China: rebalancing or end of miracle?

China lowers growth target to 7.5%. What does it say about the economy?

China’s downgrade of its 2012 real GDP growth forecast to 7.5 percent from 8 percent, the target for the previous eight years, has increased global growth anxiety and depressed prices of risk assets, igniting a debate over the future course of Chinese economy. Since China accounts for more than 10 percent of the global gross domestic product (GDP), its hard landing will deal a fatal blow to the global economy. Some underestimate the cut saying that it is just a policy shift to ensure stability. However, if you look deeper, the move spells much more than it says in just the number. The downgrade and policy shift has combined to suggest that China has become more vulnerable to an economic bubble burst and its economy is undergoing transition of growth model. In other words, the manic phase of Chinese growth may be ending. Given that the country is also awaiting a transition in political leadership in October, it will be a highly challenging year for the Chinese economy. For South Korea, China’s political and economic transformation can be the major challenge given its dependence on the neighboring country. Depending on how Korea can cope with it, its fate will change, accordingly. — ED.

By Kim Jae-kyoung

If you recently traveled around China, particularly in big cities, you may have noticed one bizarre thing. There are huge multi-purpose apartment complexes in every city but at night very few lights on, meaning that the majority of new apartments are empty.

Simply put, there are many investment properties bought and sold for profit but only a few for real use. It indicates that there is a huge bubble created by excess borrowing, mismanaged speculation and waste. This does not show every detail of the Chinese economy but it gives a big picture about where it stands, suggesting two important implications.

First, China’s economic structure is fragile and the country is exposed to a serious economic bubble. Second, the Chinese economy will lose growth momentum when its government shifts the focus of policy toward stability from growth.

The recent downgrade of the growth target is the first time in eight years. It was consistently set at 8 percent from 2005 to 2011. The Chinese authorities have said that economic stability is a priority for the country this year.

“China’s economy is facing new problems. Growth is under downward pressure. Prices remain high. Regulation of the real estate market is at a crucial stage,” China’s Premier Wen Jiabao said on March 5 when unveiling the new growth target.

“Our economic work will focus on expanding domestic demand particularly consumer demand which is essential to ensure China’s long-term, steady, and robust economic development,” he added.

Bubble and ‘hard landing’

Now market attention is moving from the eurzone to China as the world’s second-largest economy runs a growing risk of making a hard landing, an event that will have a far-reaching impact on the global economy.

There are two key factors that are fueling fears over China’s hard landing. First, there are growing signs of a bubble bursting in the real estate market. Second, most economic indicators are pointing to a slower growth in the coming months.

According to an analysis by independent economist Andy Xie, China has more housing than it needs, with its living area per capita for over 650 million urban residents already higher than that for Europe and Japan. Properties under construction in his words could house another 200 million people, equivalent to a 15-year increase in the urban population.

“China is experiencing the largest property bubble since Japan’s of two decades ago. While Japan’s price bubble was severe, things may be more serious in the Chinese market because there are distortions in both volume and prices,” Xie told Business Focus.

“China’s bubble seems to be bursting in slow motion because its banking system does not enforce loan contracts. Most developers are technically bankrupt, in my view. Banks and local governments hold them up to make them look alive, hoping that the tide will rise again. That day won’t come,” he added.

After peaking at 14.2 percent in 2007, China’s economic growth has been on a downward curve. It expanded 9.2 percent in 2011. Recent data are forecasting a further slowdown down the road.

China’s industrial production (IP) grew 11.4 percent between January and February year-on-year, the slowest growth since July in 2009. Retail sales value rose 14.7 percent during the same period, a significant slowdown from 18.1 percent in December.

What is most worrisome is that China is running a massive trade deficit. In February, the nation posted a trade deficit of $31.5 billion, the country’s biggest in more than a decade, fueling fears that China’s economy will slow more sharply than before.

The massive deficit was attributed to the Chinese New Year holiday and other one-off factors, but in the broader and longer-term perspective, it implies that consumers in the West — those from the U.S. and Europe — are no longer able to support China’s export-driven economic model.

There are more and more warning signs over China’s hard landing across the globe. Most recently, BHP Billiton, an Australian iron ore mining giant, said last Tuesday that demand growth for iron ore from China slowed to a moderate pace in response to Beijing’s moves to cool its economy.

“The (Chinese) economy is shifting, it’s changing. Steel growth rates will flatten and they have flattened,” Ian Ashby, president of BHP’s iron ore division, said ahead of the Global Iron Ore & Steel Forecast Conference in Perth.

Chinese economy in transition

The Chinese premier’s rhetoric on shifting priority from growth to stability indicates that its leaders are well aware of the seriousness of the economic troubles. The problem is that their approach is not the right solution to resolving structural problems gripping China.

A former Morgan Stanley economist Xie, who closely monitors China,urges the Chinese government to embrace the restructuring (of bad debts) that is needed to sustain economic growth, instead of using its financial muscle merely to delay the inevitable — a painful transition

“China’s bubble has covered up many structural problems. The bubble worked when the benefits from other sources were available to sustain it. As the latter vanish, the bubble deflates. Obviously, it is painful to deal with all the problems at the same time,” he said.

