China's Surprising Rebalancing Act

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China performed better than expected in 2011, managing major risks and serving as the world’s strongest economic engine. In early 2012, China is making progress towards rebalancing as its external surplus continues to shrink.
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China’s economy fared better than most had expected in 2011. Though growth has gently slowed, it remains the world’s best performing large economy and strongest economic engine.

Beijing faced a number of economic risks last year but overcame at least some of them. With a more balanced external account and lower inflation, China’s growth pattern is becoming more sustainable. But it still needs to balance investment and consumption growth.

With 9.2 percent year-over-year growth for 2011 as a whole (see figure), China’s contribution to global GDP growth fell to about one-third in 2011, and the country is facing new challenges in 2012.

China performed better than expected in 2011, managing major risks and serving as the world’s strongest economic engine. In early 2012, China is making progress towards rebalancing as its external surplus continues to shrink.

But the risk of a “hard landing” has diminished and now appears small. China’s external surplus (measured by its current account surplus-to-GDP ratio) declined in 2011 and is expected to fall further in 2012, even as its rate of growth remains very high—a projected 8.5 percent in 2012.

This relatively optimistic outlook for China’s near-term future is based, in part, on slightly improved global indicators and an unexpected uptick in China’s Manufacturing Purchasing Managers Index (PMI) for January (to 50.5, see figure). Together with a sharper uptick in the Small Business Manufacturing PMI (to 52), this suggests that the expected gradual slowdown in manufacturing output and employment growth in 2012 may be more modest than previously thought.

A look back at 2011

At the beginning of 2011, there were four major risks facing the Chinese economy:

  1. Relatively high and rising inflation, driven by domestic food shortages, exceptional growth in the money supply in 2009–2010 resulting from Beijing’s huge stimulus program, and rising commodity prices;
  2. A residential housing bubble in some big eastern cities that threatened to spin out of control;
  3. The possibility of a local government debt crisis; and
  4. Slowing external demand due to the recession in Europe and slow recovery in the United States combined with the risk of intensified international trade disputes.

China performed better than expected in 2011, managing major risks and serving as the world’s strongest economic engine. In early 2012, China is making progress towards rebalancing as its external surplus continues to shrink.

Of these risk factors, inflation was at the top of Beijing’s list of economic worries for much of the year. By November, the problem was essentially under control. Although the Consumer Price Index (CPI) rose to 4.5 percent year-over-year in January 2012 (see figure) from 4.1 percent in December, the increase was very likely due to the Chinese New Year celebrations and will not persist. Average CPI inflation for 2012 as a whole is expected to be between 3 and 4 percent. Commodity prices for the most part stabilized or declined in the second half of 2011.

The present significance of housing-related risk is harder to assess. As a result of increasingly serious efforts by the central government since April 2010 to control the surge in prices, market turnover fell sharply from mid-2011, and house prices have trended down in most large cities from around October. This looks like a successful bubble-control experiment, but there is no guarantee that the problem will not reappear—or that prices may not decline even more sharply. At the beginning of 2012, the latter is the bigger risk.

China performed better than expected in 2011, managing major risks and serving as the world’s strongest economic engine. In early 2012, China is making progress towards rebalancing as its external surplus continues to shrink.

If prices begin to fall more sharply than the 5 to 10 percent observed in most major cities so far, an avalanche of bankruptcies among China’s more than 10,000 often highly leveraged property developers and a sharp contraction in new construction may result.1 Since housing construction in China accounts for an unusually large share of GDP (almost 10 percent in 2010), a sharp slowdown in that sector, combined with an associated drop in land values, may cause serious complications for China, including fiscal problems for many local governments.2

With respect to urban housing, Beijing is facing a major dilemma: it wants to bring prices in major cities down to more affordable levels for social reasons (home ownership) while avoiding a sharp slowdown in overall growth so as to protect social and political stability. So far Beijing has stood firm in resisting pressures from local governments to relax administrative restrictions on house purchases. Nonetheless, a possible sharp decline in housing prices and land values is a significant downside risk for the economy in 2012.

The bulk of China’s huge stimulus program, begun at the end of 2008, was 80 percent bank-credit financed, and a large part of the enormous credit expansion in 2009 and 2010 was due to borrowing by thousands of investment companies owned by local governments (so-called “platform” companies) for the financing of infrastructure. China’s National Audit Office calculated that local government debt at the end of 2010 stood at no less than RMB 10.7 trillion (about 26 percent of that year’s GDP), considerably more than central government debt. Since many stimulus-related projects gestate over longer periods than loan maturities (three to five years), or are otherwise unable to generate sufficient cash flow to service the loans, many economists feared that a local government debt crisis would be hard to avoid.

