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Snaring the Dragon

by Bennett Voyles

June 19, 2012

What could stop growth in China and what can the country do about it?

After 30 years of strong, nearly unrelenting growth, some observers worry that China won’t be able to keep it up for much longer. Many countries, such as South Africa and the Philippines, have reached middle-income status only to hit a wall just when they seemed to be on the verge of becoming rich. “Historically no country has become rich without undergoing some sort of a financial calamity. To many, it’s not a matter of ‘whether’, it’s a matter of ‘when’ there’ll be such a crisis in China’s future,” says Li Wei, Professor of Economics and Emerging Markets Finance and Director of the Case Center at CKGSB.

Various factors tend to bring promising economies down, but the most common is the difficulty in making the leap from being a country that wins with low labor costs to one that wins because of its know-how. China is already on the cusp of just such a transition. As labor costs, real estate costs, and a host of other factors continue to rise and erode competitiveness, China is struggling to find a new formula for growth.

In the long run, say 100 years or so, growth seems to correlate most strongly to institutional strength, says Dirk Willem te Velde, an analyst for the Overseas Development Institute, a British think tank. Shorter term, however, other factors play a role. In the case of China, some experts point to demographics, pollution and climate change, foreign financial crises, and overinvestment as the key risks ahead.


The Coming Demographics Slump

Very gray and very male, the China of tomorrow faces demographic challenges that could have serious economic repercussions. “China has built this great industrial infrastructure and in 20 years from now, you’ll find there is no one to staff it,” says CKGSB’s Li.

A 2011 report by Swiss Re estimates that low fertility rates are leading to a steady decline in the working age population “as far as the demographer’s eye can see”. At the same time, it will be getting older. China’s cohort of workers in their 20s is set to decline by 35%, 75 million, over the next 20 years. Also, the fraction of the population over 65 will grow from 8.6% to 17.2% (115 million to nearly 240 million).

Some analysts estimate that an imbalance in the sex ratios brought on by the one-child policy will create a large group of involuntarily unmarried men. In 2000, only 5% of men in their late 30s were never married. By 2030, this ratio could rise as high as 25%. The consequences of this are not known yet, but Swiss Re notes “it is difficult to see how this could prove a plus for either economic performance or social cohesion”.

The Often Ignored Costs of Environmental Degradation

In a less densely populated country, environmental protection is often seen as an almost aesthetic concern. But with 1.3 billion people, it’s a matter of survival. Already, with an estimated 200,000-600,000 deaths a year due to air pollution,  the costs of environmental degradation are high, but they could get worse, particularly if global warming intensifies.

Resource scarcity could also threaten growth. Energy and food are threats, of course, but in northern China, even water may be difficult to find. On a per capita basis, China has only 25% of the average water supply of other countries, and of its total supply, 80% is in the South, far away from the centers of agricultural production in the North, according to a Columbia University report. This is not a theoretical problem: already, over the last 50 years, 24,000 villages have been abandoned because of desertification, according to the report.

None of this is news to Chinese leadership, of course. In the latest Five Year Plan, the government set ambitious goals to use its resources more efficiently. But will they reach their targets?

In a recent report titled Drying Up: What to do about droughts in the People’s Republic of China, the Asian Development Bank warned that, when it comes to water, although the Chinese government has earmarked $680 billion over the next 10 years to water system improvements, success will require overcoming a whole host of challenges, including “uneven distribution of water resources, uneven rainfall patterns, and a natural proclivity to droughts – all in addition to climate change and a degraded environment”.

Foreign Financial Crises

“China’s growth model has done miracles to the Chinese economy but itself, it has brought weaknesses. Much of the growth is investment-driven so it relies on huge domestic savings and in large part on the external economy,” says CKGSB’s Li. The Eurozone crisis means that China can’t count on Europe as a big consumer for its products. “We will see only trade volume falling but also a likely rise in disputes with Europe on the trade side,” he says.

