China’s Economy Suffering Cancer?

The sharp slowdown in China’s economy has policy makers around the world watching carefully. Will the government have the courage to change course?

The unexpectedly sharp slowdown of the Chinese economy has fanned anxieties around the world. Based on the latest figures released by the Chinese government, the economy slowed more than expected in the first quarter of this year compared with the fourth quarter of last year. Is the once unstoppable Chinese economic growth engine grinding to a halt?

For the West, deteriorating growth in China is obviously bad news. With Europe sinking into recession and the United States mired in an anemic recovery, growth in emerging markets, China in particular, has been a bright spot in an otherwise bleak economic landscape. As the world’s second-largest economy, annual growth at high single digit (8 percent to 9 percent) makes China the largest contributor to global GDP growth. Now that China is faltering, many worry not only about the effects of China’s stagnant growth on the rest of the world, but also about its impact on China itself.
On the surface, the recent precipitous drop in growth in China is the result of two factors. The first is the tightening of monetary policy adopted last year to cool the real estate market and fight inflation. 

The second is the rapid decline of export orders for Chinese goods, a development closely associated with the escalating debt crisis in Europe.

Had the Chinese economy been more balanced between domestic demand and exports and between household consumption and investment, monetary tightening and falling exports would not have had such dampening effects on growth. But the Chinese economy is highly unbalanced (although compared with a few years ago, China’s internal-external imbalances have moderated significantly), thus making the country less able to cope with the knock-on effects of credit-tightening and disappearing external demands.
In the short-term, most analysts are worried about a possible “heart attack” for the Chinese economy. Under this nightmarish scenario, plunging growth will expose China’s highly leveraged local governments, real estate developers and state-owned enterprises to the risks of insolvency and default while China’s export sector, dominated by foreign companies and domestic small and medium-sized private firms, contracts and lays off workers. The nasty feed-back loop looks like this: falling growth will greatly reduce the financial viability of the projects in which China has overinvested in the last three years. Such projects include real estate developments, heavy industries, and infrastructure (the most infamous example being the scandal-ridden high-speed rail system). Falling growth means lower demand. These projects won’t be able to charge higher enough prices to make a profit. Because they were financed with bank debt, it’s almost certain many of these projects will default.

In most other countries, such a crash would lead to a banking crisis, hence the “heart attack” scenario.

But China is different. Because the banking system is effectively owned and controlled by the state, a banking crisis won’t materialize unless the state itself is insolvent and Chinese depositors have completely lost confidence in the state’s sovereign guarantee of its banks. This unique character of the China’s state-owned financial system is the cause of the country’s inability to allocate capital efficiently. However, in the short term, this structural flaw may turn out to be an asset in averting a seizure of the financial system.

The Chinese government has already taken measures to prevent such a seizure. Last year, Beijing ordered a one-year moratorium on repayment of loans made to local governments and their highly leveraged financing platforms, thus delaying the day of reckoning. As the economy continues to struggle, one should expect the Chinese government to extend this moratorium to give local governments more time.

What about the banks? As state-owned institutions, these banks are in no position to say no to Beijing. Financially, these banks are under little pressure. Ever greening the loans by extending the repayment moratorium or rolling over the loans will technically maintain their “performing” status. Because interest rates are determined by the government, Chinese banks pay depositors nothing and have ultra-low funding costs. So carrying these effectively dud loans on their books does not cost banks real money. Ultimately, the Chinese government will have to cough up real money to bail out either local governments or help the banks write off these bad loans. But that is far away, and the Chinese state probably has enough resources (issuance of sovereign debt, sale of land and shares in huge state monopolies like the China Mobile, Petro-China, and the like) to pay for one more round of bank recapitalization.

Another short-term trick is to loosen the financial spigot. The People’s Bank of China has already lowered the reserve ratio, making more bank loans available. This measure is unlikely to work if effective demand remains weak and borrowers have no new projects to invest in. But if Beijing asks its local governments and state-owned enterprises to tap the banking system and use such “free money” to firing up short-term growth at all cost, this tactic might jump-start stalled growth.

That, however, could be disastrous for China’s long-term prospects. Despite the threat of a seizure in the near term, the greater danger to the Chinese economy is its structural inefficiency, which is deeply imbedded in a state-led development model.

In this model, the Chinese state collects an excessive amount of revenue (the current estimate puts effective aggregate taxes at nearly 35 percent of GDP), provides inadequate social services, and allocates most of the capital inefficiently through a highly politicized banking system (in which loans are made on the basis of government policy and political connections, not market principles). To use a medical metaphor, this model is the cancer that will kill China’s long-term prosperity.

By all accounts, the Chinese people have already paid a huge price for this cancer. Their share of the national income has fallen to 42 percent of GDP. That is why Chinese household consumption, at 35 percent of GDP, remains the lowest of the world’s major economies. The investments made by the Chinese state may have given the Communist Party a lot of prestige (think of the country’s modern infrastructure and ambitious high-tech plans), but delivers preciously few real benefits to its people. Chinese state-owned enterprises have thrived because of their access to practically free capital, but their efficiency remains abysmal compared with domestic private firms or their Western rivals.

In a crisis, a far-sighted government should have the courage to push through tough reforms and remove these “cancerous cells” in the Chinese economy. So today, Beijing must try a different strategy to revive its growth. Tax cuts, deregulation, privatization, and increasing funding for social services can all help raise domestic consumption and promote growth. The other option – repeating the folly of stimulating the economy through state-led investment – would make China’s economic cancer all but incurable.