On February 12, 2012, Beijing allayed such anxieties by announcing that it had instructed state banks to roll over stimulus loans that would otherwise become non-performing. This is a powerful illustration of how China can (and does) manage its financial system in ways that would be unthinkable in advanced capitalist economies. Although some loans will eventually become non-performing, a local government debt crisis seems unlikely.

Finally, trade disputes between China and its major trading partners intensified in 2011 but do not appear to have been reflected in the headline trade numbers. Growing at 20.4 percent in 2010, China’s exports in 2011 held up better than expected. As imports grew faster than exports, the country’s trade surplus shrank. The contribution of China’s net exports to GDP growth has indeed been negative in two out of the last three years (2009 and 2011, see figure).

Is China’s economy rebalancing?

There is strong evidence that the economy is rebalancing externally—domestic demand is rising relative to exports—but not (yet) internally, in the sense that China’s exceptionally low household consumption-to-GDP ratio (about 34 percent in 2011) failed to increase.3 However, the current account surplus, which peaked at over 10 percent of GDP in 2007, has since declined as a percentage of GDP, to well under 4 percent in 2011—the benchmark figure for an economy’s external imbalance proposed by U.S. Treasury Secretary Timothy Geithner. Based on provisional estimates, China’s current account surplus-to-GDP ratio in 2011 was 3.7 percent (about half of what the IMF projected in April). A UBS research bulletin dated February 17, 2012, puts it even lower (2.7 percent).

Gradual appreciation of the renminbi has undoubtedly helped to reduce China’s external surplus by making foreign goods cheaper. Since its currency was first de-linked from the dollar in July 2005, the nominal RMB/USD exchange rate has appreciated about 30 percent and the real rate over 40 percent.

The contribution of net exports to China’s growth has diminished sharply since the peak years of export growth (2005–2007), but the contribution of investment—which was already very high by international standards—has further increased (see figure). Some analysts express concern that China is not promoting domestic consumption growth enough and is overinvesting in residential housing and infrastructure, making the economy even more unbalanced. China’s household consumption-to-GDP ratio is indeed very low by international standards (the corresponding ratio for the United States is about 70 percent). Still, its rate of household consumption growth has been the highest in the world over the past decade, by far.

China performed better than expected in 2011, managing major risks and serving as the world’s strongest economic engine. In early 2012, China is making progress towards rebalancing as its external surplus continues to shrink.

Moreover, a declining return on domestic capital investment does not necessarily mean that China is overinvesting or that the economy is becoming more unbalanced. The alternative to additional domestic investment—investing in U.S. Treasury bills with a 2 percent return—is not appealing.

As long as domestic consumption in China is growing very fast and the country’s external surplus is declining, the country’s low household consumption-to-GDP ratio is not a problem for the rest of the world. Nonetheless, the composition of China’s investment should change in the direction of additional spending on social services.

Opinions differ on the prospects for China’s external surplus. For instance, the International Monetary Fund forecasted that the country’s external surplus-to-GDP ratio would quickly increase when demand from advanced economies recovered. It has recently revised that projection downward by a significant margin.

Whatever the prospects, the best way to promote further economic rebalancing in China is to reduce and eventually eliminate controls on domestic interest rates and to make the exchange rate more flexible. If China’s current account surplus-to-GDP ratio stabilizes around 3 percent or less in 2012, it will be hard to argue that the renminbi remains seriously undervalued. When it comes to rebalancing, the future long discussed may finally be arriving.

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]. Retail mortgage defaults cannot be ruled out but are less likely in China than defaults by developers, because loan-value ratios for retail mortgages are typically very low, on average only about 40 percent.

[2]. Over the past decade, many local governments have become very dependent on revenues from long-term land leases and sometimes resist central government efforts to control the housing bubble because of their depressing effect on land values.

[3]. China’s overall consumption (households plus government)-to-GDP ratio is around 50 percent, which is also very low by international standards.

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About the International Economics Program

The Carnegie International Economics Program monitors and analyzes short- and long-term trends in the global economy, including macroeconomic developments, trade, commodities, and capital flows, drawing out their policy implications. The current focus of the program is the global financial crisis and its related policy issues. The program also examines the ramifications of the rising weight of developing countries in the global economy among other areas of research.




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