China’s recovery from the international financial crisis, though spectacular, has not been smooth. When the government enacted the stimulus program, recession and large-scale unemployment were its top concerns; less than twelve months later, an overheating economy had become top priority. Now, China is confronting a serious residential housing bubble, large-scale labor unrest, and potential domestic debt problems. Nonetheless, Beijing appears determined to shift its growth model away from external demand and to develop its interior provinces. Prospects for robust GDP growth of 7–8 percent in the years ahead remain good, but domestic efforts to deflate a dangerous property bubble, as well as the sovereign debt crisis in Europe, will likely slow expansion in the near term. A slowdown in China, even if mild, will have important international implications, including lower commodity prices and slow growth in many parts of the world.
The Importance of Domestic Policy
China’s economy began to slow in the second half of 2007—long before the international crisis hit—as a result of domestic policy. Measures aimed at cooling an overheating economy and deflating a potential property bubble turned the housing boom into an unintended bust, dragging down the whole economy in early 2008. The stock market collapsed at the end of October 2007.
After the financial crisis compounded this domestically-engineered slowdown—leading to a near economic standstill in the last quarter of 2008 on a quarter-on-quarter, sequential basis—Beijing announced a massive stimulus program in early November 2008—only seven weeks after the Lehman Brothers collapse. Comprised of consumer subsidies, accelerated infrastructure development (especially in interior provinces), increased budget outlays for health, education, and social security, and plans to dramatically increase the supply of low-cost housing, the program aimed to substitute domestic demand for collapsing external demand.
The stimulus was effective for four reasons:
- Experience: Following the 1997/1998 Asian financial crisis, governments at all levels gained considerable experience with designing and implementing stimulus projects.
- Aligned Interests: Central and local government interests in favor of a new stimulus program were perfectly aligned in November 2008—a relatively rare occurrence in China.
- Funding: After ten years of intensive reform, banks were in relatively good shape and had ample liquidity to help fund the government-mandated lending.
- Starting Position: Unlike the United States, China was not over-leveraged when the crisis hit. Hence, stimulus spending quickly translated into aggregate demand. In contrast, most stimulus spending in the United States compensated for private sector deleveraging at best.
Overheating
The stimulus also had shortcomings. Most importantly, bank credit expanded too much too quickly. The 9.6 trillion RMB credit expansion in 2009—about $1.3 trillion and more than double a “normal” level—quickly replaced fears of deflation with concerns of sharp increases in real estate prices, consumer price inflation, and, even more so, producer price inflation.
Now, property prices are ballooning in select areas and local government debt is raising concerns after excess liquidity led to speculative property buying, including by state units flush with cash. Significantly, however, there is no bubble in equities; on the contrary, the Shanghai Composite Index has fallen by more than 20 percent since the beginning of 2010.
Property Bubble
Like the United States, China is a huge country, and China’s housing bubble is not a national phenomenon. The problem is concentrated in select eastern cities such as Beijing, Shanghai, and Shenzhen, where house prices increased several times faster than the average for 70 major cities in 2009, and in Hainan Island in the South. In those places, affordability for first-time home buyers has become a major problem and a potential source of social unrest.
| City | Average house prices in RMB (per sq. meter) | y/y increase (%) | |
|---|---|---|---|
| Dec. 2008 | Dec. 2009 | ||
| Beijing | 11,881 | 18,401 | 55 |
| Tianjin | 6,939 | 8,122 | 17 |
| Shanghai | 11,913 | 20,144 | 69 |
| Nanjing | 6,153 | 9,218 | 50 |
| Hangzhou | 12,933 | 20,846 | 61 |
| Shenzhen | 11,673 | 23,094 | 98 |
| Guangzhou | 8,012 | 11,677 | 46 |
| Source: William H. Overholt, Harvard University | |||
In contrast to late 2008, when the stimulus package was enacted, the central government is virtually alone in the current struggle against a property bubble. Many local governments have grown dependent on revenue from land leases and now support schemes to drive up local property values and land prices. Property developers and people who already own one or more apartments do not want to deflate the bubble either.
