The new normal: Can slowing China escape the middle income trap?

China’s economy has slowed in the past five years, but debt has bloomed.

The global sentiment towards China has turned to one of fear of a financial crisis like in the US in 2008. But China’s situation is very different from the US. On the positive side, China still has great potential. Its economy could double or triple with the right policies. On the downside, the required reforms appear to be inconsistent with the existing political system.

Various indicators, such as energy consumption, freight transportation or export volume, suggest that China’s economy has slowed by half from the dozen preceding years. Dollar GDP growth has slowed to 8% per annum in the past five years from 19% in the dozen years earlier.

Double-digit growth rate never lasts forever. Slowdown per se shouldn’t be viewed with alarm. The perception of instability stems from the government’s constant efforts, mainly through increasing credit with declining standards, to prop up the low growth rate. If one extrapolates, an ever-declining growth rate and rising leverage would lead to a debt crisis.

The argument against a financial crisis is China’s high savings rate. China’s debt is financed with domestic savings. Indeed, the country is running nearly half a trillion dollars in trade surplus — a form of savings surplus. This argument works if the savings have a strong local bias, as in Japan. Recent experience suggests China isn’t like Japan.

About $2 trillion has left China in the past two years. If not stopped, China would certainly have experienced a financial crisis. This is where China’s strong government has come into play.

Tighter rules on capital outflows have stabilised foreign exchange reserves. It seems that a strong government is the factor that can stop a liquidity-led financial crisis.

China has been a great economic success. From 1999-2011, GDP and exports were rising at about 20% per annum in dollar terms. Something similar was observed earlier in Japan, South Korea and Taiwan. The East Asian export model is about recycling export income into investment to expand export capacity.

When Japan slowed down in the 1980s, its income was already similar to that in the West. South Korea and Taiwan made it to about half of that. China is slowing at only one-fifth of the OECD level. And herein lies China’s dilemma.

China is too big to export all the way to the top income bracket. But the government is unwilling to shift to a balanced growth model at so low an income level.

It is sticking to investments while export dollars are not rolling in like before. This is the reason for rising indebtedness: the debt is rising like before, but the GDP tide is not.

China can solve all its problems through structural reforms. The key is to scale back investments to fit in with slower growth. If the potential growth rate is 5%, which I believe to be the case, investment needs to fall from 45% to 25% of GDP.

China’s investment model is based on the government’s ability to raise financing with whatever means are available at its disposal.

Like Japan and South Korea of yore, much of the vaunted high East Asian savings rate is forced, reflecting government power rather than people’s behaviour. If China abandons forced savings policies, the economy will be rebalanced, and the financial system will become stable.

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