With the Euro perpetually on the verge of a breakdown for years now, Chinese companies and policymakers have had some time to plan their response to a crisis. However, if the situation worsens in Europe and in the US, particularly if there is an energy crisis at the same time, exports could be hit hard: the International Monetary Fund predicted in February that a severe downturn in Europe could cut Chinese growth by almost half.

One Asia-based venture capitalist says, on condition of anonymity, that there is no way China can avoid hitting the wall along with the US and Europe. The only way the country might have avoided it, he says, would be if it had a few more years to convert to an economy based on domestic consumption. However, he says, time is evil and the West is collapsing faster than China’s strategy permits.

Overinvestment Concerns

But perhaps the greatest immediate concern is the threat of overinvestment. Superhighways, high-speed trains, airports, buildings, factories, housing – in almost every category, China is building a lot of it. But will the economy be strong enough to use all that capacity?

The question is a crucial one. Development economist te Velde says the trick to avoiding the middle income trap is to make sure that the investment leads to more productivity. “It’s really about making sure that you don’t get stuck in investment only but that investment is leading to productivity change. That’s really important,” he says. Get it right and you end up with a rich country. Get it wrong and the country stops moving forward.

Some numbers suggest that at least a temporary rollback is already underway. In housing, for instance, Jack Rodman, a Seattle-based specialist in Chinese non-performing loans, points to bank analyst estimates that housing prices fell by 20% in 2011. UBS forecasts another 5 -20% drop of house prices in 2012.

Rodman, president of Global Distressed Solutions, says he thinks real loan performance numbers are probably understated at this point. “It would be typical of China to warehouse inventories rather than report they did not meet municipal objectives and disappoint the ‘party officials’,” he says.

Another complicating factor in estimating performance is the size of the informal banking sector. Such ‘shadow banking’ may be almost as large as the formal banking sector, which Rodman estimates loaned RMB 208 billion compared to RMB 211 billion by official banks in 2011.

That could be bad news in the event of a crisis, he says, because informal loans tend to have shorter maturities and higher interest rates than formal loans.

Looking back on all the bubbles in the 40 years of his career, from the savings and loan crisis in the US, to the Japan bubble to the Asian financial crisis to the global financial crisis to the European meltdown, Rodman says the common denominators were always the same: abundant and poorly priced liquidity, rapid loan growth in the banks, a property bubble, misallocation of state assets, a belief that property can only go up, weak regulation, lack of transparency, and bad records. China has all these attributes and more, says Rodman.

Avoiding the Trap

How likely is it that the dragon will step into one of these snares?

Opinion is divided on whether China needs to brace itself for a big economic reversal, but one leading China watcher remains bullish.

“I categorically reject the view of many that the Chinese economy is headed for a hard landing,” well-known economist Stephen Roach told CKGSB Knowledge. “Unlike the case 3-4 years ago, when the global crisis pushed China to the brink of full-blown recession, the deceleration over the past year has been far more benign,” says Roach, a lecturer at the Yale School of Management, the former chairman of Morgan Stanley Asia, and the bank’s chief economist for nearly 30 years. “In fact, the 3.8 percentage point slowing of GDP growth over the most recent four-quarter period is less than half the far more precipitous deceleration of 8.2 percentage points that occurred in the depths of the Great Crisis of 2008-09. Moreover, Chinese authorities have plenty of ammunition to stave off any further downside risks to the economy – short-term policy benchmark lending rates of 6.5% and a fiscal deficit of just 2% of GDP.”

“Compared with the developed world’s zero or near-zero policy interest rates and outsize budget deficits, China is in much better shape to deploy countercyclical stimulus in order to avoid the dreaded hard landing and get on with the heavy lifting of its all-important structural rebalancing,” he says.

Longer term, Roach is also optimistic. “Like any economy, China has plenty of problems that could derail its long-run performance,” Roach says. “But if it stays the course of the pro-consumption rebalancing that is laid out in the 12th Five Year Plan, I am confident that it will avoid the middle-income trap and all the other concerns of the China doomsday crowd.”

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