Nonetheless, the government intensified efforts to rein in credit growth in the first quarter of 2010. In order to avoid killing the broader economy’s momentum as it did in 2008, the government relied on administrative measures rather than aggressive monetary tightening, reducing the availability and increasing the cost of credit. It also encouraged banks to refuse credit to people who already own more than one apartment.
It is too early to say whether the central government will succeed, but preliminary indications suggest that markets are responding to its efforts. The three-month moving average of credit growth has declined sharply since March.
As the battle continues, the government is not likely to turn to interest or exchange rate policy. China’s interest and exchange rate policies are very politically sensitive. As a growing number of Chinese economists and policy makers realize that making those policies more flexible is in China’s long-term interest, changes are likely, but probably not in the context of controlling the current property bubble.
Local Government Debt
Local-government owned investment companies undertook most of the borrowing for the stimulus-related infrastructure development. De facto local government debt is believed to have exploded as a result, but reliable information is extremely scarce.
While reports disagree on whether future non-performing loans could threaten financial stability, the threat appears small. Most of the loans are secured (usually with land made available by local governments) and most of the assets created with the loans earn revenue (for example, toll-roads and -bridges, airports, and water supply). In addition, the banking system remains majority government owned and controlled, meaning that there are no creditors who can pull the plug on individual banks. Even if property prices in urban China fall 20–30 percent over the next six to twelve months, as many expect, and the economy continues to slow in the months ahead, a financial crisis is not likely.
Labor Markets and Labor Unrest
One of the most surprising aspects of China’s roller coaster recovery has been the dramatic turnaround in labor markets. In late 2008 and early 2009, many economists expected unemployment, especially of migrants, to remain high for an extended period but the exact opposite appears to have happened, with labor markets tight almost everywhere.1
A combination of factors led to the fall in unemployment: many of the estimated 20 million migrants who were laid off in export zones in 2008 apparently found employment in rural areas (mostly related to stimulus infrastructure projects), where living conditions have been improving steadily for many years, particularly after the government’s enactment of the “harmonious society” policies.2 In addition, demographic shifts have decreased the supply of young migrant workers, particularly women.
Strikes at the company level and calls for independent labor unions (both illegal in China) have become more common, often in spite of police efforts.
The tightening has been remarkable. Real wages are now increasing more sharply than they did earlier this decade. Many municipal and county governments have raised local minimum wages by 20–30 percent in recent months. Perhaps even more telling, strikes at the company level and calls for independent labor unions (both illegal in China) have become more common, often in spite of police efforts. A wave of labor unrest now appears to be engulfing eastern China, with unpredictable consequences.
Rebalancing
Though it is too early to tell, 2009 may have been a turning point in transforming Beijing’s obsolete, export and investment dependent growth model.
Household consumption outpaced GDP growth in 2009—precisely what is needed for rebalancing—and the trend has continued so far in 2010. In addition, with productivity growth likely unable to outpace the steep wage increases in many parts of China, unit labor costs will likely rise in many industries, leading them to relocate to interior provinces or to other emerging economies, such as Vietnam, Bangladesh, and India. This will promote further domestic rebalancing. However, consumption will have to outpace GDP growth for many years before the household consumption/GDP ratio (35.5 percent in 2007, the lowest for any large economy) reaches a “normal” level (around 60 percent).
At the same time, China’s current account surplus as a percentage of GDP continues to decline.3 The surplus fell from 11 percent in 2007 to 9.7 percent in 2008, 5.5 percent in 2009, and, in spite of the unexpectedly large trade surplus in May, less than 2 percent in the first five months of 2010. Current projections place it at around 3 percent of GDP for 2010 as a whole. If China’s import growth continues to outpace its export growth, China will contribute significantly to global rebalancing.
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. With the exception of the market for university graduates, who have been in excess supply since 2008.
2. These aimed to reduce the gaps in incomes and facilities between east, central, and western China.
3. China’s exchange rate policy was not a major factor in either the emergence of unusually large trade surpluses in 2004 or in the decline of those surpluses since 2008.
