International | Mar 09 2015
By Andrew Batson of GavekalDragonomics
By lowering its target for China’s GDP growth to around 7% for 2015 from about 7.5% during the past three years, the leadership is finally bowing to the reality of a permanent economic slowdown. This is a good thing: it means less political pressure to build up debt and run polluting factories in pursuit of an unrealistic growth target. And in fact, for the past half-year or so the propaganda apparatus has been trumpeting slower growth as a virtue, under the slogan of “adapting to the new normal.” But how far have China’s famously growth-obsessed leaders really dialed back their expectations? We fear not quite enough. While China can probably manage growth of near (though likely somewhat below) 7% this year, a further slowdown in the coming years looks inevitable.
The “new normal” slogan has some useful ambiguity, as it does not come with a growth number attached. Official statements refer only to the “transition from high growth to medium-high growth,” and leave “medium-high” undefined. But the Chinese establishment appears to think that “medium-high” means at least 7% growth. The State Council’s in-house think tank, the Development Research Center, recently that growth should be around 7% for the rest of the decade. More significantly, the People’s Daily that introduced the “new normal” slogan last August said 7.5% growth is “enough” to meet the existing target of doubling GDP over the decade ending in 2020. (Though given the growth rates of recent years, in fact it would only take 6.6% growth from 2015-20 to achieve this goal.) In practice then, this sloganeering seems to mean that China has given up on pursuing 10% growth, but still wants to keep growth of at least 7%. We do not think this is possible, for at least three reasons: history, housing and leverage.
Let’s start with leverage, one of the key economic issues for China since the massive stimulus that began in 2009. Few dispute that the rapid increase in debt since then—far greater relative to GDP than in the US before the financial crisis—is unsustainable. And indeed over the past two years China’s government has been dialing back credit growth, which is now at less than half its peak rate. But this adjustment process has only just begun, and still has a ways to run: total credit is growing by around 14%, well in excess of 8% nominal GDP growth. For the authorities to stop the nation’s total debt ratio from spiraling, credit growth will need to come down further. And when that happens, GDP growth is going to slow. This is more or less what happened in Taiwan in the mid-1990s, when a new government got leverage under control but at the price of a step-down in GDP growth. China could of course just keep pumping out credit, but Japan’s example suggests that the extreme supply-side distortions resulting from such a policy would drag down growth anyway.
The state of the housing market also does not support the idea that China’s growth has now settled into a nice steady groove. The once-in-a-generation housing boom was clearly a big driver of the 10%-plus growth rates of the previous decade. Since the start of this decade, that boom has obviously cooled, with growth rates for various construction indicators going from 10-20% to the low single digits. The results of that shift are easy to see: iron ore and coal prices have collapsed, and profits in the heavy industrial sector have essentially not grown at all since 2012. But again, the adjustment here is not over yet: our models show that the peak level of housing demand has been reached and that construction volumes will start to decline outright in coming years. In other words, the housing market is in the process of changing from a boost to growth to a drag on growth. This does not mean disaster for the rest of the economy, since consumer spending remains relatively resilient and the services sector is growing smartly. But it also does not suggest that current GDP growth rates of around 7% will be anything like a floor.
Finally, history—which may not repeat itself but does offer plenty of useful examples. China’s planners may hope that economic growth stays steady at 7-7.5% for the rest of the decade. But neither economic logic nor the examples of other developing countries support the idea that China’s potential growth should remain static over long periods of time, in the face of rising incomes and structural change. Indeed as other Asian economies, following development strategies similar to China’s, have gotten richer, their growth rates have gradually but steadily come down. This is not a sign of failure but of success: their “catch-up” growth has brought them so far that there is less and less catching up to do. With China’s per-capita GDP at purchasing-power parity at about US$12,000, it is no longer at an income level where there is much precedent for 7.5% growth. It is much more likely that China’s growth will trend downward over time than that it will stay steady at an arbitrary number, be that 7% or 6% or what have you.
So yes, China’s leadership is right to declare that China’s high-growth phase is over and that the country has entered a “new normal” of slower growth. But they would be wrong to think that China’s economic adjustment is over, and that growth will not slow further.
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