As expected, growth and inflation in China have both come down moderately—to 9.1 percent year-over-year in the third quarter and 5.5 percent year-over-year in October, respectively (see charts). This is good news. However, export growth and property markets are stalling, raising the possibility of a sharper slowdown ahead, unless Beijing intervenes with some kind of new economic stimulus program.

China’s challenge is to design a program that avoids rekindling inflation and property bubbles and, at the same time, promotes macroeconomic rebalancing.1 If credit spigots are reopened too much too soon, recent gains on inflation and bubble control will erode quickly, and the task of economic restructuring will become more difficult.

Even with sound management, GDP growth is expected to continue slowing to between 8 and 9 percent in 2012 and between 7 and 8 percent in 2013. Slower but higher quality growth is needed for sustainability. Although the economic challenges China faces are unusually complex, and the coming leadership transition scheduled for late 2012 complicates the situation, widespread fears of a “hard landing” appear overblown.2

China faces the difficult challenge of promoting macroeconomic rebalancing without rekindling inflation and property bubbles.

Property Markets Pose the Most Immediate Risk

At this juncture, the most serious risk facing China’s economy is a steep downward price adjustment in residential property markets.3 A relatively sudden, significant drop in prices (say, by 30 percent) in large parts of the market would precipitate insurmountable liquidity problems for many property developers and construction companies, triggering a chain of supplier bankruptcies. On the other hand, the risk of widespread retail mortgage defaults (which spawned the financial crisis in the United States in 2007) is low because loan-to-value ratios for residential properties are typically very modest in China—on average, only about 40 percent. A key variable to watch in the months ahead, therefore, is the movement of property prices in major cities.

China faces the difficult challenge of promoting macroeconomic rebalancing without rekindling inflation and property bubbles.

Reliable information on changes in residential real estate prices in China, however, is hard to come by. Private sources and anecdotal evidence suggest that average residential real estate prices have fallen by 3 to 10 percent in parts of some major cities over the past four months. The national average price decline for urban China may be on the order of 1 percent. Beijing welcomes the slowdown in property markets, as it has been trying to deflate the housing bubble in an orderly way since December 2009.4 But larger, faster, and more widespread price drops could lead to serious problems for the financial system and the national economy.5

Beijing is not blinking so far; Prime Minister Wen Jiabao recently reaffirmed the government’s commitment to fight inflation and promote stable property markets. Monetary policy is likely to be loosened very slowly. To prevent a sharper-than-desired price drop in commercial real estate, the government’s first line of defense is to relax the administrative restrictions that were introduced to reduce speculative house buying. On the supply side of the urban real estate market, the government’s massive “social” housing program partly compensates for the sharp contraction in commercial housing starts. The rest of the economy, in addition, remains strong enough to absorb the current, relatively mild shocks in real estate.

Export Growth and Competitiveness

The slowdown in the residential property markets is compounded by sluggish export growth (mainly due to anemic growth in the advanced economies) and rising production costs in the manufacturing sector. Export growth slowed to 16 percent year-over-year in October (down 1.2 percentage points from year-over-year growth in September). Import growth picked up, reaching 29 percent year-over-year in October. China’s current account surplus is expected to fall to a little over 4 percent of GDP for 2011 (see chart).

China faces the difficult challenge of promoting macroeconomic rebalancing without rekindling inflation and property bubbles.

Despite the economic slowdown, however, average real wages for blue collar workers are still rising fast,6 faster than productivity growth in many industries.7 Hence, average unit labor costs are increasing in those industries. In addition, exporters have to cope with a rapidly appreciating real RMB/USD exchange rate.8 Margin squeeze and cash flow problems due to high interest rates in informal money markets and real estate price drops in some cities have caused many bankruptcies among manufacturing small and medium enterprises in recent months. It was mainly in response to those problems that the government relaxed some credit controls in October. Total new bank credit increased by almost 25 percent over September, but because of efforts to curb shadow banking, total credit in the economy probably did not change much in October (see chart). Lowering interest rates is not an option at this time, because government-mandated deposit rates remain negative in real terms.