“China’s obsession with stability may lead to greater instability. Reshuffling liquidity to keep everything afloat for now will lead to a collapse later. The right way forward is to accept restructuring, deal with the pain, and be reborn into a more dynamic economy. This way, China could become the world’s largest economy in 10 years.”

China has enjoyed explosive economic growth over the past decade with its nominal GDP quadrupling on the back of robust exports that grew more than seven times during the period. However, its growth isn’t so explosive anymore as its economic model is in transition.

It seems that China’s leaders are well aware of transition of economic growth model, given that they decided to shift the focus of policy from growth to stability and from exports to domestic demand. What they are missing is that without serious reforms, it would just be slower growth, not better quality of life they pursue ahead of the planned change of leadership in the autumn.

According to Natixis, the Chinese economy has moved into new growth stage — where the role of domestic demand grows — from the so-called mercantilist growth model. The French investment bank discerned three successive stages in China’s growth model — Stage 1: 1998-2007; Stage 2: 2008-2021; and Stage 3: after 2022 — and concluded that the country is now moving from stage 1 to stage 2.

“The Chinese economy is shifting gradually toward an increase in the role of domestic demand, a rapid rise in wages driven by the increase in the minimum wage, less robust growth than in the previous period, and higher sophistication of output,” Xu Bei, a China economist for Natixis, said.

Due to this transformation, the Chinese authorities are confronted with a complex economic policy problem. They have to find ways to stimulate the slowing economy without causing excess inflation and bubbles linked to excess liquidity.

“It will be necessary to be able to use instruments that would stimulate investment by private companies — not by local authorities or state-owned companies — or household consumption,” Xu said.

“As long as necessary reforms have not been carried out, and as long as structural imbalances remain, it will be increasingly difficult to produce quality economic growth. 2012 will also be a crucial year that will test the Chinese authorities’ ability to promote sufficiently strong growth and to ensure social harmony.”

Rebalancing

Concerns are growing over a hard landing of the Chinese economy but there are still plenty of people who believe that Beijing will stay the course and sustain robust growth in the years to come. They claim that China is now rebalancing after an extraordinary period of rapid growth and unbalancing that followed WTO accession.

“China’s growth will still be high in the next three years. But if previous history is a guide, no country has been able to match over the very long (100 years) growth rate run of the U.S.,” Mauro F. Giullen, a director at the Lauder Institute at the Wharton School, said.

“The question is whether China will be the first. For that to happen, China needs to avoid a hard landing due to real estate or financial bubbles and to make a transition to a consumer-driven economy,” he added.

ING Group senior Asia economist Tim Condon disagreed with characterization that the economy was a bubble, saying that there was excessive property price inflation and the authorities have taken measures.

“The government’s lowering of the growth target is a signal to sub-national level officials whose promotions depend on exceeding growth targets that slower growth is acceptable if it is accompanied by measures that promote other aims like curbing environmental degradation or reducing income inequality,” he said.

In an article titled “Fears of a hard landing,” The Economist, a British business weekly, said that the (massive trade) deficit has fuelled one fear and one hope.

“The hope is that China is rebalancing, moving away from an economic model reliant on foreign demand. Unfortunately, China has rebalanced externally without rebalancing internally. Its current-account surplus has narrowed largely because of an increase in domestic investment, not consumption,” it said.

Implications for Korea

China is one of the biggest trade partners to Korea. China accounted for almost a quarter of Korea’s export market last year. How the Chinese economy will handle its transition will have a direct impact on Asia’s fourth-largest economy.

In fact, China’s policy shift from external to domestic demand is a double-edged sword. China’s slower growth will hurt Korea’s exporters, while expanding domestic demand will create opportunities for Korean firms.

HSBC economist Ronald Man points out that declines in shipment of advanced electronics and chemicals — goods that Korea holds a strong net surplus against China — are likely to hurt the domestic economy most.

“Korean manufacturers may operate significantly below capacity for an extended period, potentially keeping the unemployment rate at elevated levels. In such a scenario, the (Korea’s) finance ministry may extend fiscal stimulus to support growth,” he added.

On the other hand, there is an opposite view that even as Chinese economic growth is slowing down, if China switches its growth engine from external to domestic demand successfully, this is quite good news for Korea thanks to Korean exporters’ strategy.

“Many countries export to China because they have relocated some of their industries in China due to low costs, and then products are exported from China to the rest of the world,” Xu of Natixis said.

“But Korea always has a more Chinese-demand-oriented strategy compared to other trade partners. Hence Korean products are very well positioned compared to for example Taiwanese products.”

In order to capitalize on China’s economic transition, Korea should diversify its export markets in the long term while making efforts to keep its industrial specialisation and innovation as it did with Japan and Taiwan.

“Korea will need to find other markets, especially for its intermediate and production goods (in order to brace for a slowing Chinese economy),” Guillen of the Wharton School said.

According to the Korea Center for International Finance, Korea’s exports to China rose 14.9 percent in 2011, well below the nation’s average export growth of 19.4 percent. This is in a stark contrast to the average growth rate for exports to China for the past decade staying well above that for the nation’s overall exports.