China’s investment binge of 2009-10 is dragging down its economy
China’s policymakers obviously recognised the challenge in 2008. Unfortunately,they botched their policy response. Instead of channelling resources to boost domestic consumption and the private sector,Beijing splurged roughly $2 trillion on fixed investments,most of them undertaken by local governments and state-owned enterprises. Predictably,such investments,financed largely by bank debt,were doomed to be unproductive.
Not too long ago,few people thought that the mighty Chinese economy,which registered an average annual growth rate of 10 per cent between 1979 and 2009,could slow down. Some economists used linear assumptions to project that the Chinese economy could overtake the American economy in size before 2020.
As with similar overly optimistic projections about the Soviet economy and the Japanese economy,the forecast of an ever-rising China now seems grossly off the mark. The latest growth data released by Beijing showed Chinese GDP rose 7.7 per cent in the first quarter of 2013. On its own (and if we accept Chinese official numbers as honest ones),this should be respectable growth. But the worlds financial markets reacted poorly. Share prices plunged. The reason? The number came in below expectations. Nearly everybody was counting on China to grow close to 8 per cent.
Although it is possible that financial markets may have overreacted to Chinas sub-par growth data,the fact that the Chinese economy has been slowing is hardly in dispute. Since it last recorded double-digit growth (10.4 per cent) in 2010,the Chinese economy has decelerated rapidly,falling to 9.3 per cent in 2011 and 7.8 per cent in 2012. Taken together,the magnitude of GDP deceleration was roughly 25 per cent.
There is no shortage of theories about the slowdown of the Chinese economy. The anaemic global economy is an obvious culprit. As the worlds largest exporting power (by volume),Chinas fortune is closely tied to the rest of the world. In particular,Chinas main export markets the United States,Europe and Japan,which account for 60 per cent of Chinese merchandise exports have been struggling with financial deleveraging,debt crisis and high unemployment. However,a poor external environment is only partly responsible for the great Chinese slowdown. While net exports contributed roughly 25 per cent of Chinas GDP growth between 2001 and 2008,their contribution to GDP growth has been negative since. In other words,in the last four years,the Chinese economy has relied almost exclusively on domestic investment and consumption for growth.
That is where the main causes of the economic slowdown lie. In the fast-growth period,China depended on three engines to power its economy: exports,investment and consumption. Exports and investment contributed roughly 60 per cent of the growth,with 40 per cent coming from consumption. But as the share of contribution to GDP growth from exports becomes negative,investment and consumption must make up the shortfall.
Chinas policymakers obviously recognised this challenge in 2008. Unfortunately,they botched their policy response. Instead of channelling resources to boost domestic consumption and the private sector,Beijing splurged roughly $2 trillion on fixed investments,most of them undertaken by local governments and state-owned enterprises. Predictably,such investments,financed largely by bank debt,were doomed to be unproductive.
But for the short-term 2009 and 2010 the Chinese GDP maintained its speed because massive fixed asset investments fuelled the economy. The rest of the world cheered. Many intelligent people went so far as to claim that only a one-party regime could deliver such an effective policy response.
Little did they know that a significant portion of the Chinese stimulus went into useless projects. Local governments went on a spending spree,building shining office buildings,shopping malls,highways,bridges and power plants. Real estate developers erected pricey apartment buildings to capitalise on sky-rocketing property prices. State-owned enterprises expanded their production capacity indiscriminately.
Today,the investment binge of 2009-2010 is dragging down economic growth through two channels. The financial leveraging in this period,during which Chinese banks issued new loans worth $3.6 trillion (about 43 per cent of the Chinese GDP in 2011),led to a massive build-up of debt accumulated by Chinese cities and corporations. While the Chinese government has not disclosed the percentage of non-performing loans on the books of Chinese banks,many economists following China believe the number is substantial. At the moment,Chinese banks have not recognised these loans as non-performing,mainly because Beijing has not pushed them to do so. However,the highly indebted local governments and corporations have become huge credit risks and,as a consequence,are finding it harder to draw new loans to survive. That is the reason why Chinas shadow banking system has grown explosively in the past few years. These entities are now issuing high-yield securities called wealth management products and,through Chinese banks,selling them to unsuspecting Chinese savers seeking better returns. The assets in the shadow banking system are estimated to be 10-15 per cent of those in the banking sector (which equal to roughly 300 per cent of the GDP). Credit tightening,prompted by rising credit risks,thus effectively shuts off access to capital for risky borrowers,thus slowing down growth. Of course,China can stimulate growth by loosening credit,as it has done in recent months. Unfortunately,even loosening is delivering less bang for the buck because the economy is highly inefficient.
This leads us to the second channel through which the stimulus of 2009-2010 is holding back growth. The massive investments in manufacturing capacity,which began earlier last decade but got a boost during this period,produced enormous overcapacity in many industries in China. As a result,profit margins have been squeezed,if not destroyed. Heavily indebted Chinese corporations,even when they get new credit,can only use it to service old loans,instead of producing for profit. Such zombie companies now dot the Chinese industrial landscape.
Without addressing the two interconnected problems of over-leveraging and excess capacity,the Chinese economy is likely to stagnate and face its own version of a debt crisis at some point in the near future. Obviously,with a closed capital account and near-total government control of the banks,a rapid meltdown of the Chinese financial sector,such as the one the world witnessed following the collapse of Lehman Brothers in September 2008,is unlikely. But the drag on growth caused by over-leveraging and excess capacity is both real and substantial.
For Chinas new leaders,financial de-leveraging and industrial consolidation are among their top economic priorities. Unfortunately,these two tasks,critically important for sustaining long-term growth,will mean only more bad news to come. If accomplished,they could further depress short-term growth.
The writer is a professor of government and non-resident senior fellow at the German Marshall Fund of the US