China faces the difficult challenge of promoting macroeconomic rebalancing without rekindling inflation and property bubbles.

Beijing realizes that bankruptcies are an inevitable part of economic adjustment in a market economy (consistent with the current Five Year Plan’s rebalancing objectives) and has so far shown a steady hand in allowing restructuring in manufacturing to proceed. As long as this process is market-driven and consistent with shifting comparative advantage, Beijing should not intervene except to alleviate undue hardship for laid-off workers through social safety nets.

Shadow Banking, an Increasingly Urgent Problem

The rise of shadow banking since 2009 is a potential threat to financial stability.9 It is a consequence of excessive credit expansion during the stimulus years (see previous IEB notes on China) and financial repression. Interest rates in official banking are very low or negative in real terms. These distortions have created possibilities and incentives for off–balance sheet financial intermediation, including the creation of a range of wealth management products by state banks. Meanwhile, nonfinancial corporations have begun to lend surplus cash at free market interest rates.

The solution to the conundrum that this situation has created lies in ending the system of financial repression. The speed at which this can be safely done (including making the exchange rate more flexible and opening the capital account) is a matter of intense debate in China. Beijing cannot continue to rely on second- or third-best administrative measures to reduce the harmful effects of market distortions that are a result of its own policies. An alternative approach to financial sector reform would be to allow shadow banking to gradually take over the system and to abolish interest rate and other key controls once that point is close. Such a “dual track” approach to market reform was successfully tried in agriculture in the early 1980s, for example.

At a Crossroads

China’s economy has arrived at a critical juncture. The observed slowdown since the second quarter of 2011 may continue in an orderly fashion and promote economic rebalancing. But if Beijing makes serious policy mistakes (for example, by loosening monetary policy too quickly), higher inflation, a rekindling of property bubbles, and a “hard landing” could be in store over the next few years. So far the government has shown foresight and restraint in responding to the painful adjustments in manufacturing and construction that are occurring as a result of slower growth and rising production costs. It must continue to support economic restructuring, and even embrace it, with consistency and vigor.

Pieter Bottelier, former chief of the World Bank’s resident mission in Beijing, is a nonresident scholar in Carnegie’s International Economics Program and senior adjunct professor of China Studies at the School of Advanced International Studies (SAIS) at Johns Hopkins University.


1. Rebalancing would entail reducing the economy’s dependence on exports and capital formation while increasing the role of domestic consumption.

2. Under the current circumstances, a “hard landing” for China could be defined as a sudden drop in annual growth to 5 percent or less.

3. The most serious external risk that China’s economy faces is a further drop-off in demand in the advanced economies.

4. Market turnover has been declining for many months. It is widely believed that Beijing aims for an average price drop for commercial residential property in major cities (as distinct from government-subsidized “social” housing) of up to 20 percent over a period of twelve to eighteen months.

5. Because of its high urbanization rate, the share of housing investment in China’s GDP is unusually high (about 10 percent in 2010). Hence, a slowdown in the housing sector reduces GDP growth relatively sharply.

6. Real wage growth in manufacturing in the third quarter slowed to 8 to 9 percent (annualized), as compared to over 10 percent in 2010. If, as expected, economic growth continues to moderate in the months and years ahead, real wage growth will probably slow down further.

7. Demographic factors—a decline in the supply of blue collar workers in younger age groups—are contributing to real wage growth, especially in manufacturing. By contrast, the supply of recent university graduates continues to exceed demand, causing relatively high unemployment and stagnating wages in that part of the labor market.

8. Since China resumed gradual renminbi appreciation against the dollar in July 2010, the nominal and real exchange rates have appreciated by 8 and about 12 percent, respectively. Since the renminbi was first de-linked from the dollar in July 2005, these rates have appreciated by 31 percent and about 40 percent, respectively.

9. Shadow banking refers to financial activity that takes place outside the regulated or monitored parts of the financial sector.