China’s economy faces the specter of a hard landing. Property bubbles, mounting local-government debt and wayward shadow-banking activities are generating considerable financial risk, complicating the government’s efforts to address rising labor costs, excessive credit, overwhelming pollution, rampant corruption, an undeveloped tax system and rising international competition.
Any strategy for mitigating the threat of a sharp slowdown must account for the dual nature of China’s economy. On the one hand, Chinese cities are becoming increasingly modern and globally engaged. China’s 17 most dynamic cities — which together account for 11 percent of the population and about 30 percent of GDP — have already reached high-income status, as defined by the World Bank, and the country is set to overtake the United States as the world’s top e-commerce market.
On the other hand, half of China’s population remains rural, deriving a large share of income from agricultural activities. According to MasterCard, 25 percent of consumer payments are still made in cash, implying that China’s informal economy remains much more robust than believed.
This duality has positive implications for China’s economic prospects. While its coastal manufacturing activities have fueled much of the economy’s growth over the last few decades, the country’s rural, inland economies will remain strong drivers of growth as domestic consumption rises. In other words, China has an even larger and more diversified economic base than many realize — implying a degree of growth momentum that would be difficult to lose.
It helps that, with $3.8 trillion in foreign-exchange reserves and a large (though declining) current-account surplus, China’s economy does not depend on foreign saving and investment. Local-government liabilities and nonperforming loans are thus a domestic problem, whose only real spillover effects would stem from debt-redistribution efforts.
Monetary and fiscal tightening aimed at curtailing credit expansion runs the risk of undermining GDP growth and reducing Chinese demand for commodities. This would hurt commodity-exporting emerging economies, many of which already suffer from capital flight, owing to the U.S. Federal Reserve’s monetary-policy reversal.
In this dualistic environment, China must calibrate its market-oriented reform strategy carefully to ensure that it does not create any new and unexpected systemic risks, while overcoming the vested interests that resist substantive reforms aimed at leveling the playing field.
Achieving this will require that China address another, more problematic dualism in its economy: the two-tiered credit system. Given excess domestic savings, a tightly controlled capital account and rapid credit creation, interest rates have been low relative to demand since 2005.
With the formal banking sector subject to strict controls on deposit and lending rates, large state-owned enterprises and local governments were the only entities that could access enough credit to finance large-scale infrastructure projects and the like.
After the 2008 global financial crisis weakened export growth, the private sector began to move toward nontradable goods and services, particularly property. This shift — together with the declining current-account surplus and massive infrastructure investment — put upward pressure on domestic interest rates.
While the authorities could keep official interest rates under control, unofficial rates began to rise irrepressibly, fueling the rapid expansion of shadow banking.
Easy credit caused property prices to skyrocket, from ¥2,291 ($374) per square meter, on average, in 2002 to ¥5,791 a decade later, as measured in 70 large and medium-size Chinese cities. The question now concerns the degree to which this increase reflected rising productivity and prosperity — as did comparable gains in newly industrialized economies like Japan, Hong Kong, Taiwan, and Korea — rather than speculation motivated by easy credit.
Given that China’s 17 top-performing cities are roughly one-third as productive as Hong Kong, where per capita GDP is three times higher, it is not surprising that their property prices amount to about one-third of Hong Kong’s. Rapidly rising property prices in some of China’s less dynamic cities are leading to outward labor flows, turning them effectively into shiny ghost towns.
In pursuing interest-rate liberalization, China must unify formal and informal rates, which requires action at both the macro and micro levels. Specifically China’s leaders must reform micro-institutions to facilitate the market-driven process of creative destruction, such as through institutionalized bankruptcy processes that help to eliminate ghost cities and failed real-estate projects, thereby minimizing the associated macroeconomic disruption.
Furthermore, relying largely on tightening credit to limit risks also raises new complications. While broader structural economic change requires tighter monetary policy and lower inflation, excessively tight monetary policy, given continued high credit demand, could disrupt the adjustment process.
In fact, the slowdown in money-supply growth — from roughly 25 percent in 2009 to roughly 14 percent today — has paralleled the shadow-banking sector’s rapid expansion. As of the end of 2012, shadow banking accounted for 24 percent of total credit, at interest rates 10 to 15 percent higher than official rates.
This has hurt the real economy by increasing the cost of capital. Unless inefficient borrowers exit the market or declare bankruptcy, they will continue to disrupt resource allocation, crowding out more productive firms.
The key to merging interest rates thus lies in reforming the credit-allocation mechanism to provide more capital to well-performing projects and enforce hard budget constraints on poor-performing borrowers. While this will inevitably trigger some defaults and erode the quality of banks’ loan portfolios, the end result — a more balanced and healthy economy — will be more than worth it.
Andrew Sheng is president of the Fung Global Institute and an adjunct professor at Tsinghua University in Beijing. Xiao Geng is director of research at the Fung Global Institute. © 2014 Project Syndicate
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