-scale reforms that opened up new sources of productivity growth. He shifted most of the manufacturing sector from state to private hands, privatized the housing market and dragged China into the WTO. These moves paid dividends in the boom that began in 2002. By contrast, current president Xi Jinping has so far failed to gain much traction in the two reforms most crucial for future productivity growth: slashing the inefficient state sector and deregulating service industries.
Second, Zhu had the good fortune to inherit a relatively low debt economy, so he could increase overall leverage to ease the pain of structural reform. Xi has far less room to maneuver. The economy’s debt level is high and rising fast, so over the medium to long term credit must be tightened.
Third, in Zhu’s era there was little doubt that economic restructuring and growth was the state’s priority. Today there is equally little doubt that tightening political control tops Xi’s agenda. The priorities are anti-corruption, ideological purification and clamping down on the internet.
As we have argued before, Xi’s economic and governance reform programme is serious, and his fierce political offensive (particularly the anti-graft drive) is essential groundwork for China’s future. His grand design may eventually pay off in more robust growth. In the short run, the economic picture is likely to grow uglier.
The monetary easing cycle that began with last November’s interest rate cut and continued with last week’s reserve ratio cut will probably see another couple of rate cuts this year. These will be welcome, as China’s borrowers now face among the highest real rates in the world. But the most that monetary easing can achieve will be the stabilisation of growth at a lower level, somewhere between 6.5% and 7% this year (down from 2014’s full year figure of 7.3%), and perhaps as low as 6% in 2016. China may well fix its deep economic problems, but the process will take several years and it will be painful. In the meantime, don’t expect China to take the lead in pulling the world out of its cycle of stagnant growth and disinflation.